UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
X QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
-------
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
---------
TRANSITION REPORT PURSUANT TO SECTION 13 OR
---------
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-14762
THE SERVICEMASTER COMPANY
(Exact name of registrant as specified in its charter)
Delaware 36-3858106
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
2300 Warrenville Road, Downers Grove, Illinois 60515-1700
(Address of principal executive offices) (Zip Code)
630-271-1300
(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______ .
Indicate the number of shares outstanding of each of the issuer's classes of
common stock: 302,368,000 shares of common stock on August 7, 2002.
TABLE OF CONTENTS
Page
NO.
THE SERVICEMASTER COMPANY (Registrant)
PART I. FINANCIAL INFORMATION
Item 1 : Financial Statements
Consolidated Statements of Income for the three and six
months ended June 30, 2002 and June 30, 2001 2
Consolidated Statements of Financial Position
as of June 30, 2002 and December 31, 2001 4
Consolidated Statements of Cash Flows for the six months
ended June 30, 2002 and June 30, 2001 5
Notes to Consolidated Financial Statements 6
Item 2: Management Discussion and Analysis of Financial
Condition and Results of Operations 14
Item 3: Quantitative and Qualitative Disclosures About
Market Risk 22
PART II. OTHER INFORMATION
Item 4: Submission of Matters to a Vote of Security Holders 23
Item 6: Exhibits and Reports on Form 8-K 23
Exhibit 18.1 : Letter re: Change in Accounting Principle 24
Exhibit 99.1: Certification of Chief Executive Officer Pursuant
to Section 1350 of Chapter 63 of Title 18 of the
United States Code 25
Exhibit 99.2: Certification of Chief Financial Officer Pursuant
to Section 1350 of Chapter 63 of Title 18 of the
United States Code 26
Signature 27
1
PART I. FINANCIAL INFORMATION
THE SERVICEMASTER COMPANY
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Six Months Ended
June 30, June 30,
2002 2001 2002 2001
------------ ------------ ------------ ------------
OPERATING REVENUE ...................................................... $ 1,048,008 $ 1,030,176 $ 1,795,290 $ 1,765,897
OPERATING COSTS AND EXPENSES:
Cost of services rendered and products sold............................. 700,007 697,072 1,242,801 1,238,000
Selling and administrative expenses..................................... 226,978 207,973 368,239 325,670
Goodwill, trade name and other intangible amortization (1).............. 2,534 18,335 5,070 35,901
------------ ------------ ------------ -----------
Total operating costs and expenses...................................... 929,519 923,380 1,616,110 1,599,571
------------ ------------ ------------ -----------
OPERATING INCOME ....................................................... 118,489 106,796 179,180 166,326
NON-OPERATING EXPENSE (INCOME):
Interest expense ....................................................... 21,725 31,825 44,266 66,399
Interest and investment income.......................................... (2,886) (3,745) (6,533) (7,263)
Minority interest and other expense, net................................ 2,014 2,838 3,584 1,064
------------ ------------ ------------ ------------
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES................... 97,636 75,878 137,863 106,126
Provision for income taxes.............................................. 35,412 31,796 50,655 44,253
------------ ------------ ------------ ------------
INCOME FROM CONTINUING OPERATIONS BEFORE EXTRAORDINARY
ITEMS AND CUMULATIVE EFFECT OF ACCOUNTING CHANGE .................. 62,224 44,082 87,208 61,873
Income from discontinued operations, net of income taxes (2) ........... - 6,631 - 12,064
Extraordinary gain (loss), net of income taxes (4) ..................... (9,229) - (9,229) 6,003
Cumulative effect of accounting change (3) - - (44,577) -
------------ ------------ ------------ ------------
NET INCOME ............................................................. $ 52,995 $ 50,713 $ 33,402 $ 79,940
============ ============ ============ ============
PER SHARE:
BASIC EARNINGS PER SHARE:
Income from continuing operations before extraordinary items
and cumulative effect of accounting change........................... $.21 $.15 $.29 $.21
Discontinued operations, net (2) ....................................... - .02 - .04
Extraordinary gain (loss) (4)........................................... (.03) - (.03) .02
Cumulative effect of accounting change (3).............................. - - (.15) -
------------ ------------ ------------ ------------
$.18 $.17 $.11 $.27
============ ============ ============ ============
SHARES 301,092 298,547 300,653 298,170
DILUTED EARNINGS PER SHARE:
Income from continuing operations before extraordinary items
and cumulative effect of accounting change........................... $.20 $.15 $.28 $.21
Discontinued operations, net (2) ....................................... - .02 - .04
Extraordinary gain (loss) (4)........................................... (.03) - (.03) .02
Cumulative effect of accounting change (3).............................. - - (.14) -
------------ ------------ ------------ ------------
$.17 $.17 $.11 $.27
============ ============ ============ ============
------------ ------------ ------------ ------------
SHARES 316,474 310,764 315,900 310,300
Dividends per share..................................................... $.10 $.10 $.20 $.20
============ ============ ============ ============
2
(1) The Company adopted SFAS 142, "Goodwill and Other Intangible Assets", which
eliminates the amortization of goodwill and intangible assets with
indefinite lives beginning in 2002. Had the provisions of SFAS 142 been
applied to 2001, amortization expense would have been reduced by $15.9
million ($10.7 million, after-tax) and $31.0 million ($21.0 million,
after-tax) for the three and six month periods ended June 30, 2001
respectively.
(2) In the fourth quarter of 2001, the Company's Board of Directors approved a
series of actions related to the strategic review of its portfolio of
businesses that commenced earlier in 2001. These actions included the sale
in November 2001 of the Company's Management Services business as well as
the decision to exit certain non-strategic and under-performing businesses
including TruGreen LandCare Construction, Certified Systems, Inc. and
certain other operations. These operations are included in "Discontinued
operations" in 2001.
(3) In the second quarter of 2002, the Company changed its accounting method
for customer acquisition costs in its American Home Shield business. In
accordance with Accounting Principles Board Opinion No. 20, "Accounting
Changes", the cumulative effect of this change in accounting policy has
been recorded as of the beginning of fiscal 2002. The impact of
retroactively applying the change in method of accounting to 2001 would
have reduced pretax earnings by $1.0 million ($.7 million, after-tax) and
$7.8 million ($5.1 million, after-tax) for the three and six month periods
ended June 30, 2001.
(4) The Company purchased a portion of its public debt securities in the second
quarter of 2002 and in the first quarter of 2001. The Company has recorded
an extraordinary gain (loss) from the early extinguishment of debt related
to these repurchases.
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3
THE SERVICEMASTER COMPANY
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
(IN THOUSANDS)
As of
ASSETS June 30, December 31,
2002 2001
----------- -----------
CURRENT ASSETS:
Cash and cash equivalents .............................................. $ 153,852 $ 421,550
Marketable securities .................................................. 60,697 61,561
Receivables, less allowance of $32,204 and $27,951, respectively ....... 424,632 366,284
Inventories ............................................................ 75,345 71,336
Prepaid expenses, deferred costs and other assets ...................... 164,254 169,327
Deferred taxes ......................................................... 87,436 60,600
----------- -----------
Total Current Assets ............................................ 966,216 1,150,658
----------- -----------
PROPERTY AND EQUIPMENT:
At cost ............................................................. 479,354 473,651
Less: accumulated depreciation ...................................... 293,603 284,679
----------- -----------
Net property and equipment ........................................ 185,751 188,972
----------- -----------
OTHER ASSETS:
Goodwill ............................................................... 1,852,018 1,844,468
Intangible assets, primarily trade names ............................... 320,355 323,255
Assets of discontinued operations ...................................... 15,294 33,398
Notes receivable ....................................................... 63,033 62,116
Long-term securities and other assets .................................. 81,557 71,872
----------- -----------
Total Assets .................................................... $ 3,484,224 $ 3,674,739
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ....................................................... $ 142,026 $ 123,800
Accrued liabilities:
Payroll and related expenses ........................................ 80,535 83,973
Insurance and related expenses ...................................... 45,851 40,019
Income taxes payable ................................................ 37,745 24,243
Other ............................................................... 112,687 133,291
Deferred revenues ...................................................... 451,457 373,916
Current portion of long-term debt ...................................... 44,496 35,159
----------- -----------
Total Current Liabilities ....................................... 914,797 814,401
----------- -----------
LONG-TERM DEBT ......................................................... 817,141 1,105,518
LONG-TERM LIABILITIES:
Deferred tax liability ............................................ 263,000 263,000
Liabilities of discontinued operations ............................ 49,968 75,159
Other long-term obligations ....................................... 128,524 93,023
----------- -----------
Total Long-Term Liabilities .................................... 441,492 431,182
----------- -----------
MINORITY INTEREST ...................................................... 102,200 102,677
Commitments and Contingencies
SHAREHOLDERS' EQUITY:
Common stock $0.01 par value, authorized 1 billion shares; issued
and outstanding 302,210 and 300,531 shares, respectively .......... 3,022 3,005
Additional paid-in capital ............................................. 1,049,451 1,037,969
Retained earnings ...................................................... 311,036 337,232
Accumulated other comprehensive loss ................................... (7,792) (1,888)
Restricted stock ....................................................... (1,195) (1,285)
Treasury stock ......................................................... (145,928) (154,072)
----------- -----------
Total Shareholders' Equity ...................................... 1,208,594 1,220,961
----------- -----------
Total Liabilities and Shareholders' Equity ...................... $ 3,484,224 $ 3,674,739
=========== ===========
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4
THE SERVICEMASTER COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
Six Months Ended
June 30,
2002 2001
---------- ---------
CASH AND CASH EQUIVALENTS AT JANUARY 1 ......................................... $ 421,550 $ 57,948
CASH FLOWS FROM OPERATIONS:
NET INCOME ..................................................................... 33,402 79,940
Adjustments to reconcile net income to net cash flows from operations:
Income from discontinued operations .................................... - (12,064)
Extraordinary (gain) loss .............................................. 9,229 (6,003)
Cumulative effect of accounting change ................................. 44,577 --
Depreciation expense ................................................... 25,938 28,018
Amortization expense ................................................... 5,070 35,901
Tax refund from prior years payments ...................................... - 21,000
Deferred income tax expense ............................................... 41,557 49,927
Change in working capital, net of acquisitions:
Receivables ........................................................ (58,836) (67,988)
Sale of receivables ................................................ - 100,000
Inventories and other current assets ............................... (68,133) (90,891)
Accounts payable ................................................... 20,037 830
Deferred revenues .................................................. 82,468 80,454
Accrued liabilities ................................................ 15,739 11,399
Other, net ............................................................ 1,818 2,325
---------- ---------
NET CASH PROVIDED FROM OPERATIONS .............................................. 152,866 232,848
---------- ---------
MEMO: NET CASH PROVIDED FROM OPERATIONS
(EXCLUDING PRIOR YEAR SALE OF RECEIVABLES AND TAX REFUNDS) .............. 152,866 111,848
CASH FLOWS FROM INVESTING ACTIVITIES:
Property additions ....................................................... (29,458) (22,865)
Sale of equipment and other assets ....................................... 1,532 7,994
Business acquisitions, net of cash acquired .............................. (9,299) (21,065)
Proceeds from business sales and minority interests ...................... - 12,542
Notes receivable, financial investments and securities ................... (3,453) (21,522)
---------- ---------
NET CASH USED FOR INVESTING ACTIVITIES ......................................... (40,678) (44,916)
---------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net payments of debt ..................................................... (295,570) (141,310)
Purchase of ServiceMaster stock .......................................... - (1,308)
Shareholders' dividends .................................................. (59,598) (59,792)
Other, net ............................................................... 12,821 5,216
---------- ---------
NET CASH USED FOR FINANCING ACTIVITIES ......................................... (342,347) (197,194)
---------- ---------
---------- ---------
CASH USED FOR DISCONTINUED OPERATIONS .......................................... (37,539) (12,433)
---------- ---------
CASH DECREASE DURING THE PERIOD ................................................ (267,698) (21,695)
---------- ---------
CASH AND CASH EQUIVALENTS AT JUNE 30 ........................................... $ 153,852 $ 36,253
========== =========
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5
THE SERVICEMASTER COMPANY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1: The consolidated financial statements include the accounts of
ServiceMaster and its subsidiaries, collectively referred to as "the Company".
Intercompany transactions and balances have been eliminated in consolidation.
NOTE 2: The consolidated financial statements included herein have been prepared
by the Company pursuant to the rules and regulations of the Securities and
Exchange Commission. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to such rules and
regulations. However, the Company believes that the disclosures are adequate to
make the information presented not misleading. The Company suggests that these
consolidated financial statements be read in conjunction with the consolidated
financial statements and the notes thereto included in the Company's latest
Annual Report to Shareholders and the Annual Report to the Securities and
Exchange Commission on Form 10-K for the year ended December 31, 2001. In the
opinion of the Company, all adjustments necessary to present fairly the
financial position of The ServiceMaster Company as of June 30, 2002 and December
31, 2001, and the results of operations for the three and six month periods
ended June 30, 2002 and 2001 and cash flows for the six months ended June 30,
2002 and 2001 have been included. The results of operations for any interim
period are not necessarily indicative of the results which might be obtained for
a full year.
As further discussed in Note 5, effective January 2002, the Company adopted
Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets". In addition, the Company changed its accounting method
for customer acquisition costs in its American Home Shield business. In
accordance with Accounting Principles Board Opinion No. 20, "Accounting
Changes", the cumulative effect of this change in accounting policy (totaling a
charge of $.14 per diluted share) has been recorded as of the beginning of
fiscal 2002. The Company also announced that, beginning in 2003, it will begin
accounting for employee stock options as compensation expense in accordance with
SFAS No. 123, "Accounting for Stock-Based Compensation." If the Company
continues its historical pattern of option granting, the impact would be
approximately $.005 per share in 2003, growing to approximately $.03 per share
over five years.
NOTE 3: The Company has identified the most important accounting policies in
order to portray its financial condition and results of operations. These relate
primarily to revenue recognition and the deferral of customer acquisition costs.
The following revenue recognition policies have not changed since year-end.
Revenues from lawn care, non-baiting termite, pest control, heating/air
conditioning and plumbing services are recognized as the services are provided.
Revenues from landscaping services are recognized based upon agreed monthly
contract payments or when services are performed for non-contractual
arrangements. Revenues from the Company's commercial installation contracts,
primarily relating to HVAC, are recognized on the percentage of completion
method in the ratio that total incurred costs bear to total estimated costs.
Fees from home warranty and termite baiting contracts are recognized as revenues
over the life of the contract in proportion to the direct costs (service or
claim), which are expensed as incurred. Franchised revenues (which in aggregate
represents approximately three percent of consolidated totals) consist of
initial franchise fees and continuing monthly fees based upon the franchisee
revenue. Revenue is recognized when reported from the franchisee and
collectibility is assured. Customer acquisition costs, which are incremental and
direct costs of obtaining the customer, relating to several of the Company's
contracts are deferred and amortized over the life of the contract, in
proportion to revenue recognized. These costs include sales commissions and
direct selling costs which can be shown to have resulted in a successful sale.
The Company expenses the cost of advertising the first time the advertising
takes place, except for direct-response advertising at Terminix. This
direct-response advertising consists primarily of direct-mail promotions, of
which the cost is capitalized and amortized over the one year customer contract
life. On an interim basis, TruGreen LawnCare incurs significant sales and other
costs at the beginning of the fiscal year that directly relate to supporting
services to customers throughout the production season (April through October).
These
6
costs are deferred and recognized in proportion to the contract revenue over the
year. These costs are not deferred beyond the calendar year-end.
The preparation of the financial statements requires management to make certain
estimates and assumptions required under generally accepted accounting
principles which may differ materially from the actual results. Disclosures in
the 2001 Annual Report presented the significant areas that require the use of
management's estimates and discussed how management formed its judgment. The
areas discussed included the allowance for receivables, accruals for
self-insured retention limits related to medical, workers compensation, auto and
general liability insurance, the possible outcome of litigation and the useful
lives for depreciation and amortization expense. There have been no changes in
these areas or methodologies in 2002.
NOTE 4: The Company carries insurance policies on insurable risks which it
believes to be appropriate. The Company generally has self-insured retention
limits and has obtained fully insured layers of coverage above such self-insured
retention limits. Accruals for self-insurance losses are made based on the
Company's claims experience and actuarial assumptions. The Company has certain
liabilities with respect to existing or potential claims, lawsuits, and other
proceedings. The Company accrues for these liabilities when it is probable that
future costs will be incurred and such costs can be reasonably estimated.
The Company believes that other legal proceedings and currently pending
litigation arising in the ordinary course of business will not have a material
effect on the consolidated financial statements.
NOTE 5: The Company periodically reviews its accounting practices to ensure that
its adopted policies appropriately reflect current conditions in its businesses,
the industries it operates in, and the regulatory and business environments.
During the second quarter, the Company reviewed and compared its accounting
principles for its American Home Shield business with its direct competitors as
well as with companies operating in various aspects of the insurance industry.
Although there is some diversity of practice in these industries, the Company
determined to change its policy to the more prevalent and conservative method of
accounting for deferred acquisition costs from SFAS No. 60, "Accounting and
Reporting by Insurance Enterprises", where deferred acquisition costs were
amortized over the expected customer life to a more preferable method, FASB
Technical Bulletin No. 90-1, "Accounting for Separately Priced Extended Warranty
and Product Maintenance Contracts", where deferred acquisition costs are
amortized over the initial contract life. Such accounting principle is
consistent with the Company's understanding of the methods used by others in the
warranty industry. This new method of accounting is expected to result in a
reduction of $.03 per share in reported earnings in 2002, but will have no
impact on cash flow in the current or future years. In accordance with
Accounting Principles Board Opinion No. 20 "Accounting Changes", the cumulative
effect of this change in accounting policy (totaling a charge of $.14 per
diluted share) has been recorded as of the beginning of fiscal 2002.
In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No.142, "Goodwill and Other Intangible Assets"
(SFAS 142). SFAS 142 requires that after December 31, 2001, existing goodwill
will no longer be amortized and intangible assets with indefinite useful lives
will not be amortized until their useful lives are determined to be no longer
indefinite. Goodwill and intangible assets that are not amortized will be
subject to at least an annual assessment for impairment by applying a
fair-value-based test. As of July 30, 2002, the Company's impairment testing was
completed and the testing concluded that there were no impairment issues.
Estimated fair value was determined for each reporting unit by utilizing the
expected present value of the future cash flows of the units. In all instances,
the estimated fair value of the reporting units exceeded their book values.
The following table provides summarized financial information for the three and
six month periods ended June 30, 2002 and 2001, with the 2001 information
presented on an adjusted basis to reflect the elimination of amortization
expense required under SFAS 142 and the impact of retroactively applying the
change in method of accounting for customer acquisition costs at American Home
Shield.
7
Three Months Ended Six Months Ended
June 30, June 30,
(in thousands, except per share data) 2002 2001 2002 2001
------------- ------------- ------------- -------------
Operating Income and Margins:
Reported operating income $118,489 $ 106,796 $179,180 $ 166,326
Add back: Goodwill and trade name amortization - 15,883 - 30,995
Subtract: Impact of retroactively applying the change in method of
accounting for customer acquisition costs at AHS - (1,032) - (7,770)
--------- ---------- --------- ----------
Operating income as adjusted under SFAS 142 and for
retroactive application of accounting change $118,489 $ 121,647 $179,180 $ 189,551
========= ========== ========= ==========
Margin percentage (1) 11.3% 11.8% 10.0% 10.7%
(1) The 2001 margin percentages are based on adjusted operating income amounts which are non-GAAP financial measures
Net Income:
---------------------
Reported net income from continuing operations before
extraordinary gain (loss) and cumulative
effect of accounting change $ 62,224 $ 44,082 $ 87,208 $ 61,873
Add back: Goodwill and trade name amortization, net of tax - 10,700 - 21,000
Subtract: Impact of retroactively applying the change in method of
accounting for customer acquisition costs at AHS, net of tax - (670) - (5,050)
--------- ---------- --------- ----------
Net income from continuing operations before extraordinary gain (loss) and
cumulative effect of accounting change as adjusted under SFAS 142 and
for retroactive application of accounting change $ 62,224 $ 54,112 $ 87,208 $ 77,823
========= ========== ========= ==========
Diluted Earnings Per Share:
Reported earnings per share from continuing operations before
extraordinary gain (loss) and cumulative
effect of accounting change $ 0.20 $ 0.15 $ 0.28 $ 0.21
Add back: Goodwill and trade name amortization, net of tax - 0.03 - 0.06
Subtract: Impact of retroactively applying the change in method of
accounting for customer acquisition costs at AHS, net of tax - - - (0.02)
--------- ---------- --------- ----------
Earnings per share from continuing operations before extraordinary gain (loss)
and cumulative effect of accounting change as adjusted under SFAS 142 and
for retroactive application of accounting change $ 0.20 $ 0.18 $ 0.28 $ 0.25
========= ========== ========= ==========
The following table summarizes goodwill and intangible assets.
As of As of
(in thousands) June 30, 2002 December 31, 2001
------------ ------------
Covenants not to compete $ 139,407 $ 138,445
Accumulated amortization (1) (64,057) (59,952)
------------ ------------
Net covenants not to compete 75,350 78,493
Other intangibles 7,847 6,639
Accumulated amortization (1) (1,392) (427)
------------ ------------
Net other intangibles 6,455 6,212
Trade names (2) 238,550 238,550
Goodwill (2), (3) 1,852,018 1,844,468
------------ ------------
Total $ 2,172,373 $ 2,167,723
============ ============
(1) Amortization expense of approximately $8-10 million is expected
for the next five years.
(2) Not subject to amortization.
(3) For the six months ended June 30, 2002 approximately $7.6 million
of additional goodwill was recorded.
8
NOTE 6: On October 3, 2001 the Company's Board of Directors approved a series of
strategic actions which were the culmination of an extensive portfolio review
process that was initiated in the first quarter of 2001. The goal of the
portfolio review was to increase shareholder value by creating a focused and
aligned company that provides the greatest return and growth potential. The
Company determined it could best achieve these goals with a portfolio of
businesses which support the business strategy to become America's Home Service
Company and have attractive cash flow and return characteristics. As part of
this determination, in the fourth quarter of 2001, the Company sold its
Management Services business to ARAMARK Corporation for approximately $800
million. Also in the fourth quarter of 2001, the Company's Board of Directors
approved the exit of non-strategic and under-performing businesses including
TruGreen LandCare Construction, Certified Systems Inc. (CSI), and certain other
small operations. The Company sold its TruGreen LandCare Construction operations
to Environmental Industries, Inc. (EII) in certain markets and entered into an
agreement with EII to manage the wind-down of commercial landscaping
construction contracts in the remaining markets. In addition, the Company sold
all of its customer contracts relating to the exit of CSI (the Company's
professional employer organization), to AMS Staff Leasing, N.A., Inc. The
Company also completed, in the fourth quarter of 2001, the sale of certain
subsidiaries of its European pest control and property services operations. The
results of these discontinued business units have been separated and classified
as Discontinued Operations in the accompanying financial statements.
The Company continues to carry certain assets on its financial statements
relating to these operations. Management is actively selling the remaining
equipment and collecting the outstanding receivables. The Company believes that
the remaining assets are presented at their net realizable value. In addition,
reserves and accrual balances remain on the financial statements relating to
these operations. Cash payments incurred for the wind-down of LandCare
construction contracts, lease termination costs, workers compensation and health
claims as well as professional service fees have been made in the first six
months of the year. The remaining balances are outlined in the table below.
In the fourth quarter of 2001, the Company recorded a charge for asset
impairments and other items which included accruals for residual value
guarantees on leased properties, severance for former executives and terminated
employees, and other costs. During the second quarter of 2002, the Company
completed the sale of its ownership interest in five assisted living facilities.
These properties were financed through a synthetic lease arrangement, whereby,
the Company guaranteed the residual value of the properties. At year-end, a
$13.5 million reserve was established representing the amount by which the
residual value guarantees exceeded the value of bids to purchase the facilities
at that time. The final sales price was significantly greater than these bid
levels and the Company realized a gain of $3.6 million from the sale on the
assisted living properties.
The table below summarizes the activity during the six months ended June 30,
2002 for the remaining liabilities from the discontinued operation and the
reserves for items recorded in the fourth quarter of 2001. The Company believes
that the remaining reserves continue to be adequate and reasonable.
(IN THOUSANDS) Balance at Cash Balance at
DEC. 31, 2001 PAYMENTS INCOME JUNE 30, 2002
-------------- --------- ------ -------------
Remaining liabilities from discontinued operations
LandCare Construction $33,700 $11,600 -- $22,100
Certified Systems, Inc. 23,800 5,500 -- 18,300
Management Services 11,400 1,800 -- 9,600
Other 6,300 6,300 -- --
Reserves related to strategic actions in the fourth
quarter of 2001 $36,000 $10,600 $3,600 $21,800
The Company recorded a $3.2 million charge in the second quarter of 2002
relating to the severance and termination agreement of a key executive. This
severance will be paid out over three years.
9
NOTE 7: Basic earnings per share are computed by dividing income available to
common stockholders by the weighted-average number of shares outstanding for the
period. The weighted average common shares for the diluted earnings per share
calculation includes the incremental effect related to outstanding options whose
market price is in excess of the exercise price. Shares potentially issuable
under convertible securities have been considered outstanding for purposes of
the diluted earnings per share calculations. In computing diluted earnings per
share, the after-tax interest expense related to convertible debentures is added
back to net income in the numerator, while the diluted shares in the denominator
include the shares issuable upon conversion of the debentures.
The following chart reconciles both the numerator and the denominator of the
basic earnings per share computation to the numerator and the denominator of the
diluted earnings per share computation.
(IN THOUSANDS, EXCEPT PER SHARE DATA) Three Months Three Months
Ended June 30, 2002 Ended June 30, 2001
-------------------------------- ------------------------------
INCOME SHARES EPS INCOME SHARES EPS
-------- -------- ----- -------- -------- ----
Basic earnings per share $52,995 301,092 $0.18 $50,713 298,547 $0.17
===== =====
Effect of dilutive securities, net of tax:
Options - 7,182 - 4,060
Convertible securities 1,195 8,200 1,191 8,157
---------- --------- ---------- ---------
Diluted earnings per share $54,190 316,474 $0.17 $51,904 310,764 $0.17
========== ========= ===== ========== ========= =====
Six Months Six Months
Ended June 30, 2002 Ended June 30, 2001
-------------------------------- ------------------------------
INCOME SHARES EPS INCOME SHARES EPS
-------- -------- ----- -------- -------- ----
Basic earnings per share $33,402 300,653 $0.11 $79,940 298,170 $0.27
===== =====
Effect of dilutive securities, net of tax:
Options - 7,047 - 3,973
Convertible securities 2,390 8,200 2,383 8,157
---------- --------- ---------- ---------
Diluted earnings per share $35,792 315,900 $0.11 $82,323 310,300 $0.27
========== ========= ===== ========== ========= =====
NOTE 8: In the Consolidated Statements of Cash Flows, the caption Cash and Cash
Equivalents includes investments in short-term, highly-liquid securities having
a maturity of three months or less. Supplemental information relating to the
Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and
2001 is presented in the following table:
(IN THOUSANDS)
2002 2001
--------- ---------
CASH PAID OR (RECEIVED) FOR:
Interest expense............................. $ 44,956 $ 64,845
Interest and dividend income................. $ (6,108) $ (4,366)
Income taxes................................. $ 31,294 $ (12,277)
The decrease in interest paid in 2002 is primarily due to reduced debt levels
reflecting debt retirements utilizing the proceeds from the sale of Management
Services. The increase in interest income received is also due to the proceeds
received from the Management Services sale as the Company maintained significant
cash levels throughout the year. The tax payment in 2002 resulted from the gain
on the sale of the Management Services business which compared to the prior year
tax refund of $21 million related to prior year over-payments.
NOTE 9: Total comprehensive income was $46.3 million and $49.3 million for the
three months ended June 30, 2002 and 2001, respectively, and $27.5 million and
$68.6 million for the six months ended June 30, 2002 and 2001, respectively.
Comprehensive income for the six months ended June 30, 2002 includes the
cumulative adjustment of $45 million related to the change in accounting method
for customer acquisition costs at American Home Shield. Total comprehensive
income includes primarily net income, changes in unrealized gains and losses on
marketable securities and translation balances.
NOTE 10: On March 23, 2001, the Company entered into an agreement which provides
for the ongoing revolving sale of a designated pool of accounts receivable of
TruGreen and Terminix. At
10
June 30, 2002, there were no outstanding receivables sold to third parties under
this agreement. However, the Company may sell its receivables in the future
which would provide an alternative funding source.
NOTE 11: In the second quarter of 2002, the Company recorded an extraordinary
loss on early debt extinguishment of $9.2 million after-tax or $.03 per diluted
share resulting from the repurchase of approximately $218 million in
ServiceMaster corporate bonds pursuant to a tender offer. In the first quarter
of 2001, the Company repurchased approximately $35 million of its public debt
securities and recorded an extraordinary gain of $6.0 million after-tax or $.02
per diluted share.
In April 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard No. 145, "Recission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No.13, and Technical
Corrections" (SFAS 145). The primary impact to the Company of this Statement is
that it rescinds Statement No. 4 which required all material gains and losses
from extinguishment of debt to be classified as extraordinary items. SFAS 145
requires that the more restrictive criteria of APB Opinion No. 30 will be used
to determine whether such gains or losses are extraordinary. The Company intends
to adopt this Statement in its fiscal year 2003, as required by the Statement.
Adoption of this Statement will result in the reclassification of the
extraordinary gain (loss) included in the accompanying Consolidated Statements
of Income.
In June 2002, the FASB issued Statement of Financial Accounting Standard No.
146, "Accounting for Costs Associated with Exit or Disposal Activities". This
Statement requires recording costs associated with exit or disposal activities
at their fair values when a liability has been incurred. Under previous
guidance, certain exit costs were accrued upon management's commitment to an
exit plan, which is generally before an actual liability has been incurred. The
provisions of this statement are effective for exit or disposal activities that
are initiated after December 31, 2002.
NOTE 12: The Company continues to maintain minority investors in the combined
ARS/AMS entity as well as in Terminix. Members of management acquired, at fair
market value, equity interests in ARS. The Company and the equity investors have
respective options to acquire or sell the minority interests in the future at a
price based on fair market value. The future acquisition of this minority
interest will be recorded as additional purchase cost at the time of payment. At
Terminix, the minority ownership reflects an interest issued to the prior owners
of the Allied Bruce Terminix Companies in connection with that acquisition. This
equity security is exchangeable into eight million ServiceMaster common shares.
The ServiceMaster shares are included in the shares used for the calculation of
diluted earnings per share.
In January 2001, Jonathan P. Ward, President and Chief Executive Officer of
ServiceMaster, purchased from ServiceMaster a 5.50% convertible debenture due
January 9, 2011, with a face value of $1.1 million. ServiceMaster financed the
purchase of the debenture with a 5.50% full recourse loan due January 9, 2011.
In May 2001, Mr. Ward purchased a second 5.50% convertible debenture due May 10,
2011, with a face value of $1.1 million. ServiceMaster financed 50% of the
purchase price of this second debenture with a 5.50% full recourse loan due May
10, 2011. Each debenture becomes convertible into 20,000 shares of ServiceMaster
common stock on December 31 on each of the years 2001 through 2005.
NOTE 13: The business of the Company is primarily conducted through three
operating segments: TruGreen, Terminix, and Home Maintenance and Improvement. In
accordance with Statement of Financial Accounting Standards No. 131 (SFAS 131),
the Company's reportable segments are strategic business units that offer
different services. The TruGreen segment provides residential and commercial
lawn care and landscaping services through the TruGreen ChemLawn and TruGreen
LandCare companies. As a result of the decision in the fourth quarter of 2001 to
exit the LandCare Construction business, the results of the construction
operations are now included in discontinued operations for all periods. The
Terminix segment provides termite and pest control services to residential and
commercial U.S. customers. The Home Maintenance and Improvement segment includes
American Residential Services, (ARS) and American Mechanical Services (AMS) that
provide heating, ventilation, air conditioning (HVAC) and plumbing services as
well as American Home Shield which provides home warranties to consumers that
cover HVAC, plumbing
11
and other appliances. The segment also includes the two franchise operations,
ServiceMaster Clean and Merry Maids, which provide disaster restoration and
cleaning services.
The Other Operations segment includes entities that are managed separately from
the three major units and aggregated together in accordance with SFAS 131 due to
their size or developmental nature. This segment includes ServiceMaster Home
Service Center, an initiative that has developed valuable competencies and has
built an infrastructure that allows customers the ability to purchase all of the
Company's services through a single point of contact; the Company's
international operations which include the retained Terminix operations in the
United Kingdom and Ireland; and the Company's headquarters operations which
provides various technology, marketing, finance and other support services to
the business units.
Segment information as of and for the three months and six months ended June 30,
2002 and 2001 is presented below. The table below also presents an "Adjusted"
column of 2001 information which includes two adjustments made to the reported
amounts: (1) SFAS 142, "Goodwill and Other Intangible Assets", eliminates the
amortization of goodwill and intangible assets with indefinite lives beginning
in 2002. The 2001 operating income information has been adjusted to eliminate
amortization expense related to goodwill and intangible assets with indefinite
lives, and (2) the change in method of accounting for deferred acquisition costs
at American Home Shield has been reflected as a cumulative adjustment as of
January 1, 2002. The 2001 operating income, capital employed, and identifiable
asset information has been adjusted to reflect the retroactive application of
the change in method of accounting.
(In thousands) Three Months Three Months Three Months
Ended June 30, Ended June 30, Ended June 30,
2002 2001 2001
Reported Reported Adjusted
- --------------------------------------------------------------------------------------------------------------------------
Operating Revenue:
TruGreen $ 434,279 $ 430,065
Terminix 255,399 229,192
Home Maintenance and Improvement 339,588 353,220
Other Operations 18,742 17,699
- ---------------------------------------------------------------------------------------------------------
Total Operating Revenue $ 1,048,008 $ 1,030,176
- ---------------------------------------------------------------------------------------------------------
Operating Income:
TruGreen $ 53,140 $ 51,419 $ 58,014
Terminix 45,369 35,024 40,460
Home Maintenance and Improvement 33,469 32,920 35,390
Other Operations (13,489) (12,567) (12,217)
- --------------------------------------------------------------------------------------------------------------------------
Total Operating Income $ 118,489 $ 106,796 $ 121,647
- --------------------------------------------------------------------------------------------------------------------------
Capital Employed:
CAPITAL EMPLOYED REPRESENTS THE NET ASSETS OF THE SEGMENT; I.E., TOTAL ASSETS LESS LIABILITIES (LIABILITIES DO NOT INCLUDE
DEBT BALANCES).
TruGreen $ 1,073,181 $ 1,091,947 $ 1,091,947
Terminix 600,936 593,783 593,783
Home Maintenance and Improvement 628,347 677,263 633,919
Other Operations (and discontinued businesses) (130,033) 623,161 623,161
- --------------------------------------------------------------------------------------------------------------------------
Total Capital Employed $ 2,172,431 $ 2,986,154 $ 2,942,810
- --------------------------------------------------------------------------------------------------------------------------
Identifiable Assets:
TruGreen $ 1,160,194 $ 1,217,438 $ 1,217,438
Terminix 859,040 797,145 797,145
Home Maintenance and Improvement 1,006,454 1,042,942 999,597
Other Operations (and discontinued businesses) 458,536 1,046,808 1,046,808
- --------------------------------------------------------------------------------------------------------------------------
Total Identifiable Assets $ 3,484,224 $ 4,104,333 $ 4,060,988
- --------------------------------------------------------------------------------------------------------------------------
12
Six Months Six Months Six Months
Ended June 30, Ended June 30, Ended June 30,
2002 2001 2001
Reported Reported Adjusted
- --------------------------------------------------------------------------------------------------------------------------
Operating Revenue:
TruGreen $ 663,422 $ 659,820
Terminix 475,449 424,964
Home Maintenance and Improvement 620,515 644,233
Other Operations 35,904 36,880
- ---------------------------------------------------------------------------------------------------------
Total Operating Revenue $ 1,795,290 $ 1,765,897
- ---------------------------------------------------------------------------------------------------------
Operating Income:
TruGreen $ 77,761 $ 73,856 $ 87,046
Terminix 81,622 60,526 70,344
Home Maintenance and Improvement 44,881 52,937 52,448
Other Operations (25,084) (20,993) (20,287)
- --------------------------------------------------------------------------------------------------------------------------
Total Operating Income $ 179,180 $ 166,326 $ 189,551
- --------------------------------------------------------------------------------------------------------------------------
The following table summarizes by segment goodwill and trade names that are not
subject to amortization:
June 30, December 31,
2002 2001
------------- -------------
TruGreen $ 896,310 $ 895,744
Terminix 667,320 661,864
Home Maintenance and Improvement 506,938 505,410
Other Operations 20,000 20,000
------------- -------------
Total $ 2,090,568 $ 2,083,018
============= =============
13
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
SECOND QUARTER 2002 COMPARED TO SECOND QUARTER 2001
CONSOLIDATED REVIEW
Revenue for the second quarter totaled $1.05 billion, two percent above the
prior year. Reported operating income was $118 million in 2002 compared with
$107 million in 2001 and reported diluted earnings per share from continuing
operations was $.20 in 2002 compared with $.15 in 2001. During the second
quarter of 2002, the Company incurred a $.03 per share extraordinary loss from
the early extinguishment of debt. Including this item, reported diluted earnings
per share was $.17 in 2002. The financial statement comparison between the two
years is impacted by the adoption of SFAS 142 and a change in accounting method
which were effective at the beginning of 2002 and the sale and exit of certain
businesses in late 2001.
Statement of Financial Accounting Standards No. 142, "Goodwill and Other
Intangible Assets" (SFAS 142), requires that beginning in 2002, goodwill and
trade names will no longer be amortized. SFAS 142 does not permit the
restatement of 2001 financial information to reflect the impact of this
Statement. In the second quarter of 2002, the Company changed its accounting
method for customer acquisition costs in its American Home Shield business. In
accordance with Accounting Principles Board Opinion No. 20, "Accounting
Changes", prior period financial statements are not restated for the impact of
the new accounting method, rather the cumulative effect of this change in
accounting policy has been recorded as of the beginning of 2002. This new policy
is expected to result in a reduction of $.03 per share in reported earnings in
2002, but will have no impact on cash flow in the current or future years.
In order to assist in the comparison of earnings per share, the table below
presents diluted earnings per share on a comparable basis, assuming: (i) only
continuing operations existed, (ii) SFAS 142 was effective, (iii) the change in
method of accounting for customer acquisition costs was applied retroactively,
and (iv) after-tax proceeds from the 2001 sales of Management Services and
certain European pest control operations were used to repay debt. These
adjustments in the aggregate provide a less favorable comparison to the prior
year than the reported results, however, they allow for the review of the
underlying base business performance on a comparable basis. On a comparable
basis, second quarter diluted earnings per share of $.20 in 2002 was consistent
with last year.
Three months ended Six months ended
June 30, June 30,
2002 2001 2002 2001
--------- ------- -------- -----------
Continuing operations before extraordinary items $0.20 $0.15 $0.28 $0.21
Earnings per share equivalent of reduced amortization
expense under new accounting rules - 0.03 - 0.06
Interest expense reduction - 0.02 - 0.04
Retroactive application of accounting change - - - (0.02)
--------- ------- -------- -----------
As adjusted earnings per share $0.20 $0.20 $0.28 $0.29
========= ======= ======== ===========
For comparative purposes, the Company has provided supplemental information in
Note 5 which presents certain 2001 information as adjusted to reflect the
elimination of goodwill and trade name amortization and the impact of
retroactively applying the change in method of accounting for American Home
Shield customer acquisition costs. Second quarter operating income on this
comparable basis decreased three percent to $118 million from $122 million, with
operating margins decreasing to 11.3 percent from 11.8 percent. The decline in
operating income reflects continued strong growth at Terminix and American Home
Shield offset by lower volume in the HVAC and plumbing businesses of ARS and
AMS, increased workers compensation claims at TruGreen LandCare, as well as
increased expenditures related to Company-wide operational initiatives and
overhead support.
14
Cost of services rendered and products sold increased slightly for the quarter
and decreased as a percentage of revenue to 66.8 percent in 2002 from 67.7
percent in 2001. Selling and administrative expenses increased nine percent and
increased as a percentage of revenue to 21.7 percent from 20.2 percent in 2001
(20.3 percent in 2001, retroactively applying the prior year impact of the
American Home Shield accounting change). The increase in selling and
administrative expenses reflects initiatives to measure customer and employee
satisfaction, improved marketing techniques and investments in the Six Sigma
programs.
In the second quarter of 2002, the Company completed two non-recurring
transactions. The ownership interest in five assisted living facilities was sold
in the quarter, and a gain of $3.6 million was realized. In addition, a key
executive signed a termination and severance agreement in the quarter. The
Company recorded a $3.2 million charge relating to this agreement. Cash payments
will be made over a three year period.
Interest expense decreased from the prior year, primarily due to reduced debt
levels as a portion of the proceeds received from sales of the Management
Services and certain European pest control businesses were used to pay down
debt. Interest and investment income decreased primarily reflecting a reduced
level of investment gains realized on the American Home Shield investment
portfolio. Minority interest and other expense decreased primarily due to prior
year losses incurred relating to the sale of accounts receivables under the
Company's securitization program.
The tax provision reflects a lower effective tax rate, which includes the
benefit of the utilization of prior year net operating losses of a subsidiary
operation, the ServiceMaster Home Service Center.
OUTLOOK
The current combination of the Company's strengths, challenges and trends leads
the Company to the low end of its previously stated guidance of $.60 to $.63 per
share, before adjusting for the $.03 per share reduction from the change in
method of accounting. The Company continues to see measurable improvements in
TruGreen lawn care, Terminix and American Home Shield, despite difficult
economic conditions. To stay within guidance, these businesses need to continue
to perform. In addition, the Company must see improvements in TruGreen LandCare,
and the turnaround at ARS must take hold and show clear progress in the second
half of the year.
The Company continues to estimate a cost in 2002 of $20 million related to the
implementation of Six Sigma and initiatives to measure customer and employee
satisfaction, with an offsetting return on these initiatives of approximately
$15 million in 2002.
OTHER DEVELOPMENTS
New distribution channels for the Company's services continue to be explored. In
July 2002, the Company announced that it had entered into an agreement to
provide Yahoo! consumers the ability to schedule and purchase ServiceMaster home
services through the newly created Home Service Center on Yahoo! Real Estate.
Also in August, the Home Service Center (a subsidiary of the Company) partnered
with Sears, Roebuck and Company to allow customers to tap into the network of
Sears parts and repair services.
In July 2002, the Company and the Home Depot announced that they had concluded
their joint home services pilot program. The two companies will, however,
continue to explore ways to expand existing relationships for installation and
other services on a local basis.
SEGMENT REVIEW
NOTE: THE COMPANY ADOPTED SFAS 142, "GOODWILL AND OTHER INTANGIBLE ASSETS",
WHICH ELIMINATES THE AMORTIZATION OF GOODWILL AND INTANGIBLE ASSETS WITH
INDEFINITE LIVES BEGINNING IN 2002. THE CHANGE IN METHOD OF ACCOUNTING FOR
CUSTOMER ACQUISITION COSTS AT AMERICAN HOME SHIELD HAS BEEN REFLECTED AS A
CUMULATIVE ADJUSTMENT AS OF JANUARY 1, 2002. FOR COMPARATIVE PURPOSES, 2001
15
SEGMENT RESULTS HAVE BEEN RESTATED TO EXCLUDE THE AMORTIZATION EXPENSE AFFECTED
BY THE NEW ACCOUNTING STANDARD AND RETROACTIVELY APPLY THE CHANGE IN METHOD OF
ACCOUNTING.
The TruGreen segment includes lawn care operations performed under the TruGreen
ChemLawn brand name and landscape maintenance services provided under the
TruGreen LandCare brand name. This segment's results for both 2002 and 2001
exclude the discontinued TruGreen LandCare Construction business. The TruGreen
segment reported revenue of $434 million, one percent above the prior year.
Operating income decreased to $53 million from $58 million last year, primarily
reflecting an increased level of seasonal costs in the lawn care operations and
increased workers compensation claims (approximately $5 million) at TruGreen
LandCare. Revenue in the lawn care business improved modestly over the prior
year, reflecting growth in customer counts from increased sales and improved
retention rates. The sales growth has been supported by the deployment of more
sophisticated marketing tools and by reaching customers more effectively through
broader distribution channels. The higher level of full program customers has
also increased the sale of ancillary services in the quarter. Operating margins
in the lawn care operations declined, because a greater portion of the first
quarter sales and support costs were expensed in the second quarter compared
with last year. The Company defers certain sales and support costs in the first
part of the year that directly relate to supporting services to customers
throughout the production season (April through October). These costs are then
amortized in proportion to the revenues in later quarters. Last year, more of
the expense was deferred in the second quarter based on a higher level of
expected future revenue than actually materialized. The landscape maintenance
operations experienced a decline in revenue for the quarter. Although volume was
down, the base of business consists of more profitable contracts with stronger
customers and improved pricing. Operating margins in the landscaping operations
declined primarily reflecting lower material costs offset by increased workers
compensation claims. This business is focusing on specific operating initiatives
including hiring a senior sales and operating leader, expanding and developing
its sales force, continuing to focus on labor efficiency programs, and improving
the results of the bottom quartile of its branches. Capital employed decreased
two percent, primarily reflecting improved working capital management and a
reduction in capital equipment.
The Terminix segment, which includes the domestic termite and pest control
services, reported an 11 percent increase in revenue to $255 million from $229
million in 2001 and operating income growth of 12 percent to $45 million from
$40 million last year. Revenue growth was supported by the 2001 acquisition of
Sears Termite & Pest Control as well as new sales and improved customer
retention in both the termite and pest control business. Operating margins
improved over the prior year reflecting the beneficial impact of acquisitions
and improved labor efficiency, offset in part by costs for quality improvement
initiatives and direct marketing expenditures. The segment has produced steady
improvement in customer retention rates which reflects the increased emphasis on
training and customer service processes in the branches. Capital employed
increased one percent reflecting acquisitions offset in part by a higher level
of deferred revenue.
The Home Maintenance and Improvement segment includes heating, ventilation, air
conditioning (HVAC), and plumbing services provided under the American
Residential Services (ARS), Rescue Rooter, and American Mechanical Services
(AMS) (for commercial accounts) brand names; home systems and appliance warranty
contracts offered through American Home Shield; and the Company's primary
franchised operations, ServiceMaster Clean and Merry Maids. The segment reported
revenue of $340 million, a decrease of four percent from $353 million last year.
Operating income decreased five percent to $33 million compared to $35 million
last year. Performance in the segment was supported by double-digit revenue and
profit growth at American Home Shield offset by a decline in volume of air
conditioning and plumbing services in the ARS and AMS businesses. American Home
Shield reported strong growth in the real estate and third party channels as
well as improved customer renewal rates. Operating margins improved reflecting
both lower service costs per claim and a decrease in the incidence of claims. In
the combined ARS and AMS operations, a decline in call volume for air
conditioning and plumbing repairs and reduced construction activity continued to
affect the industry and resulted in a double-digit decline in revenue and
profit. A comprehensive rebuilding of marketing and sales strategies is underway
to counteract the impact of the decrease in demand, and in the second quarter,
the Company hired a chief marketing officer for the ARS operations. The combined
franchise operations achieved
16
revenue and profit growth, primarily driven by a strong growth in disaster
restoration and increased franchise sales at ServiceMaster Clean and growth in
the direct-owned branch operations of Merry Maids. Capital employed decreased
one percent reflecting the change in accounting for American Home Shield
deferred customer acquisition costs and improved working capital management.
Other Operations consists of the Company's international operations;
ServiceMaster Home Service Center; and the Company's headquarters operations.
Revenue for the quarter increased slightly to $19 million. This segment shows a
net operating expense, which increased from the prior year reflecting the
increased investments in the headquarters organization for Six Sigma and other
enterprise initiatives to support purchasing efficiencies, marketing programs
and technology projects. Capital employed in this segment includes the
discontinued operations and therefore is significantly reduced from the prior
year, reflecting the prior year divestitures of businesses.
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 2002 AS COMPARED TO JUNE 30, 2001
CONSOLIDATED REVIEW
Revenue for the six months increased two percent to $1.8 billion. Reported
operating income was $179 million in 2002 compared with $166 million in 2001,
and reported diluted earnings per share from continuing operations was $.28 in
2002 compared with $.21 in 2001. The six month results in 2002 include a $.14
charge related to the cumulative effect of the change in accounting method and a
$.03 extraordinary loss from early debt extinguishment. Including these items,
reported diluted earnings per share was $.11 for the six months in 2002.
The Company has changed significantly since last year and in the second quarter
consolidated review section there is a table that presents the 2001 earnings per
share adjusted to be comparable to the 2002 figures. In order to assist in the
comparison of earnings per share, the table presents 2001 diluted earnings per
share on a comparable basis, assuming: (i) only continuing operations existed,
(ii) SFAS 142 was effective, (iii) the change in method of accounting for
customer acquisition costs was applied retroactively, and (iv) after-tax
proceeds from the 2001 sales of Management Services and certain European pest
control operations were used to repay debt. These adjustments in the aggregate
provide for a less favorable comparison to the prior year than the reported
results, however, they allow for the review of the underlying base business
performance on a comparable basis. Diluted earnings per share for the six months
on a comparable basis was $.28 in 2002 compared to $.29 in 2001.
As presented in the supplemental information in Note 5, operating income on this
basis decreased five percent to $179 million in 2002 from $190 million in 2001,
with margins decreasing to 10.0 percent from 10.7 percent. The decline in
operating income reflects strong increases at Terminix and American Home Shield
offset by reduced volume in the HVAC and plumbing businesses of ARS and AMS, a
reduced deferral of seasonal costs compared to the prior year at TruGreen,
increased workers compensation claims at TruGreen LandCare, as well as increased
investments for Company-wide initiatives.
Cost of services rendered and products sold increased slightly for the six
months and decreased as a percentage of revenue to 69.2 percent in 2002 from
70.1 percent in 2001. Selling and administrative expenses increased 13 percent
and increased as a percentage of revenue to 20.5 percent from 18.4 percent in
2001 (18.9 percent in 2001, retroactively applying the prior year impact of the
American Home Shield accounting change), reflecting initiatives to measure
customer and employee satisfaction, improved marketing techniques and
investments in Six Sigma.
Interest expense decreased from the prior year, primarily due to reduced debt
levels as a portion of the proceeds received from the sales of the Management
Services and certain European pest control businesses were used to pay down
debt. The Company realized a reduced level of investment gains on the American
Home Shield investment portfolio this year which is in the interest and
investment income line on the Income Statement. Minority interest and other
expense increased from the prior year primarily due to the elimination of
minority interest income related to the ServiceMaster Home
17
Service Center initiative that was recorded in 2001. In the first quarter of
2001 and until May 2001, the operating losses of ServiceMaster Home Service
Center had been offset through minority interest income (below the operating
income line) because of investments in the venture made by Kleiner, Perkins,
Caufield & Byers. In December 2001, the Company acquired the minority interest
in the ServiceMaster Home Service Center held by Kleiner Perkins. The operating
losses incurred in the first six months of 2002 from ServiceMaster Home Service
Center have been absorbed in the accompanying financial statements without an
offset at the minority interest income line.
The tax provision reflects a lower effective tax rate based on benefits received
through the consolidation for tax purposes of the ServiceMaster Home Service
Center. The Company was able to utilize prior year net operating losses of this
subsidiary operation.
KEY PERFORMANCE INDICATORS
The table below presents selected metrics related to customer counts and
customer retention for the three stet businesses of the Company. These measures
are presented on a rolling, twelve month basis in order to avoid seasonal
anomalies.
KEY PERFORMANCE INDICATORS
As of June 30,
2002 2001
---------- ------------
TRUGREEN -
Growth in Full Program Contracts 1% -3%
Customer Retention Rate 64.5% 62.4%
TERMINIX -
Growth in Pest Control Customers 12% 14%
Pest Control Customer Retention Rate 77.5% 76.2%
Growth in Termite Customers 8% 20%
Termite Customer Retention Rate 90.1% 88.8%
AMERICAN HOME SHIELD -
Growth in Warranty Contracts 15% 11%
Customer Retention Rate 53.2% 51.1%
SEGMENT REVIEW
NOTE: THE COMPANY ADOPTED SFAS 142, "GOODWILL AND OTHER INTANGIBLE ASSETS",
WHICH ELIMINATES THE AMORTIZATION OF GOODWILL AND INTANGIBLE ASSETS WITH
INDEFINITE LIVES BEGINNING IN 2002. THE CHANGE IN METHOD OF ACCOUNTING FOR
CUSTOMER ACQUISITION COSTS AT AMERICAN HOME SHIELD HAS BEEN REFLECTED AS A
CUMULATIVE ADJUSTMENT AS OF JANUARY 1, 2002. FOR COMPARATIVE PURPOSES, 2001
SEGMENT RESULTS HAVE BEEN RESTATED TO EXCLUDE THE AMORTIZATION EXPENSE AFFECTED
BY THE NEW ACCOUNTING STANDARD AND RETROACTIVELY APPLY THE CHANGE IN METHOD OF
ACCOUNTING.
The TruGreen segment reported revenue of $663 million, slightly above the prior
year. Operating income decreased to $78 million from $87 million last year,
primarily reflecting an increased level of seasonal costs in the lawn care
operations, increased workers compensation claims in the landscaping operations
(approximately $5 million) and a lower volume of snow removal business
(approximately $2.5 million) early in the year. Revenue in the lawn care
business improved modestly over the prior year. Customer contracts have
increased one percent over the prior twelve months compared with a three percent
decline in the prior year period, reflecting the benefit of new marketing
strategies as well as the impact of improved customer retention. In addition to
telemarketing, which is the primary channel used by TruGreen ChemLawn to sell
its services, the business has expanded investments in direct mail and
television advertising leading to higher sales of new customers. Quality and
other satisfaction initiatives have resulted in improving retention of existing
customers. The customer retention rate improved 210 basis points to 64.5 percent
compared to the same period last year. The retention rate continued to increase
in the second
18
quarter. Operating margins in the lawn care operations declined, reflecting
improved labor productivity offset by an increased level of seasonal costs.
Year-to-date this year, the Company has expensed approximately $5 million more
in seasonal costs than in the prior year due to a higher expectation of revenue
in the prior year that did not materialize. Revenue in the landscaping business
declined reflecting a decrease in snow removal services due to mild winter
weather and a slight decrease in its core maintenance business. Despite the
decline in the maintenance business, the base of contracts is more profitable
reflecting stronger customers and improved pricing. Operating margins in the
landscaping services business declined primarily reflecting the decreased volume
of higher margin snow removal business and increased workers compensation
claims. Management is highly focused on mid-season sales of enhanced services to
support second half of the year growth expectations.
The Terminix segment reported a 12 percent increase in revenue to $475 million
from $425 million in 2001 and operating income growth of 16 percent to $82
million from $70 million last year. Revenue growth was driven by the acquisition
in 2001 of Sears Termite & Pest Control as well as solid internal growth. The
Sears acquisition continues to meet management's expectations with respect to
customer retention, remediation costs and overall profitability. One area where
the Company has begun to see challenges is in the sale of new pest control
customers to replace terminations in the Sears markets. As a result, the Company
expects to see a reduction in revenue growth in the fourth quarter. Terminix has
continued to show favorable comparisons in both termite and pest control
customer retention, reflecting increased focus on quality, training, and
customer service processes in the branches. Operating margins improved over the
prior year reflecting the impact of the acquisitions, continuing migration to
higher margin products, improved labor efficiencies and lower material costs.
Terminix is in the process of rolling out a new operating system to support its
field operations. This system is expected to be in all branches within the next
year.
The Home Maintenance and Improvement segment reported revenue of $621 million, a
decrease of four percent from $644 million last year. Operating income decreased
14 percent to $45 million compared to $52 million last year. American Home
Shield reported double-digit growth in revenue and profit. Both sales and
retention rates continued to show improvements over prior year levels. Operating
margins improved benefiting from lower service costs per claim and a decrease in
the incidence of claims. The combined ARS and AMS operations reported revenue
and profit significantly below the prior year. A softer economic environment
combined with mild weather led to lower demand for heating, air conditioning and
plumbing repairs and replacement service. These operations also experienced
lower construction activity in both the residential and commercial sectors. With
new leadership in place, this business continues to focus on cost containment
initiatives and is implementing significant changes to its sales and marketing
programs. The franchise operations achieved solid revenue and profit growth,
supported by strong demand for disaster restoration services at ServiceMaster
Clean, growth in the direct-owned branch operations at Merry Maids, and
acquisitions.
Other Operations revenue declined to $36 million from $37 million in the prior
year. This segment shows a net operating expense, which increased from the prior
year reflecting the increased investments in the headquarters organization for
Six Sigma and other initiatives including purchasing, marketing, and technology.
FINANCIAL CONDITION
Net cash provided from operations of $153 million was $41 million higher than
the first six months of 2001 before the impact of the Company's accounts
receivable securitization program and tax refunds in 2001. Net cash provided
from operations is 75 percent higher than earnings for the six months and
represents a 37 percent increase over the $112 million that was reported last
year. This increase was driven, in part, by a significant reduction in the use
of working capital, primarily at TruGreen ChemLawn and American Home Shield as a
result of better receivables, payables and inventory management. Management
believes that funds generated from operations and other existing resources will
continue to be adequate to satisfy ongoing working capital needs of the Company.
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Cash and marketable securities totaled approximately $215 million at June 30,
2002, including approximately $123 million of required regulatory investments at
American Home Shield. During the second quarter, the Company completed the last
major phase of the debt reduction program announced in October 2001, through the
repurchase of $218 million in face value of its corporate bonds. As a result the
Company reduced its total outstanding debt level in the quarter to approximately
$862 million. This represents a reduction in debt outstanding of approximately
$1.1 billion over the last two years and the Company's lowest level since the
first quarter of 1997. The debt repurchase allowed the Company the opportunity
to strengthen its credit profile by focusing the majority of the repurchase on
bonds with shorter maturities. Approximately 60% of the Company's debt now
matures beyond seven years and 40% beyond fifteen years. The Company's first
public bond maturity is not due until 2005.
The Company maintains a three-year revolving credit facility for $490 million,
which will expire in December 2004. As of June 30, 2002 the Company had issued
approximately $130 million of letters of credit under the facility and had
unused commitments of approximately $360 million. The Company also has $550
million of senior unsecured debt and equity securities available for issuance
under an effective shelf registration statement. In addition, the Company has an
agreement to ultimately sell, on a revolving basis, certain receivables to
unrelated third party purchasers. At June 30, 2002, there were no receivables
outstanding that had been sold to third parties. The agreement is a 364-day
facility that is renewable at the option of the purchasers. The Company may sell
up to $65 million of its eligible receivables to these purchasers in the future
and therefore has immediate access to cash proceeds from these sales. The amount
of eligible receivables varies during the year based on seasonality of the
business and will at times limit the amount available to the Company. The
Company also maintains operating lease facilities with banks totaling $95
million that provide for the acquisition and development of properties to be
leased by the Company. There is a residual value guarantee of these properties
up to 82 percent of the fair market value of the properties. At June 30, 2002,
there was approximately $72 million funded under these facilities. Of the $95
million in facilities, $80 million expires in October 2004 and $15 million
expires in January 2008. The majority of the Company's vehicle fleet and some of
its equipment needs are leased through cancelable operating leases. There are
residual value guarantees (ranging from 70% to 87% depending on the agreement)
on these vehicles and equipment, which historically have not resulted in
significant net payments to the lessors. At June 30, 2002, there was
approximately $265 million of residual value relating to these leases.
The following table presents the Company's obligations and commitments:
2003 and 2005 and 2007 and
(IN MILLIONS) TOTAL 2002 2004 2006 LATER YEARS
- -------------------------------------------------------------------------------------------------------------------
Debt balances $862 $21 $64 $169 $608
Non-cancelable operating leases 256 31 94 63 68
- -------------------------------------------------------------------------------------------------------------------
Total amount $1,118 $52 $158 $232 $676
There have been no material changes in the terms of the Company's financing
agreements since December 31, 2001. As described in the Company's latest Annual
Report to Shareholders, the Company is party to a number of debt agreements
which require it to maintain certain financial and other covenants, including
limitations on indebtedness and interest coverage ratio. In addition, under
certain circumstances, the agreements may limit the Company's ability to pay
dividends and repurchase shares of common stock. These limitations are not
expected to be a factor in the Company's future dividend and share repurchase
plans. Failure by the Company to maintain these covenants could result in the
acceleration of the maturity of the debt. At June 30, 2002, the Company is in
compliance with the covenants related to these debt agreements and based on its
operating outlook for the remainder of 2002, expects to be able to maintain
compliance in the future.
The assets and liabilities relating to the discontinued companies have been
classified in separate captions on the Consolidated Statements of Financial
Position. In the first quarter, the Company made approximately $70 million in
tax payments relating to the sale of Management Services. There were other cash
payments relating to the wind-down of the discontinued operations which
20
were offset by cash collected on assets remaining from these operations. Assets
of the discontinued operations have declined reflecting cash collections on
receivables and the sale of fixed assets. The liabilities from discontinued
operations have decreased reflecting cash outflows related to the wind-down of
contracts, lease termination costs, workers' compensation payments and legal
costs.
Accounts receivable and inventories increased from year-end levels, reflecting
general business growth and increased seasonal activity. Deferred revenues grew
significantly reflecting increases in customer prepayments for lawn care
services and strong growth in warranty contracts written at American Home
Shield. Prepaids and other assets have decreased from year-end reflecting the
impact of the change in accounting for customer acquisition costs at American
Home Shield, offset by the deferred seasonal costs in the lawn care business. As
required by APB No. 20 "Change in Accounting", the reduction in deferred
customer acquisition costs resulting from the change in accounting method has
been reflected as a cumulative adjustment as of January 1, 2002 and prior
periods have not been restated. The lawn care operation defers marketing and
other costs that are incurred earlier in the year, but are directly associated
with revenues realized in subsequent quarters of the current year. These costs
are then amortized over the balance of the current lawn care production season,
as the related revenues are recognized. No amounts are carried over the fiscal
year-end. In addition to the American Home Shield customer acquisition costs,
the Company capitalizes sales commission and other direct contract acquisition
costs relating to termite baiting and pest contracts.
Capital expenditures which include recurring capital needs and information
technology projects are higher than prior year levels reflecting the payments of
the residual value guarantees relating to leases for the five assisted living
facilities sold in the quarter. See Note 6 for additional details. The Company
has no material capital commitments at this time.
Total shareholders' equity was $1.2 billion at June 30, 2002 and December 31,
2001, reflecting earnings which were offset by cash dividends. Cash dividends
paid directly to shareholders totaled $60 million or $.20 per share for the six
months ended June 30, 2002. In July 2002, the Company paid a third quarter cash
dividend of $.105 per share and declared a fourth quarter cash dividend of $.105
per share payable on October 31, 2002. This quarterly dividend payment provides
for an annual payment for 2002 of $.41 per share, a 2.5% increase over 2001. The
Company approves its actual dividend payment on a quarterly basis and
continually reviews its dividend policy, share repurchase program and other
capital structure objectives. The Company has not undertaken material share
repurchases in 2001 and 2002 to date. Decisions relating to any future share
repurchases will take various factors into consideration such as the Company's
commitment to maintain investment grade credit ratings, general business
conditions, and other strategic investment opportunities.
As disclosed in Note 3, the Company has identified the most important accounting
policies in order to portray its financial condition and results of operations.
These policies relate primarily to revenue recognition and the deferral of
customer acquisition costs. Except for the change in accounting principle at
American Home Shield and the capitalization of direct-response advertising at
Terminix, the policies are the same as discussed in the 2001 Annual Report. The
critical estimates and assumptions required by management in order to prepare
the financial statements were also discussed in the 2001 Annual Report and in
Note 3 in this report. There have been no changes in the areas or methodologies
in 2002.
FORWARD LOOKING STATEMENT
The Company notes that statements that look forward in time, which include
everything other than historical information, involve risks and uncertainties
that affect the Company's results of operations. Factors which could cause
actual results to differ materially from those expressed or implied in a
forward-looking statement include the following (among others): weather
conditions adverse to certain of the Company's residential and commercial
services businesses; the entry of additional competitors in any of the markets
served by the Company; labor shortages; unexpected changes in operating costs;
the condition of the U.S. economy; the cost and length of time associated with
integrating or winding down businesses and other factors listed from time to
time in the Company's filings with the Securities and Exchange Commission.
21
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The Company does not hold or issue financial instruments for trading or
speculative purposes. The Company has entered into specific financial
arrangements in the normal course of business to manage certain market risks,
with a policy of matching positions and limiting the terms of contracts to
relatively short durations. The effect of financial instrument transactions is
not material to the Company's financial statements.
The Company generally maintains the majority of its debt at fixed rates (over
95% of total debt at both December 31, 2001, and June 30, 2002) and, therefore,
its exposure to interest rate fluctuations is not significant to the Company's
results of operations. The payments on the $72 million of outstandings on the
Company's real estate operating lease facilities as well as its cancelable
vehicle fleet and equipment operating leases are tied to floating interest
rates. However, the Company does not expect that interest rate fluctuations are
likely to be significant to the Company's results of operations.
The economy and its impact on discretionary consumer spending, labor wages, fuel
costs and medical inflation rates could be significant to future operating
earnings.
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PART II. OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The 2002 Annual Meeting of Shareholders was held on April 26, 2002.
(b) The following persons were elected as Class of 2005 directors:
NAME VOTES FOR VOTES WITHHELD BROKER NON-VOTES
- ---- --------- -------------- ----------------
Paul W. Berezny, Jr. 247,162,142 7,248,494 N/A
Carlos H. Cantu 248,659,562 5,751,074 N/A
Vincent C. Nelson 246,594,910 7,815,726 N/A
Charles W. Stair 248,226,619 6,184,017 N/A
Jonathan P. Ward 250,546,178 3,864,458 N/A
No votes were cast for any other nominee for directors. The Class of 2003
continuing in office are: Herbert P. Hess, Michele M. Hunt, Dallen W. Peterson,
and David K. Wessner. The Class of 2004 continuing in office are: Brian
Griffiths, Sidney E. Harris, James D. McLennan, C. William Pollard and Donald G.
Soderquist.
No other matters were submitted to shareholders.
ITEM 6(A): EXHIBITS
Exhibit 18.1 Letter Re: Change in Accounting Principles
Exhibit 99.1 Certification of Chief Executive Officer Pursuant to Section
1350 of Chapter 63 of Title 18 of the United States Code
Exhibit 99.2 Certification of Chief Financial Officer Pursuant to Section
1350 of Chapter 63 of Title 18 of the United States Code
ITEM 6(B): REPORTS ON FORM 8-K
A report on Form 8-K was filed on May 22, 2002 reporting under "Item 4. Changes
in Registrant's Certifying Accountant." In this filing, the Company reported
that on May 20, 2002 it had dismissed ArthurAndersen LLP as its independent
accountants and, effective May 22, 2002, the Company engaged Deloitte & Touche
LLP as its new independent accountants.
A report on Form 8-K/A was filed on May 24, 2002 for the purpose of including a
revised Exhibit 16.1 to the Form 8-K filed on May 22, 2002.
A report on Form 8-K was filed on June 20, 2002 reporting under "Item 5. Other
Events". The purpose of the report was to provide updated Key Performance
Indicators that were included in the Company's first quarter earnings release.
The Company discussed these metrics in an investors conference on June 20, 2002.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: August 13, 2002
THE SERVICEMASTER COMPANY
(Registrant)
By: /S/STEVEN C. PRESTON
------------------------------------------------------
Steven C. Preston
Executive Vice President and Chief Financial Officer
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