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(G&K SERVICES LOGO)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


F O R M 10 - Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarter Ended March 27, 2004 Commission file number 0-4063

G&K SERVICES, INC.

(Exact name of registrant as specified in its charter)
     
MINNESOTA   41-0449530

 
 
 
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

5995 OPUS PARKWAY, SUITE 500
MINNETONKA, MINNESOTA 55343
(Address of principal executive offices and zip code)

(952) 912-5500
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES   x        NO    o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YES  x        NO  o

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

     
CLASS A   Outstanding May 3, 2004
Common Stock, par value $0.50 per share   19,392,506
     
CLASS B   Outstanding May 3, 2004
Common Stock, par value $0.50 per share   1,474,996

 


G&K Services, Inc.
Form 10-Q

Table of Contents

             
PART I       PAGE
  Financial Statements        
 
           
  Consolidated Condensed Balance Sheets as of        
 
  March 27, 2004 and June 28, 2003     3  
 
           
  Consolidated Statements of Operations for the three and nine months ended        
 
  March 27, 2004 and March 29, 2003     4  
 
           
  Consolidated Condensed Statements of Cash Flows for the nine        
 
  months ended March 27, 2004 and March 29, 2003     5  
 
           
  Notes to Consolidated Condensed Financial Statements     6  
 
           
  Management’s Discussion and Analysis of Financial Condition and        
 
  Results of Operations     12  
 
           
  Quantitative and Qualitative Disclosure About Market Risk     19  
 
           
  Controls and Procedures     19  
 
           
           
  Exhibits and Reports on Form 8-K     20  
        21  
 Certification of CEO - Section 302
 Certification of CFO - Section 302
 Certification of CEO - Section 906
 Certification of CFO - Section 906

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PART I
FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CONSOLIDATED CONDENSED BALANCE SHEETS
G&K Services, Inc. and Subsidiaries
                 
    March 27,   June 28,
(In thousands)
  2004
  2003
  (Unaudited)  
ASSETS
               
Current Assets
               
Cash and cash equivalents
  $ 24,757     $ 11,504  
Accounts receivable, less allowance for doubtful accounts of $3,234 and $3,687
    68,462       69,839  
Inventories
    90,911       95,853  
Prepaid expenses
    8,688       14,848  
 
   
 
     
 
 
Total current assets
    192,818       192,044  
 
   
 
     
 
 
Property, Plant and Equipment, net
    244,028       250,757  
Goodwill
    285,148       266,140  
Other Assets
    72,901       69,865  
 
   
 
     
 
 
 
  $ 794,895     $ 778,806  
 
   
 
     
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities
               
Accounts payable
  $ 17,608     $ 20,228  
Accrued expenses
    83,617       68,679  
Deferred income taxes
    13,742       13,459  
Current maturities of long-term debt
    24,321       14,430  
 
   
 
     
 
 
Total current liabilities
    139,288       116,796  
 
   
 
     
 
 
Long-Term Debt, net of Current Maturities
    193,899       236,731  
Deferred Income Taxes
    30,627       28,667  
Other Noncurrent Liabilities
    19,402       16,343  
Stockholders’ Equity
    411,679       380,269  
 
   
 
     
 
 
 
  $ 794,895     $ 778,806  
 
   
 
     
 
 

The accompanying notes are an integral part of these consolidated condensed financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS
G&K Services, Inc. and Subsidiaries
(Unaudited)

                                 
    For the Three Months Ended
  For the Nine Months Ended
    March 27,   March 29,   March 27,   March 29,
(In thousands, except per share data)
  2004
  2003
  2004
  2003
Revenues
                               
Rental operations
  $ 173,531     $ 171,065     $ 521,431     $ 508,149  
Direct sales
    5,494       5,455       18,736       17,822  
 
   
 
     
 
     
 
     
 
 
Total revenues
    179,025       176,520       540,167       525,971  
 
   
 
     
 
     
 
     
 
 
Operating Expenses
                               
Cost of rental operations
    110,382       108,524       331,289       316,084  
Cost of direct sales
    4,061       4,566       14,145       13,494  
Selling and administrative
    37,353       40,070       114,677       115,552  
Depreciation and amortization
    9,865       9,511       29,328       27,984  
 
   
 
     
 
     
 
     
 
 
Total operating expenses
    161,661       162,671       489,439       473,114  
 
   
 
     
 
     
 
     
 
 
Income from Operations
    17,364       13,849       50,728       52,857  
Interest expense
    2,826       3,406       8,914       10,198  
 
   
 
     
 
     
 
     
 
 
Income before Income Taxes
    14,538       10,443       41,814       42,659  
Provision for income taxes
    5,524       4,073       15,889       16,637  
 
   
 
     
 
     
 
     
 
 
Net Income
  $ 9,014     $ 6,370     $ 25,925     $ 26,022  
 
   
 
     
 
     
 
     
 
 
Basic weighted average number of shares outstanding
    20,767       20,608       20,681       20,574  
Basic Earnings per Common Share
  $ 0.43     $ 0.31     $ 1.25     $ 1.26  
 
   
 
     
 
     
 
     
 
 
Diluted weighted average number of shares outstanding
    20,974       20,676       20,851       20,707  
Diluted Earnings per Common Share
  $ 0.43     $ 0.31     $ 1.24     $ 1.26  
 
   
 
     
 
     
 
     
 
 
Dividends per share
  $ 0.0175     $ 0.0175     $ 0.0525     $ 0.0525  

The accompanying notes are an integral part of these consolidated condensed financial statements.

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CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
G&K Services, Inc. and Subsidiaries
(Unaudited)

                 
    For the Nine Months Ended
    March 27,   March 29,
(In thousands)
  2004
  2003
Operating Activities:
               
Net income
  $ 25,925     $ 26,022  
Adjustments to reconcile net income to net cash provided by operating activities -
               
Depreciation and amortization
    29,328       27,984  
Deferred income taxes
    671       (320 )
Amortization of deferred compensation – restricted stock
    659       768  
Changes in current operating items, exclusive of acquisitions
    24,758       17,945  
Other, net
    308       867  
 
   
 
     
 
 
Net cash provided by operating activities
    81,649       73,266  
 
   
 
     
 
 
Investing Activities:
               
Property, plant and equipment additions, net
    (12,790 )     (24,703 )
Acquisitions of business assets and other
    (26,082 )     (75,795 )
 
   
 
     
 
 
Net cash used for investing activities
    (38,872 )     (100,498 )
 
   
 
     
 
 
Financing Activities:
               
Proceeds from debt financing
    141,026       166,814  
Repayments of debt financing
    (173,428 )     (135,225 )
Cash dividends paid
    (1,090 )     (1,088 )
Sale of common stock
    3,714       500  
 
   
 
     
 
 
Net cash provided by (used for) financing activities
    (29,778 )     31,001  
 
   
 
     
 
 
Increase in Cash and Cash Equivalents
    12,999       3,769  
Effect of Exchange Rates on Cash
    254       295  
 
Cash and Cash Equivalents:
               
Beginning of period
    11,504       9,986  
 
   
 
     
 
 
End of period
  $ 24,757     $ 14,050  
 
   
 
     
 
 

The accompanying notes are an integral part of these consolidated condensed financial statements.

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G&K SERVICES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Amounts in thousands, except per share data)
Three and nine month periods ended March 27, 2004 and March 29, 2003
(Unaudited)

    The consolidated condensed financial statements included herein, except for the June 28, 2003 balance sheet which was derived from the audited consolidated financial statements for the fiscal year ended June 28, 2003, have been prepared by G&K Services, Inc. (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of the Company, the accompanying unaudited consolidated condensed financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of the Company as of March 27, 2004, and the results of its operations for the three and nine months ended and its cash flows for the nine months ended March 27, 2004 and March 29, 2003. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures herein are adequate to make the information presented not misleading. It is suggested that these consolidated condensed financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s latest report on Form 10-K.
 
    The results of operations for the three and nine month periods ended March 27, 2004 and March 29, 2003 are not necessarily indicative of the results to be expected for the full year.
 
1.   Summary of Significant Accounting Policies
 
    Accounting policies followed by the Company are set forth in Note 1 in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2003.
 
    Nature of Business
 
    G&K Services, Inc. is a market leader in providing corporate identity apparel and facility services programs to a wide variety of industrial, service and high-technology companies. The Company’s apparel programs provide rental-lease or purchase options as well as non-apparel items such as floor mats, dust mops, wiping towels, selected linen items and several restroom products. The Company also manufactures certain uniform garments that it uses to support its garment rental programs.
 
    Principles of Consolidation
 
    The accompanying consolidated condensed financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned. Intercompany balances and transactions have been eliminated in consolidation.
 
    Revenue Recognition
 
    The Company recognizes revenue from rental operations in the period in which the services are provided. Direct sale revenue is recognized in the period in which the product is shipped.

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    Derivative Financial Instruments
 
    The Company uses derivative financial instruments principally to manage the risk that changes in interest rates will affect the amount of its future interest payments. Interest rate swap contracts are used to adjust the proportion of total debt that is subject to variable and fixed interest rates. The interest rate swap contracts are reflected at fair value in the consolidated condensed balance sheet and the related gains or losses on these contracts are deferred in stockholders’ equity (as a component of other comprehensive income). Amounts to be paid or received under the contracts are accrued as interest rates change and are recognized over the life of the contracts as an adjustment to interest expense. The net effect of this accounting is that interest expense on the portion of variable rate debt being hedged is at a fixed rate during the interest rate swap contract period.
 
    The Company may periodically hedge firm cash flow commitments with its foreign subsidiary, generally with foreign currency contracts. These agreements are recorded at current market values and the gains and losses are included in earnings. Gains and losses on such transactions were not significant in the third quarter of fiscal 2004 or fiscal 2003. Notional amounts outstanding under foreign currency contracts at March 27, 2004 were $424, all of which will mature during fiscal 2004. Notional amounts outstanding under foreign currency contracts at March 29, 2003 were $2,524, all of which matured during fiscal 2003. Foreign currency contracts were recorded at fair value as of March 27, 2004.
 
    Per Share Data
 
    Basic earnings per common share was computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share was computed similar to the computation of basic earnings per share, except that the denominator is increased for the assumed exercise of dilutive options and other dilutive securities, including nonvested restricted stock, using the treasury stock method.

                                 
    Three Months Ended
  Nine Months Ended
    March 27,   March 29,   March 27,   March 29,
    2004
  2003
  2004
  2003
Weighted average number of common shares outstanding used in computation of basic earnings per share
    20,767       20,608       20,681       20,574  
Weighted average effect of nonvested restricted stock grants and assumed exercise of options
    207       68       170       133  
 
   
 
     
 
     
 
     
 
 
Shares used in computation of diluted earnings per share
    20,974       20,676       20,851       20,707  
 
   
 
     
 
     
 
     
 
 

    Stock-Based Compensation
 
    The Company maintains Stock Option and Compensation Plans (the “Employee Plans”), which are more fully described in Note 6 in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2003. The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock option plans. Accordingly, only compensation cost related to restricted stock issued under the Employee Plans has been recognized in the accompanying consolidated statements of operations. Compensation cost related to the restricted shares was $192 and $224 for the three-month periods and

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    $659 and $768 for the nine-month periods ended March 27, 2004 and March 29, 2003, respectively. Had compensation cost been recognized based on the fair values of options at the grant dates consistent with the provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company’s net income and net income per common share would have been adjusted as follows:

                                 
    Three Months Ended
  Nine Months Ended
    March 27,   March 29,   March 27,   March 29,
    2004
  2003
  2004
  2003
Net income, as reported
  $ 9,014     $ 6,370     $ 25,925     $ 26,022  
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    (398 )     (298 )     (1,348 )     (1,228 )
 
   
 
     
 
     
 
     
 
 
Pro forma net income
  $ 8,616     $ 6,072     $ 24,577     $ 24,794  
 
   
 
     
 
     
 
     
 
 
Basic net income per share:
                               
As reported
  $ 0.43     $ 0.31     $ 1.25     $ 1.26  
Pro forma
    0.42       0.29       1.19       1.21  
Diluted net income per share:
                               
As reported
  $ 0.43     $ 0.31     $ 1.24     $ 1.26  
Pro forma
    0.41       0.29       1.18       1.20  
 
   
 
     
 
     
 
     
 
 

    Recent Accounting Pronouncements
 
    In December 2003, the Financial Accounting Standards Board revised SFAS No. 132, “Employer’s Disclosures About Pensions and Other Postretirement Benefits” (“SFAS 132”). The FASB’s revision of Statement No. 132 requires new annual disclosures about the types of plan assets, investment strategy, measurement date, plan obligations and cash flows as well as the components of the net periodic benefit cost recognized in interim periods. The Company adopted the disclosure requirements of SFAS 132 (revised) beginning with the third quarter ended March 27, 2004.
 
2.   Comprehensive Income
 
    For the three and nine month periods ended March 27, 2004 and March 29, 2003, the components of comprehensive income were as follows:

                                 
    Three Months Ended
  Nine Months Ended
    March 27,   March 29,   March 27,   March 29,
    2004
  2003
  2004
  2003
Net income
  $ 9,014     $ 6,370     $ 25,925     $ 26,022  
Other comprehensive income
                               
Foreign currency translation adjustments, net of tax
    (635 )     4,793       1,867       2,822  
Net unrealized holding gain on derivative financial instruments, net of tax
    9       128       335       98  
 
   
 
     
 
     
 
     
 
 
Comprehensive income
  $ 8,388     $ 11,291     $ 28,127     $ 28,942  
 
   
 
     
 
     
 
     
 
 

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3.   Goodwill and Intangible Assets
 
    In July 2001, the Company adopted the provisions of SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill and Other Intangible Assets.” The changes in the carrying amount of goodwill for the nine months ended March 27, 2004, by operating segment, are as follows:

                         
    United States
  Canada
  Total
Balance as of June 28, 2003
  $ 236,913     $ 29,227     $ 266,140  
Acquired goodwill
    18,458             18,458  
Other, primarily foreign currency translation
          550       550  
 
   
 
     
 
     
 
 
Balance as of March 27, 2004
  $ 255,371     $ 29,777     $ 285,148  
 
   
 
     
 
     
 
 

    Information regarding the Company’s other intangible assets are as follows:

                         
    As of March 27, 2004
    Carrying   Accumulated    
    Amount
  Amortization
  Net
Customer contracts and related customer relationships
  $ 81,896     $ 37,214     $ 44,682  
Non-competition agreements
    9,819       5,772       4,047  
 
   
 
     
 
     
 
 
Total
  $ 91,715     $ 42,986     $ 48,729  
 
   
 
     
 
     
 
 
                         
    As of June 28, 2003
    Carrying   Accumulated    
    Amount
  Amortization
  Net
Customer contracts and related customer relationships
  $ 76,853     $ 31,919     $ 44,934  
Non-competition agreements
    9,721       5,055       4,666  
 
   
 
     
 
     
 
 
Total
  $ 86,574     $ 36,974     $ 49,600  
 
   
 
     
 
     
 
 

    Amortization expense was $5,891 and $5,362 for the nine months ended March 27, 2004 and March 29, 2003, respectively. Estimated amortization expense for each of the five succeeding fiscal years based on the intangible assets as of March 27, 2004 is as follows:

         
2004 remaining
  $ 2,024  
2005
    8,065  
2006
    7,737  
2007
    7,612  
2008
    7,239  
2009
    3,563  
 
   
 
 

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4.   Long-Term Debt
 
    The Company maintains a $325,000 term loan and revolving credit facility. On December 17, 2003 the credit facility was amended to revise certain restrictive covenants providing additional flexibility in meeting our capital needs. Under the amended credit facility, the Company is required to maintain a minimum fixed charge coverage ratio, minimum stockholders’ equity and a maximum leverage ratio, all as defined. As of March 27, 2004, the Company was in compliance with all debt covenants.
 
5.   Employee Benefit Plans
 
    The components of net periodic pension cost are as follows for the three months ended March 27, 2004 and March 29, 2003:

                                 
                    Supplemental Executive
    Pension Plan
  Retirement Plan
    Three Months Ended
  Three Months Ended
    March 27,   March 29,   March 27,   March 29,
    2004
  2003
  2004
  2003
Service cost
  $ 987     $ 668     $ 183     $ 105  
Interest cost
    629       516       142       152  
Expected return on assets
    (379 )     (386 )            
Prior service cost
    14       14       9       19  
(Gain) loss
    263             78       18  
 
   
 
     
 
     
 
     
 
 
Net periodic pension cost
  $ 1,514     $ 812     $ 412     $ 294  
 
   
 
     
 
     
 
     
 
 

    The components of net periodic pension cost are as follows for the nine months ended March 27, 2004 and March 29, 2003:

                                 
                    Supplemental Executive
    Pension Plan
  Retirement Plan
    Nine Months Ended
  Nine Months Ended
    March 27,   March 29,   March 27,   March 29,
    2004
  2003
  2004
  2003
Service cost
  $ 2,969     $ 1,873     $ 547     $ 263  
Interest cost
    1,890       1,447       428       379  
Expected return on assets
    (1,139 )     (1,082 )            
Prior service cost
    42       40       27       47  
(Gain) loss
    791             235       45  
 
   
 
     
 
     
 
     
 
 
Net periodic pension cost
  $ 4,553     $ 2,278     $ 1,237     $ 734  
 
   
 
     
 
     
 
     
 
 

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6.   Segment Information
 
    The Company has two operating segments under the guidelines of SFAS No. 131: United States and Canada, which have been identified as components of the Company that are reviewed by the Company’s Chief Executive Officer to determine resource allocation and evaluate performance. Each operating segment derives revenues from the corporate identity apparel and facility services industry, which includes garment rental and non-apparel items such as floor mats, dust mops, wiping towels, selected linen items and several restroom products. No one customer’s transactions account for 1.0% or more of the Company’s revenues.
 
    The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 1). Corporate expenses are allocated to the segments based on segment revenue. The Company evaluates performance based on income from operations. Financial information by geographic location for the three and nine month periods ended March 27, 2004 and March 29, 2003 is as follows:

                         
    United        
For the Three Months Ended
  States
  Canada
  Total
Third Quarter Fiscal Year 2004:
                       
Revenues
  $ 153,696     $ 25,329     $ 179,025  
Income from operations
    12,442       4,922       17,364  
Property, plant and equipment additions, net
    3,807       611       4,418  
Depreciation and amortization
    8,771       1,094       9,865  
Third Quarter Fiscal Year 2003:
                       
Revenues
  $ 154,793     $ 21,727     $ 176,520  
Income from operations
    11,000       2,849       13,849  
Property, plant and equipment additions, net
    4,170       2,459       6,629  
Depreciation and amortization
    8,669       842       9,511  
 
   
 
     
 
     
 
 
                         
    United        
For the Nine Months Ended
  States
  Canada
  Total
Fiscal Year 2004:
                       
Revenues
  $ 466,662     $ 73,505     $ 540,167  
Income from operations
    36,824       13,904       50,728  
Property, plant and equipment additions, net
    11,278       1,512       12,790  
Depreciation and amortization
    26,069       3,259       29,328  
Fiscal Year 2003:
                       
Revenues
  $ 462,678     $ 63,293     $ 525,971  
Income from operations
    41,227       11,630       52,857  
Property, plant and equipment additions, net
    17,011       7,692       24,703  
Depreciation and amortization
    25,420       2,564       27,984  
 
   
 
     
 
     
 
 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Unaudited)

Overview

G&K Services, Inc., founded in 1902 and headquartered in Minnetonka, Minnesota, is a market leader in providing corporate identity apparel and facility services programs to a wide variety of North American industrial, service and high-technology companies. We rent uniforms and other related products such as floor mats, dust mops, wiping towels, restroom supplies and selected linen items. We also sell uniforms and other apparel items to customers in our direct sale programs. The North American rental market is approximately $6.3 billion, while the direct sales market, targeted by us, is approximately $4.5-$5.0 billion in size.

Critical Accounting Policies

The discussion of the financial condition and results of operations are based upon the consolidated condensed financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. As such, management is required to make certain estimates, judgments and assumptions that are believed to be reasonable based on the information available. These estimates and assumptions affect the reported amount of assets and liabilities, revenues and expenses, and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. See Note 1 to the consolidated condensed financial statements for additional discussion of the application of these and other accounting policies.

Revenue Recognition and Allowance for Doubtful Accounts

Our rental operations business is largely based on written service agreements whereby we agree to collect, launder and deliver uniforms and other related products. The service agreements provide for weekly billing upon completion of the laundering process and delivery to the customer. Accordingly, we recognize revenue from rental operations in the period in which the services are provided. Direct sale revenue is recognized in the period in which the product is shipped.

Estimates are used in determining the collectibility of billed accounts receivable. Management analyzes specific accounts receivable and historical bad debt experience, customer credit worthiness, current economic trends and the age of outstanding balances when evaluating the adequacy of the allowance for doubtful accounts. Significant management judgments and estimates are used in connection with establishing the allowance in any accounting period. Material differences may result in the amount and timing of bad debt expense recognition for any given period if management makes different judgments or utilizes different estimates.

Inventories

Our inventories consist of new goods and rental merchandise in service. Estimates are used in determining the likelihood that new goods on hand can be sold to customers or used in rental operations. Historical inventory usage and current revenue trends are considered in estimating both obsolete and excess inventories. New goods are stated at lower of cost or market, net of any reserve for obsolete or excess inventory. Merchandise placed in service to support rental operations is amortized into cost of rental operations over the estimated useful lives of the underlying inventory items, primarily on a straight-line basis, which results in a matching of the cost of the merchandise with the weekly rental revenue generated by merchandise. Estimated lives of rental merchandise in service range from nine months to three years. In establishing estimated lives for merchandise in service, management considers historical experience and the intended use of the merchandise. Material differences may result in the amount and timing of operating profit for any period if management makes different judgments or utilizes different estimates.

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Goodwill, Intangibles and Other Long-Lived Assets

We adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) at the beginning of fiscal 2002 and as a result no longer amortize goodwill. SFAS 142 also requires that companies test goodwill for impairment on an annual basis and when events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit to which goodwill is assigned below its carrying amount. Our evaluation considers changes in the operating environment, competitive information, market trends, operating performance and cash flow modeling. Management completes its annual impairment test in the fourth quarter of each fiscal year and there have been no impairments of goodwill or definite-lived intangible assets in fiscal 2003 or through the first nine months of fiscal 2004. Future events could cause management to conclude that impairment indicators exist and that goodwill and other intangibles associated with acquired businesses are impaired. Any resulting impairment loss could have a material impact on our financial condition and results of operations.

Property, plant and equipment and definite-lived intangible assets are depreciated or amortized over their useful lives. Useful lives are based on management estimates of the period that the assets will generate revenue. Long-lived assets are evaluated for impairment whenever events and circumstances indicate an asset may be impaired. There have been no write-downs of any long-lived assets in fiscal 2003 or through the first nine months of fiscal 2004.

Insurance

We self-insure for certain obligations related to health and workers’ compensation programs. We purchase stop-loss insurance policies to protect us from catastrophic losses. Estimates are used in determining the potential liability associated with reported claims and for losses that have occurred, but have not been reported. Management estimates consider historical claims experience, escalating medical cost trends, expected timing of claim payments and an actuarial analysis provided by a third party. Changes in the cost of medical care, our ability to settle claims and the estimates and judgment used by management could have a material impact on the amount and timing of expense for any period.

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Results of Operations

The percentage relationships to net sales of certain income and expense items for the three and nine month periods ended March 27, 2004 and March 29, 2003, and the percentage changes in these income and expense items between periods are presented in the following table:

                                                 
    Three Months   Nine Months   Percentage
    Ended
  Ended
  Change
                                    Three Months   Nine Months
    March 27,   March 29,   March 27,   March 29,   FY 2004   FY 2004
    2004
  2003
  2004
  2003
  vs. FY 2003
  vs. FY 2003
Revenues:
                                               
Rental
    96.9 %     96.9 %     96.5 %     96.6 %     1.4 %     2.6 %
Direct
    3.1       3.1       3.5       3.4       0.7       5.1  
 
   
 
     
 
     
 
     
 
                 
Total revenues
    100.0       100.0       100.0       100.0       1.4       2.7  
Expenses:
                                               
Cost of rental sales
    63.6       63.4       63.5       62.2       1.7       4.8  
Cost of direct sales
    73.9       83.7       75.5       75.7       (11.1 )     4.8  
 
   
 
     
 
     
 
     
 
                 
Total cost of sales
    63.9       64.1       63.9       62.7       1.2       4.8  
Selling and administrative
    20.9       22.7       21.2       22.0       (6.8 )     (0.8 )
Depreciation and amortization
    5.5       5.4       5.5       5.3       3.7       4.8  
 
   
 
     
 
     
 
     
 
                 
Income from operations
    9.7       7.8       9.4       10.0       25.4       (4.0 )
Interest expense
    1.6       1.9       1.7       1.9       (17.0 )     (12.6 )
 
   
 
     
 
     
 
     
 
                 
Income before income taxes
    8.1       5.9       7.7       8.1       39.2       (2.0 )
Provision for income taxes
    3.1       2.3       2.9       3.2       35.6       (4.5 )
 
   
 
     
 
     
 
     
 
                 
Net income
    5.0 %     3.6 %     4.8 %     4.9 %     41.5 %     (0.4 )%
 
   
 
     
 
     
 
     
 
                 

Three months ended March 27, 2004 compared to three months ended March 29, 2003

Revenues. Total revenues in the third quarter of fiscal 2004 increased 1.4% to $179.0 million from $176.5 million in the third quarter of fiscal 2003. Rental revenue increased $2.5 million in the third quarter, or 1.4%. The organic industrial rental growth rate, which is calculated using industrial rental revenue adjusted for foreign currency exchange rate differences and revenue from newly acquired business compared to prior-period results, was approximately negative 2.0%. We believe that the organic industrial rental growth rate better reflects the growth of our existing industrial business and is therefore useful in analyzing our financial condition and results of operations.

Direct sale revenue was up 0.7% over last year at $5.5 million in the third quarter of fiscal 2004, largely consistent with the amount reported in the same period of fiscal 2003.

Cost of Rental and Direct Sale. Cost of rental operations increased 1.7% to $110.4 million in the third quarter of fiscal 2004 from $108.5 million in the same period of fiscal 2003. Gross margin from rental sales decreased to 36.4% in the third quarter of fiscal 2004 from 36.6% in the third quarter of fiscal 2003. The decrease in rental gross margins was due to employee benefit costs (including pension), higher energy costs and lost margin from lower employment levels within our existing customer base. Both rental and direct sale margins in the prior-year quarter were negatively impacted by the closing of the Canadian manufacturing facility. Total one-time expenses related to closing the facility reduced the overall combined margin by 0.6% in the quarter and will have minimal impact on future results of operations.

We have plans to shift production of certain high-volume core products to our Dominican Republic garment manufacturing facility. This will create excess capacity at our United States manufacturing facility and allow us to begin producing a variety of specialized garments currently sourced from outside vendors. The impact of these changes is expected to improve gross margins by approximately 50 basis points over the next two years.

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Cost of direct sales decreased 11.1% to $4.1 million in the third quarter of fiscal 2004 from $4.6 million in the same period of fiscal 2003. Gross margin from direct sales increased to 26.1% in the third quarter of fiscal 2004 from 16.3% in the third quarter of fiscal 2003. The increase in gross margin was due to the impact of liquidating remaining inventories with the closing of the Canadian manufacturing facility in the third quarter of fiscal 2003.

Selling and Administrative. Selling and administrative expenses decreased to $37.4 million in the third quarter of fiscal 2004 from $40.1 million in the same period of fiscal 2003. As a percentage of total revenues, selling and administrative expenses decreased to 20.9% in the third quarter of fiscal 2004 from 22.7% in the third quarter of fiscal 2003. The decrease as a percent of revenue was due to reduced expenses related to uncollectible accounts receivable and selling expenses. Additionally, during the prior-year period, we took actions to reduce certain selling and administrative costs, including the closing of the Canadian manufacturing facility, and incurred severance and other employee-related costs. These actions had an impact of increasing selling and administrative expenses in the prior-year quarter as a percent of total revenue by 0.5% and did not have a significant impact on results of operations in subsequent periods.

Depreciation and Amortization. Depreciation and amortization expense increased 3.7% to $9.9 million in the third quarter of fiscal 2004 from $9.5 million in the same period of fiscal 2003. As a percentage of total revenues, depreciation and amortization expense increased to 5.5% in the third quarter of fiscal 2004 from 5.4% in the third quarter of fiscal 2003. Capital expenditures, excluding acquisition of businesses, were $4.4 million in the third quarter of fiscal 2004 compared to $6.6 million in the prior year’s quarter. The lower level of capital expenditures was primarily due to timing of new plant construction and a continued focus on asset utilization.

Interest Expense. Interest expense was $2.8 million in the third quarter of fiscal 2004, down from $3.4 million in the same period of fiscal 2003. This decrease was due primarily to lower debt levels.

Provision for Income Taxes. Our effective tax rate decreased to 38.0% in the third quarter of fiscal 2004 from 39.0% in the same period of fiscal 2003 largely due to decreases in Canadian statutory income tax rates.

Nine months ended March 27, 2004 compared to nine months ended March 29, 2003

Revenues. Total revenues for the first nine months of fiscal 2004 increased 2.7% to $540.2 million from $526.0 million for the same period of fiscal 2003. Rental revenue increased $13.3 million in the first nine months, or 2.6%. The organic industrial rental growth rate, which is calculated using industrial rental revenue adjusted for foreign currency exchange rate differences and revenue from newly acquired business compared to prior-period results, was approximately negative 1.7%. We believe that the organic industrial rental growth rate better reflects the growth of our existing industrial business and is therefore useful in analyzing our financial condition and results of operations.

Direct sale revenue increased 5.1% to $18.7 million in the first nine months of fiscal 2004 compared to $17.8 million in the same period of fiscal 2003. The increase in revenue was driven by a focused effort to provide direct sale garment solutions to our existing rental customers.

Cost of Rental and Direct Sale. Cost of rental operations increased 4.8% to $331.3 million in the first nine months of fiscal 2004 from $316.1 million in the same period of fiscal 2003. Gross margin from rental sales decreased to 36.5% in the first nine months of fiscal 2004 from 37.8% in the same period of fiscal 2003. The decrease in rental gross margins was due to employee benefit costs (including pension), higher energy costs, acquisition integration, expenses related to closing a manufacturing facility and plant consolidation costs and lost margin from lower employment levels within our existing customer base.

Cost of direct sales increased 4.8% to $14.1 million in the first nine months of fiscal 2004 from $13.5 million in the same period of fiscal 2003. Gross margin from direct sales increased to 24.5% in the first nine months of fiscal 2004 from 24.3% in the same period of fiscal 2003.

Selling and Administrative. Selling and administrative expenses decreased 0.8% to $114.7 million in the first nine months of fiscal 2004 from $115.6 million in the same period of fiscal 2003. As a percentage of total revenues, selling and administrative expenses decreased to 21.2% in the first nine months of fiscal 2004 from 22.0% in the same period of fiscal 2003. Reduced expense related to uncollectible accounts

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receivable, reduced selling expenses and severance costs included in the prior-year quarter were partially offset by increased employee benefit costs, including pension.

Depreciation and Amortization. Depreciation and amortization expense increased 4.8% to $29.3 million in the first nine months of fiscal 2004 from $28.0 million in the same period of fiscal 2003. As a percentage of total revenues, depreciation and amortization expense increased to 5.5% in the first nine months of fiscal 2004 from 5.3% in the same period of fiscal 2003. Capital expenditures, excluding acquisition of businesses, were $12.8 million in the first nine months of fiscal 2004 compared to $24.7 million in the same period of fiscal 2003. The lower level of capital expenditures was primarily due to timing of new plant construction and a continued focus on asset utilization.

Interest Expense. Interest expense was $8.9 million in the first nine months of fiscal 2004, down from $10.2 million in the same period of fiscal 2003.

Provision for Income Taxes. Our effective tax rate decreased to 38.0% in the first nine months of fiscal 2004 from 39.0% in the same period of fiscal 2003 due largely to decreases in Canadian statutory income tax rates.

Liquidity, Capital Resources and Financial Condition

Our primary sources of cash are net cash flows from operations and borrowings under our credit facilities. Primary uses of cash are interest payments on indebtedness, capital expenditures, acquisitions and general corporate purposes.

Operating Activities. Net cash provided by operating activities was $81.6 million in the first nine months of fiscal 2004 and $73.3 million in the same period of fiscal 2003. Operating cash flow was up over the prior year due to effective working capital management including management of new and in-service inventory levels, a continued focus on timely collection of accounts receivable and timing of payments for various liabilities.

Working capital at March 27, 2004 was $53.5 million, down 28.9% from $75.2 million at June 28, 2003. The decrease is due to an increase in the current maturities of long-term debt associated with scheduled debt payments and an increase in income tax payable due to timing of payments.

Investing Activities. Net cash used in investing activities was $38.9 million in the first nine months of fiscal 2004 and $100.5 million in the same period of fiscal 2003. In both fiscal 2004 and 2003, cash was primarily used for acquisition of business assets and property, plant and equipment additions.

Financing Activities. Cash used for financing activities was $29.8 million in the first nine months of fiscal 2004 and cash provided by financing activities was $31.0 million in the same period of fiscal 2003. Cash used in fiscal 2004 was primarily related to the repayment of long-term debt. Cash provided in fiscal 2003 was from debt proceeds used primarily for acquisitions of businesses. The Company paid dividends of $1.1 million during the first nine months of fiscal 2004.

We maintain a $325.0 million term loan and revolving credit facility. On December 17, 2003 the credit facility was amended to revise certain restrictive covenants providing additional flexibility in meeting our capital needs. Under the amended credit facility, we are required to maintain a minimum fixed charge coverage ratio, minimum stockholders’ equity and a maximum leverage ratio, all as defined. As of March 27, 2004, we were in compliance with all debt covenants.

Cash Obligations. Under various agreements, we are obligated to make future cash payments in fixed amounts. These include payments under the variable rate term loan and revolving credit facility, the fixed rate term loan, capital lease obligations and rent payments required under non-cancelable operating leases with initial or remaining terms in excess of one year.

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The following table summarizes our fixed cash obligations as of March 27, 2004 for the fiscal years ending June (in thousands):

                                                         
                                            2009 and    
    2004                                   There-    
    Remaining
  2005
  2006
  2007
  2008
  after
  Total
Variable rate term loan and revolving credit facility
  $ 2,813     $ 15,000     $ 18,750     $ 22,500     $ 105,000     $     $ 164,063  
Fixed rate term loan
          7,143       7,143       7,143       7,143       21,428       50,000  
Other debt arrangements, including capital leases
    1,863       1,734       531       29                   4,157  
Operating leases
    3,473       12,920       10,347       8,475       6,633       4,121       45,969  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Total contractual cash obligations
  $ 8,149     $ 36,797     $ 36,771     $ 38,147     $ 118,776     $ 25,549     $ 264,189  
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
 

Also, at March 27, 2004, we had stand-by letters of credit totaling $17.6 million that have been issued and are outstanding, primarily in connection with our property and casualty insurance programs. No amounts have been drawn upon these letters of credit.

At March 27, 2004, we had available cash on hand of $24.8 million and over $100.0 million of available capacity under our revolving credit facility. We anticipate that we will generate sufficient cash flows from operations to satisfy our cash commitments and capital requirements for fiscal 2004; however, we may utilize borrowings under the revolving credit facility to supplement our cash requirements from time to time.

The amount of cash flow generated from operations is subject to a number of risks and uncertainties. In fiscal 2004, we may actively seek and consider acquisitions of business assets, the consummation of any acquisition could affect our liquidity profile and level of outstanding debt. We believe that available capacity under our revolving credit facility will be adequate to finance any such acquisitions and planned capital expenditures in fiscal 2004.

On October 22, 2003, we filed a registration statement with the Securities and Exchange Commission to issue, at an indeterminate date, debt securities, Class A Common Stock and securities warrants with an aggregate initial offering price not to exceed $200 million. The SEC declared this registration statement effective on November 5, 2003. The securities covered by the registration statement, which may be offered in one or more offerings and in any combination, would in each case be offered pursuant to a prospectus supplement that will describe the specific types, amounts, price and other terms of the offered securities. Unless the applicable prospectus supplement states otherwise, the net proceeds from any sale of the offered securities would be used for working capital, the repayment of indebtedness, the funding of certain expenditures in connection with acquisitions and for general corporate purposes. Currently, we have no specific plans to issue any securities under the registration statement.

Pension Obligations

We account for our defined benefit pension plan using Statement of Financial Accounting Standards No. 87 “Employer’s Accounting for Pensions” (“SFAS 87”). Under SFAS 87, pension expense is recognized on an accrual basis over employees’ approximate service periods. Pension expense calculated under SFAS 87 is generally independent of funding decisions or requirements. We recognized expense for our defined benefit pension plan of $1.5 million in the third quarter of fiscal 2004 and $0.8 million in the same period of fiscal 2003. At June 28, 2003, the fair value of our pension plan assets totaled $16.8 million. Lower investment returns, benefit payments and declining discount rates resulted in additional minimum pension liability of $2.9 million (net of tax of $1.7 million) as of June 28, 2003. We made a cash contribution of approximately $2.8 million in the first quarter of fiscal 2004.

The calculation of pension expense and the corresponding liability requires the use of a number of critical assumptions, including the expected long-term rate of return on plan assets and the assumed discount rate. Changes in these assumptions can result in different expense and liability amounts, and future actual experience can differ from these assumptions. Pension expense increases as the expected rate of return on pension plan assets decreases.

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At June 28, 2003, we estimated that the pension plan assets will generate a long-term rate of return of 8.0%. This rate was developed by evaluating input from our actuary as well as long-term inflation assumptions. The expected long-term rate of return on plan assets at June 28, 2003 is based on an allocation of U.S. equities and U.S. fixed income securities. Decreasing the expected long-term rate of return by 0.5% (from 8.0% to 7.5%) would increase our estimated fiscal 2004 pension expense by approximately $0.1 million. Pension liability and future pension expense increase as the discount rate is reduced. We discounted future pension obligations using a rate of 6.0% at June 28, 2003. The discount rate is determined based on the current rates earned on high quality long-term bonds. Decreasing the discount rate by 0.5% (from 6.0% to 5.5%) would have increased our accumulated benefit obligation at June 28, 2003 by approximately $3.4 million and increased the estimated fiscal 2004 pension expense by approximately $1.0 million.

Future changes in plan asset returns, assumed discount rates and various other factors related to the participants in our pension plan will impact our future pension expense and liabilities. We cannot predict with certainty what these factors will be in the future.

Impact of Inflation

In general, management believes that our results of operations are not dependent on moderate changes in the inflation rate. Historically, we have been able to manage the impact of more significant changes in inflation rates through our customer relationships, customer agreements that generally provide for price increases consistent with the rate of inflation or 5.0%, whichever is greater, and continued focus on improvements of operational productivity.

Significant increases in energy costs, specifically natural gas and gasoline, can materially affect our results of operations and financial condition. Currently, energy costs represent between 3-4% of our total revenue.

Litigation

We are involved in a variety of legal actions relating to personal injury, customer contracts, employment, trade practices, environmental and other legal matters that arise in the normal course of business. These legal actions include lawsuits that challenge the practice of charging for certain environmental services on invoices, being named, along with other defendants, as a potentially responsible party at certain waste disposal sites where ground water contamination has been detected or is suspected and a lawsuit in California that alleges G&K violated certain state wage and hour laws applicable to its route representatives. None of these legal actions are expected to have a material adverse effect on our results of operations or financial position.

Recent Accounting Pronouncements

In December 2003, the Financial Accounting Standards Board revised SFAS No. 132, “Employer’s Disclosures About Pensions and Other Postretirement Benefits” (“SFAS 132”). The FASB’s revision of Statement No. 132 requires new annual disclosures about the types of plan assets, investment strategy, measurement date, plan obligations and cash flows as well as the components of the net periodic benefit cost recognized in interim periods. We adopted the disclosure requirements of SFAS 132 (revised) beginning with the third quarter ended March 27, 2004.

Cautionary Statements Regarding Forward-Looking Statements

The Private Securities Litigation Reform Act of 1995 (the “Act”) provides companies with a “safe harbor” when making forward-looking statements as a way of encouraging them to furnish their shareholders with information regarding expected trends in their operating results, anticipated business developments and other prospective information. Statements made in this report concerning our intentions, expectations or predictions about future results or events are “forward-looking statements” within the meaning of the Act. These statements reflect our current expectations or beliefs, and are subject to risks and uncertainties that could cause actual results or events to vary from stated expectations, which could be material and adverse. Given that circumstances may change, and new risks to the business may emerge from time to time, having the potential to negatively impact our business in ways we could not anticipate at the time of making a forward-looking statement, you

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are cautioned not to place undue reliance on these statements, and we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Some of the factors that could cause actual results or events to vary from stated expectations include, but are not limited to, the following: unforeseen operating risks; the effects of overall economic conditions; fluctuations in costs of insurance and energy; acquisition integration costs; the performance of acquired businesses; preservation of positive labor relationships; competition, including pricing, within the corporate identity apparel and facility services industry; and the availability of capital to finance planned growth. Additional information concerning potential factors that could effect future financial results is included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2003.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Interest Rate Risk

We are subject to market risk exposure related to changes in interest rates. We use financial instruments, including fixed and variable rate debt, as well as interest rate swaps to manage interest rate risk. Interest rate swap agreements are entered into for periods consistent with related underlying exposures and do not constitute positions independent of those exposures. Assuming the current level of borrowings, a one percentage point increase in interest rates under these borrowings would have increased our interest expense for the third quarter of fiscal 2004 by approximately $0.3 million. This estimated exposure considers the mitigating effects of interest rate swap agreements outstanding at March 27, 2004 on the change in the cost of variable rate debt.

Foreign Currency Exchange Risk

We have a significant foreign subsidiary located in Canada. The assets and liabilities of this subsidiary are denominated in the Canadian dollar and as such are translated into U.S. dollars at the exchange rate in effect at the balance sheet date. Results of operations are translated using the average exchange rates throughout the period. The effect of exchange rate fluctuations on translation of assets and liabilities are recorded as a component of stockholders’ equity. Gains and losses from foreign currency transactions are included in results of operations.

ITEM 4. CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) or Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this Form 10-Q. Based on their evaluation, our chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures are effective.

There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referenced above.

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PART II

OTHER INFORMATION

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

     a. Exhibits

31.1 Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-15(e)/15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2 Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-15(e)/15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

     b. Reports on Form 8-K

None

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

                 
            G&K SERVICES, INC.
(Registrant)
 
               
 
               
Date:
  May 6, 2004       By:   /s/ Jeffrey L. Wright
 
         
              Jeffrey L. Wright
              Senior Vice President, Chief Financial Officer and Secretary
              (Principal Financial Officer)
 
               
 
               
          By:   /s/ Michael F. Woodard
              Michael F. Woodard
              Controller
              (Principal Accounting Officer)

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