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, 2004
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)
3250 Lacey Road, Ste. 600, Downers Grove, Illinois 60515-1700
(Address of principal executive offices) (Zip Code)
630-663-2000
(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 by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes X No .
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock: 290,861,000 shares of common stock on August 2, 2004.
TABLE OF CONTENTS
Page
NO.
THE SERVICEMASTER COMPANY (Registrant) -
PART I. FINANCIAL INFORMATION
Item 1: Financial Statements (Unaudited)
Condensed Consolidated Statements of Operations for the three and
six months ended June 30, 2004 and June 30, 2003 3
Condensed Consolidated Statements of Financial Position
as of June 30, 2004 and December 31, 2003 4
Condensed Consolidated Statements of Cash Flows for the six months
ended June 30, 2004 and June 30, 2003 5
Notes to Condensed Consolidated Financial Statements 6
Item 2: Management Discussion and Analysis of Financial
Condition and Results of Operations 13
Item 3: Quantitative and Qualitative Disclosures About
Market Risk 22
Item 4: Controls and Procedures 23
PART II. OTHER INFORMATION
Item 2: Changes in Securities, Use of Proceeds and Issuer
Purchases of Equity Securities 24
Item 4: Submission of Matters to a Vote of Security Holders 24
Item 6: Exhibits and Reports on Form 8-K 25
Signature 26
PART I. FINANCIAL INFORMATION
THE SERVICEMASTER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Six Months Ended
June 30, June 30,
2004 2003 2004 2003
------------- ------------- ------------- -------------
OPERATING REVENUE .................................... $ 1,088,716 $ 1,031,470 $ 1,845,607 $ 1,743,813
OPERATING COSTS AND EXPENSES:
Cost of services rendered and products sold .......... 697,706 657,883 1,242,762 1,174,237
Selling and administrative expenses .................. 260,128 247,049 439,438 416,257
Amortization expense ................................. 1,511 1,722 2,933 3,362
----------- ----------- ----------- -----------
Total operating costs and expenses ................... 959,345 906,654 1,685,133 1,593,856
----------- ----------- ----------- -----------
OPERATING INCOME ..................................... 129,371 124,816 160,474 149,957
NON-OPERATING EXPENSE (INCOME):
Interest expense ..................................... 15,007 16,655 29,938 32,938
Interest and investment income ....................... (3,036) (3,125) (7,606) (4,344)
Minority interest and other expense, net ............. 2,086 2,046 4,132 4,118
----------- ----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS BEFORE
INCOME TAXES .................................. 115,314 109,240 134,010 117,245
Provision for income taxes............................ 44,626 42,911 51,861 46,073
----------- ----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS .................... 70,688 66,329 82,149 71,172
Loss from discontinued operations, net of income taxes (292) (779) (554) (947)
----------- ----------- ----------- -----------
NET INCOME ........................................... $ 70,396 $ 65,550 $ 81,595 $ 70,225
=========== =========== =========== ===========
PER SHARE:
BASIC EARNINGS PER SHARE:
Income from continuing operations .................... $ 0.24 $ 0.22 $ 0.28 $ 0.24
Discontinued operations .............................. - - - -
----------- ----------- ----------- -----------
Basic earnings per share ............................. $ 0.24 $ 0.22 $ 0.28 $ 0.24
=========== =========== =========== ===========
SHARES ............................................... 289,887 296,819 290,843 297,307
DILUTED EARNINGS PER SHARE:
Income from continuing operations .................... $ 0.24 $ 0.22 $ 0.28 $ 0.24
Discontinued operations .............................. - - - -
----------- ----------- ----------- -----------
Diluted earnings per share ........................... $ 0.24 $ 0.22 $ 0.28 $ 0.23
=========== =========== =========== ===========
SHARES ............................................... 302,944 308,947 295,490 301,188
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
3
THE SERVICEMASTER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
As of June 30, As of Dec. 31,
ASSETS 2004 2003
------------- -------------
CURRENT ASSETS:
Cash and cash equivalents ...................................................... $ 176,196 $ 228,161
Marketable securities .......................................................... 87,293 90,540
Receivables, less allowance of $29,266 and $26,220, respectively ............... 420,568 333,834
Inventories .................................................................... 71,507 70,163
Prepaid expenses and other assets .............................................. 74,860 33,408
Deferred customer acquisition costs ............................................ 59,239 41,806
Deferred taxes and income taxes receivable ..................................... 92,206 87,589
Assets of discontinued operations .............................................. 4,894 5,273
----------- -----------
Total Current Assets .................................................... 986,763 890,774
----------- -----------
PROPERTY AND EQUIPMENT:
At cost ..................................................................... 406,417 387,569
Less: accumulated depreciation .............................................. (221,638) (208,054)
----------- -----------
Net property and equipment ................................................ 184,779 179,515
----------- -----------
OTHER ASSETS:
Goodwill ....................................................................... 1,545,466 1,516,206
Intangible assets, primarily trade names ....................................... 219,782 216,453
Notes receivable ............................................................... 40,701 46,441
Long-term marketable securities ................................................ 97,560 92,562
Other assets ................................................................... 12,909 14,475
----------- -----------
Total Assets ............................................................ $ 3,087,960 $ 2,956,426
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ............................................................... $ 111,895 $ 86,963
Accrued liabilities:
Payroll and related expenses ................................................ 99,502 89,427
Self-insured claims and related expenses .................................... 84,842 73,320
Income taxes payable ........................................................ 22,567 -
Other ....................................................................... 114,523 100,454
Deferred revenues .............................................................. 467,184 419,915
Liabilities of discontinued operations ......................................... 11,494 14,380
Current portion of long-term debt .............................................. 29,346 33,781
----------- -----------
Total Current Liabilities ............................................... 941,353 818,240
----------- -----------
LONG-TERM DEBT ................................................................. 786,431 785,490
LONG-TERM LIABILITIES:
Deferred taxes ............................................................ 302,215 276,000
Liabilities of discontinued operations .................................... 31,064 34,396
Other long-term obligations ............................................... 122,903 125,474
----------- -----------
Total Long-Term Liabilities ............................................ 456,182 435,870
----------- -----------
MINORITY INTEREST .............................................................. 100,000 100,309
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Common stock $0.01 par value, authorized 1,000,000 shares; issued
317,700 and 317,315 shares, respectively .................................. 3,177 3,173
Additional paid-in capital ..................................................... 1,065,324 1,061,640
Retained earnings .............................................................. 26,646 6,365
Accumulated other comprehensive income ......................................... 6,539 7,932
Restricted stock ............................................................... (9,583) (4,368)
Treasury stock ................................................................. (288,109) (258,225)
----------- -----------
Total Shareholders' Equity .............................................. 803,994 816,517
----------- -----------
Total Liabilities and Shareholders' Equity .............................. $ 3,087,960 $ 2,956,426
=========== ===========
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
4
THE SERVICEMASTER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
Six Months Ended
June 30,
2004 2003
---------- -----------
CASH AND CASH EQUIVALENTS AT JANUARY 1 .................................. $228,161 $ 227,177
CASH FLOWS FROM OPERATING ACTIVITIES:
NET INCOME .......................................................................... 81,595 70,225
Adjustments to reconcile net income to net cash flows from operating activities:
Loss from discontinued operations ........................................... 554 947
Depreciation expense ........................................................ 24,327 24,782
Amortization expense ........................................................ 2,933 3,362
Deferred income tax expense ................................................. 44,961 39,738
Change in working capital, net of acquisitions:
Receivables ............................................................. (81,111) (64,553)
Inventories and other current assets .................................... (57,695) (47,130)
Accounts payable ........................................................ 25,126 (2,271)
Deferred revenues ....................................................... 40,360 38,154
Accrued liabilities ..................................................... 29,200 (4,428)
Other, net .............................................................. 5,446 1,554
--------- ---------
NET CASH PROVIDED FROM OPERATING ACTIVITIES ......................................... 115,696 60,380
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Property additions ............................................................ (24,226) (21,142)
Sale of equipment and other assets ............................................ 1,525 7,702
Business acquisitions, net of cash acquired ................................... (20,875) (16,630)
Notes receivable, financial investments and securities ........................ (3,370) (20,173)
--------- ---------
NET CASH USED FOR INVESTING ACTIVITIES .............................................. (46,946) (50,243)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net payments of debt .......................................................... (17,751) (15,256)
Purchase of ServiceMaster stock ............................................... (41,286) (48,975)
Shareholders' dividends ....................................................... (61,314) (62,815)
Other, net .................................................................... 5,648 6,399
--------- ---------
NET CASH USED FOR FINANCING ACTIVITIES .............................................. (114,703) (120,647)
--------- ---------
CASH USED FOR DISCONTINUED OPERATIONS ............................................... (6,012) (15,123)
--------- ---------
CASH DECREASE DURING THE PERIOD ..................................................... (51,965) (125,633)
--------- ---------
CASH AND CASH EQUIVALENTS AT JUNE 30 ................................................ $ 176,196 $ 101,544
========= =========
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
5
THE SERVICEMASTER COMPANY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1: The condensed 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 condensed consolidated financial statements have been prepared by
the Company in accordance with accounting principles generally accepted in the
United States (GAAP) and pursuant to the rules and regulations of the Securities
and Exchange Commission. The Company recommends that the quarterly condensed
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, 2003 (2003
Annual Report). The condensed consolidated financial statements reflect all
adjustments, which are, in the opinion of management, necessary for the fair
presentation of the financial position, results of operations and cash flows for
the interim periods. The results of operations for any interim period are not
necessarily indicative of the results which might be achieved for a full year.
NOTE 3: The Company has identified the most important accounting policies with
respect to its financial position 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, pest control, liquid and fumigation termite
applications, as well as heating/air conditioning and plumbing services are
recognized as the services are provided. Revenues from landscaping services are
recognized as they are earned based upon agreed monthly contract arrangements or
when services are performed for non-contractual arrangements. Revenues from the
Company's commercial installation contracts, primarily relating to heating,
ventilation and air conditioning (HVAC), and electrical are recognized on the
percentage of completion method in the ratio that total incurred costs bear to
total estimated costs. The Company eradicates termites through the use of
baiting systems, as well as through non-baiting methods (e.g., fumigation or
liquid treatment). Termite services using baiting systems as well as home
warranty services typically are sold through annual contracts for a one-time,
upfront payment. Direct costs of these contracts (service costs for termite
contracts and claim costs for warranty contracts) are expensed as incurred. The
Company recognizes revenue over the life of these contracts in proportion to the
expected direct costs. Revenue from trade name licensing arrangements is
recognized when earned. Franchised revenues (which in the aggregate represent
approximately three percent of consolidated revenue) consist principally of
monthly fee revenue, which is recognized when the related customer level revenue
is reported by the franchisee and collectibility is assured. Franchise revenue
also includes initial fees resulting from the sale of a franchise. These fees
are fixed and are recognized as revenue when collectibility is assured and all
material services or conditions relating to the sale have been substantially
performed. Income from franchised revenue represented nine percent and 13
percent of consolidated operating income for the three month periods and the six
month periods ended June 30, 2004 and 2003, respectively. The portion of total
franchise fee income related to initial fees received from the sale of a
franchise were immaterial to the Company's consolidated financial statements for
all periods.
The Company had $467 million and $420 million of deferred revenue at June 30,
2004 and December 31, 2003, respectively, which consist primarily of payments
received for annual contracts relating to home warranty, termite baiting, pest
control and lawn care services. The revenue related to these services is
recognized over the contractual period as the direct costs occur, such as when
the services are performed or claims are incurred.
Customer acquisition costs, which are incremental and direct costs of obtaining
a customer, are deferred and amortized over the life of the related 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.
TruGreen ChemLawn has significant seasonality to its business. In the winter and
early spring, this business sells a series of lawn applications to customers
which are rendered primarily in March through October. The Company incurs and
defers incremental selling expenses at the beginning of the year that directly
relate to successful sales for which the revenues will be recognized in later
quarters. This business
6
also defers, on an interim basis, pre-season advertising costs and the costs of
annual repairs and maintenance procedures that are performed in the first
quarter. These costs are deferred and recognized approximately in proportion to
the contract revenue over the production season, and are not deferred beyond the
calendar year-end.
As noted above, TruGreen's pre-season advertising costs are deferred and
recognized approximately in proportion to the contract revenue over the
production season. Terminix and ARS also defer advertising costs in the first
quarter and recognize the expense over the year approximately in proportion to
their revenue. These costs are not deferred beyond the calendar year-end. The
cost of direct-response advertising at Terminix is capitalized and amortized
over its expected period of future benefits. This direct-response advertising
consists primarily of direct-mail promotions, for which the cost is capitalized
and amortized over the one-year customer contract life.
The preparation of the financial statements requires management to make certain
estimates and assumptions required under GAAP which may differ materially from
the actual results. Disclosures in the 2003 Annual Report presented the
significant areas that require the use of management's estimates and discussed
how management formed its judgments. The areas discussed included the allowance
for receivables, accruals for self-insured retention limits related to medical,
workers compensation, auto and general liability insurance, accruals for home
warranty claims, the possible outcome of outstanding litigation, accruals for
income tax liabilities as well as deferred tax accounts, useful lives for
depreciation and amortization expense, and the valuation of tangible and
intangible assets. In 2004, there have been no changes in these significant
areas that require estimates or in the methodologies which underlie these
associated estimates. In the second quarter of 2004, there was a change in the
estimated allocation of annual fertilizer and weed control costs to first half
applications, which are relatively more costly. This change accelerated
recognition of approximately $6 million of expense into the second quarter that
will result in a corresponding benefit in later quarters of 2004.
NOTE 4: The Company carries insurance policies on insurable risks at levels
which it believes to be appropriate, including workers' compensation, auto and
general liability risks. The Company has self-insured retention limits and
insured layers of excess insurance coverage above those limits. Accruals for
self-insurance losses and warranty claims in the American Home Shield business
are made based on the Company's claims experience and actuarial projections.
Current activity could differ causing a change in estimates. 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 records deferred income tax balances based on the net tax effects of
temporary differences between the carrying value of assets and liabilities for
financial reporting purposes and income tax purposes. There are significant
amortizable intangible assets for tax reporting purposes (not for financial
reporting purposes) which arose as a result of the Company's reincorporation
from partnership to corporate form in 1997. The Company records its deferred tax
items based on the estimated ultimate value of the tax basis. The Company's tax
estimates are adjusted when required to reflect changes based on factors such as
changes in tax laws, results of tax authority reviews and statutory limitations.
In the event that actual results differ from the estimates discussed in this
note, the Company would reflect those changes, which could be material, in the
period that the difference is identified.
NOTE 5: In accordance with Statement of Financial Accounting Standards (SFAS)
142, goodwill and intangible assets that are not amortized are subject to
assessment for impairment by applying a fair-value based test on an annual basis
or more frequently if circumstances indicate a potential impairment. Such
circumstances could include actual earnings being significantly below
management's estimates. The Company's annual assessment date is October 1.
In April 2004, TruGreen ChemLawn acquired the assets of Greenspace Services
Limited, Canada's largest professional lawn care service company. Intangible
assets recorded were less than $15 million. The preliminary allocation of
purchase price is subject to change later this year as additional information is
obtained.
7
The table below summarizes the goodwill and intangible asset activity and
balances:
(In thousands) As of As of
Dec. 31, June 30,
2003 Additions Amort. 2004
------------ ------------ ----------- -------------
Goodwill(1) $ 1,516,206 $ 29,260 $ - $ 1,545,466
Trade names(1) 204,793 - - 204,793
Other intangible assets 35,432 6,262 - 41,694
Accumulated amortization(2) (23,772) - (2,933) (26,705)
------------ ------------ ------------ ------------
Net other intangibles 11,660 6,262 (2,933) 14,989
------------ ------------ ------------ ------------
Total $ 1,732,659 $ 35,522 $ (2,933) $ 1,765,248
=========== =========== ============ ============
(1) Not subject to amortization.
(2) Annual amortization expense of approximately $6 million in 2004 is expected
to decline over the next five years.
The table below presents, by segment, the goodwill that is not subject to
amortization:
(In thousands) June 30, Dec. 31,
2004 2003
----------- ----------
TruGreen $ 672,638 $ 652,534
Terminix 631,374 622,351
American Home Shield 72,085 72,085
ARS/AMS 56,171 56,171
Other Operations 113,198 113,065
---------- ----------
Total $1,545,466 $1,516,206
========== ==========
NOTE 6: Basic earnings per share is 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. Shares
potentially issuable under convertible securities have been considered
outstanding for the three months ended June 30, 2004 and 2003. However, for the
six months ended June 30, 2004 and 2003, shares potentially issuable under
convertible securities have not been considered outstanding as their inclusion
results in a less dilutive computation. Had the inclusion of convertible
securities not resulted in a less dilutive computation for the six months ended
June 30, 2004 and 2003, incremental shares attributable to the assumed
conversion of the debentures would have increased shares outstanding by 8.0
million shares and 8.2 million shares, respectively, and the after-tax interest
expense related to the convertible debentures that would have been added to net
income in the numerator would have been $2.4 million for both periods.
The following table reconciles both the numerator and the denominator of the
basic earnings per share from continuing operations computation to the numerator
and the denominator of the diluted earnings per share from continuing operations
computation.
(In thousands, except per share data) Three Months Three Months
Ended June 30, 2004 Ended June 30, 2003
-------------------------------- ------------------------------
CONTINUING OPERATIONS: Income Shares EPS Income Shares EPS
- ---------------------- ---------- --------- -------- ---------- --------- -------
Basic earnings per share $70,688 289,887 $0.24 $66,329 296,819 $0.22
======== =======
Effect of dilutive securities, net of tax:
Options 5,057 3,928
Convertible Securities 1,178 8,000 1,195 8,200
---------- --------- ---------- ---------
Diluted earnings per share $71,866 302,944 $0.24 $67,524 308,947 $0.22
========== ========= ======== ========== ========= =======
8
(In thousands, except per share data) Six Months Six Months
Ended June 30, 2004 Ended June 30, 2003
-------------------------------- ------------------------------
CONTINUING OPERATIONS: Income Shares EPS Income Shares EPS
- ---------------------- ---------- --------- -------- ---------- --------- -------
Basic earnings per share $82,149 290,843 $0.28 $71,172 297,307 $0.24
======== =======
Effect of dilutive securities, net of tax:
Options 4,647 3,881
---------- --------- ---------- ---------
Diluted earnings per share
$82,149 295,490 $0.28 $71,172 301,188 $0.24
========== ========= ======== ========== ========= =======
NOTE 7: The Company is accounting for employee stock options as compensation
expense in accordance with SFAS 123, "Accounting for Stock-Based Compensation."
SFAS 148 "Accounting for Stock-Based Compensation - Transition and Disclosure,
an amendment of FASB Statement No. 123", provides alternative methods of
transitioning to the fair-value based method of accounting for employee stock
options as compensation expense. The Company is using the "prospective method"
of SFAS 148 and is expensing the fair-value of new employee option grants
awarded subsequent to 2002.
Prior to 2003, the Company accounted for employee share options under the
intrinsic method of Accounting Principles Board Opinion No. 25, as permitted
under GAAP. Had compensation expense for employee options been determined under
the fair-value based method of SFAS 123 for all periods, proforma reported net
income and net earnings per share would reflect the following:
Three Months Ended Six Months Ended
June 30, June 30,
(In thousands, except per share data) 2004 2003 2004 2003
---------------------------------- -----------------------------
Net income as reported $ 70,396 $ 65,550 $ 81,595 $ 70,225
Add back: Stock-based compensation
expense included in reported net income,
net of related tax effects 290 313 539 477
Deduct: Stock-based compensation
expense determined under fair-value method,
net of related tax effects (1,396) (1,884) (2,820) (3,761)
-------- -------- -------- --------
Proforma net income $ 69,290 $ 63,979 $ 79,314 $ 66,941
======== ======== ======== ========
Basic Earnings Per Share:
As reported $0.24 $0.22 $0.28 $0.24
Proforma $0.24 $0.22 $0.27 $0.23
Diluted Earnings Per Share:
As reported $0.24 $0.22 $0.28 $0.23
Proforma $0.23 $0.21 $0.27 $0.22
In March 2004, the Financial Accounting Standards Board (FASB) issued an
Exposure Draft, "Share-Based Payment, an Amendment of FASB Statements No. 123
and 95". In its current form, this Exposure Draft would require companies to
record stock options and share grants at fair value and recognize this value as
compensation expense over their vesting period. The Exposure Draft would require
companies to record compensation expense for newly issued awards as well as the
unvested portion of previously issued awards that remain outstanding as of the
date of the adoption of the Exposure Draft. ServiceMaster has recorded
compensation expense relating to the vesting of awards granted subsequent to
2002. If adopted in its current form, the Exposure Draft would be effective for
fiscal years beginning after December 15, 2004. ServiceMaster is currently
assessing the potential impact of this Exposure Draft.
NOTE 8: In the Condensed 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 Condensed Consolidated Statements of Cash Flows for the six
months ended June 30, 2004 and 2003 is presented in the following table:
9
(IN THOUSANDS)
2004 2003
------------ ------------
CASH PAID FOR OR (RECEIVED FROM):
Interest expense.............................. $ 29,829 $ 30,799
Interest and investment income................ $ (8,446) $ (3,850)
Income taxes.................................. $ 6,296 $ 5,617
The increase in cash received from interest and investment income reflects a
higher level of gains realized on the investment portfolio at American Home
Shield.
NOTE 9: Total comprehensive income was $69 million and $72 million for the three
months ended June 30, 2004 and 2003, respectively and $80 million and $75
million for the six months ended June 30, 2004 and 2003, respectively. Total
comprehensive income includes primarily net income, changes in unrealized gains
and losses on marketable securities and foreign currency translation balances.
NOTE 10: The Company has an agreement which provides for the ongoing revolving
sale of a designated pool of accounts receivable of TruGreen and Terminix to a
wholly owned, bankruptcy-remote subsidiary, ServiceMaster Funding LLC.
ServiceMaster Funding LLC has entered into an agreement to transfer, on a
revolving basis, an undivided percentage ownership interest in a pool of
accounts receivable to unrelated third party purchasers. ServiceMaster Funding
LLC retains an undivided percentage interest in the pool of accounts receivable
and bad debt losses for the entire pool are allocated first to this retained
interest. During the six months ended June 30, 2004 and 2003, there were no
receivables sold to third parties under this agreement. However, the Company may
sell its receivables in the future, which would provide an additional funding
source. 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 receivables to
these purchasers in the future and therefore has immediate access to cash
proceeds from these sales. The amount of the eligible receivables varies during
the year based on seasonality of the business and will at times limit the amount
available to the Company.
NOTE 11: Total debt was $816 million at June 30, 2004, slightly below the prior
year end level. Approximately 65 percent of the Company's debt matures beyond
five years and 35 percent beyond fifteen years. The Company's next public debt
maturity of approximately $138 million is in April 2005. The Company has both
the intent and ability to pay this debt with other long term financing, and it
is classified as long-term debt in the Consolidated Statements of Financial
Position.
NOTE 12: During the third quarter of 2003, the Company sold substantially all of
the assets and related operational obligations of Trees, Inc., the utility line
clearing operations of TruGreen LandCare. The results of the utility line
clearing operations of Trees, Inc. have been reclassified as "Discontinued
Operations" and are not included in continuing operations.
In October 2001, the Company's Board of Directors approved a series of strategic
actions, which were the culmination of an extensive portfolio review process. As
part of this portfolio review, the Company sold or exited certain non-strategic
or under-performing businesses in 2001 and 2002. The results of these
discontinued business units have been reclassified as "Discontinued Operations"
in the accompanying financial statements.
The following table summarizes the activity during the six months ended June 30,
2004 for the remaining liabilities from the discontinued operations. The Company
believes that the remaining reserves continue to be adequate and reasonable.
10
(IN THOUSANDS) Balance at Balance at
December 31, Cash June 30,
2003 Payments 2004
----------- ----------- -----------
Remaining liabilities from
discontinued operations
LandCare Construction $ 7,152 $ 2,015 $ 5,137
LandCare utility line
clearing business 9,011 1,705 7,306
Certified Systems, Inc. 11,024 1,436 9,588
Management Services 283 56 227
International businesses 12,017 1,006 11,011
Other 9,289 - 9,289
NOTE 13: In the ordinary course, the Company is subject to review by domestic
and foreign taxing authorities, including the Internal Revenue Service ("IRS").
From 1986 through 1997 most operations of the Company were conducted in
partnership form, free of federal corporate income tax. During that period, the
Company was not reviewed by the IRS. In 1997, the Company converted from
partnership to corporate form. In 2003, the IRS commenced an examination of the
Company's consolidated income tax returns for 2002, 2001 and 2000. The Company
expects the IRS' examination to be in its final stages in late 2004 and
completed early in 2005. As with any review of this nature, the outcome of the
IRS examination is not known at this time.
NOTE 14: The business of the Company is conducted through five operating
segments: TruGreen, Terminix, American Home Shield, ARS/AMS and Other
Operations. In accordance with 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. The Terminix segment
provides termite and pest control services to residential and commercial
customers. The American Home Shield segment provides home warranties to
consumers that cover HVAC, plumbing and other home systems and appliances. This
segment also includes home inspection services provided by AmeriSpec. The
ARS/AMS segment provides HVAC and plumbing installation and repair services
provided under the ARS Service Express, American Mechanical Services and Rescue
Rooter brand names. The Other Operations segment includes the franchise and
company-owned operations of ServiceMaster Clean, Furniture Medic and Merry
Maids, which provide disaster restoration, cleaning, furniture repair and maid
services. The segment also includes the Company's headquarters operations, which
provide various technology, marketing, finance and other support services to the
business units. Segment information is presented in the following table.
11
(IN THOUSANDS) Three Months Three Months Six Months Six Months
Ended June 30, Ended June 30, Ended June 30, Ended June 30,
2004 2003 2004 2003
- -------------------------------------------------------------------------------- --------------------------------------------
Operating Revenue:
TruGreen $ 453,710 $ 434,290 $ 678,369 $ 638,837
Terminix 282,318 260,588 519,114 486,494
American Home Shield 133,462 126,149 236,259 220,373
ARS/AMS 179,697 172,977 333,681 324,410
Other Operations 39,529 37,466 78,184 73,699
- -------------------------------------------------------------------------------- --------------------------------------------
Total Operating Revenue $ 1,088,716 $ 1,031,470 $ 1,845,607 $ 1,743,813
================================================================================ ============================================
Operating Income:
TruGreen $ 65,897 $ 67,959 $ 62,999 $ 59,409
Terminix 48,483 41,897 84,737 75,425
American Home Shield 23,837 23,162 33,953 31,321
ARS/AMS 1,613 3,838 (2,035) 2,668
Other Operations (10,459) (12,040) (19,180) (18,866)
- -------------------------------------------------------------------------------- --------------------------------------------
Total Operating Income $ 129,371 $ 124,816 $ 160,474 $ 149,957
================================================================================ ============================================
(IN THOUSANDS) As of As of
June 30, 2004 Dec. 31, 2003
- --------------------------------------------------------------------------------------------------------
Identifiable Assets:
TruGreen $1,031,470 $ 911,958
Terminix 842,813 822,407
American Home Shield 450,087 422,765
ARS/AMS 197,443 185,528
Other Operations (and discontinued operations) 566,147 613,768
- --------------------------------------------------------------------------------------------------------
Total Identifiable Assets $3,087,960 $2,956,426
========================================================================================================
(IN THOUSANDS) As of As of
June 30, 2004 June 30, 2003
- --------------------------------------------------------------------------------------------------------
Capital Employed: (1)
TruGreen $ 895,246 $ 1,063,659
Terminix 602,811 577,985
American Home Shield 144,082 119,337
ARS/AMS 93,933 387,016
Other Operations (and discontinued operations) (16,301) (26,746)
- --------------------------------------------------------------------------------------------------------
Total Capital Employed $ 1,719,771 $ 2,121,251
========================================================================================================
(1) Capital employed is a non-U.S. GAAP measure that is defined as the
segment's total assets less liabilities, exclusive of debt balances. The
Company believes this information is useful to investors in helping them
compute return on capital measures and therefore better understand the
performance of the Company's business segments.
12
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
SECOND QUARTER 2004 COMPARED TO SECOND QUARTER 2003
CONSOLIDATED OVERVIEW
ServiceMaster (the "Company") reported second quarter 2004 revenue of $1.09
billion, six percent above 2003, with all of the business segments achieving
growth in revenue. Approximately five percent of the revenue growth was from
internal sources. Second quarter 2004 diluted earnings per share was $.24
compared to $.22 in 2003. Operating income for the second quarter increased four
percent to $129 million compared to $125 million in 2003. The increase in
operating income reflects double-digit growth at Terminix supported by an
improved termite swarm season this year and improved profitability in TruGreen's
landscape operations. This growth was partially offset by reduced profits at ARS
due to higher marketing, insurance and fuel costs and reduced project margins at
AMS due to depressed conditions in the commercial construction industry. In
addition, second quarter operating income was adversely impacted by an increase
in materials expense in the lawn care operations of TruGreen resulting from a
change in the estimated allocation of annual fertilizer and weed control costs
to first half applications, which are relatively more costly. This change
accelerated recognition of approximately $6 million more of expense into the
second quarter that will result in a corresponding benefit in later quarters of
2004.
The Company has re-affirmed its outlook for the year. The Company expects
revenue growth to be in the mid-single digits and earnings per share growing
somewhat faster than revenues. The Company projects that earnings per share for
the last six months of the year should be comparable to last year, reflecting
continued solid growth from operating activities offset by a lower level of
gains from the American Home Shield investment portfolio and a higher effective
tax rate. Economic conditions and consumer confidence continue to be favorable,
although the Company's projected results for the year continue to be tempered by
large increases in key costs such as variable compensation (returning to more
normal levels), insurance, and fuel ("factor costs") as well as the Company's
commitment to make appropriate investments in the business to sustain its
growth.
Overall, the Company believes it is well poised to continue to achieve solid
growth in income from operating activities in the second half of the year, after
absorbing the net effects of disproportionate increases in key factor costs,
continuing investments to sustain growth, and a few non-comparable items
recorded in 2003. There are three key factor costs that the Company has
previously discussed and that it believes will continue to increase much faster
than general inflation in the second half of 2004; (1) variable compensation
expense, which is being earned at more normal levels in 2004, but is up sharply
over the modest amounts accrued in 2003, (2) umbrella insurance premiums, which
increased significantly in 2004 when a multi-year contract expired, and (3)
higher fuel costs for the Company's fleet of over 24,000 vehicles, one of the
largest in the U.S. The Company estimates that on a combined basis, these three
costs will increase approximately $.05 per share in the second half of the year,
consistent with the first half of the year increase. Partially offsetting the
effect of these cost items, second half results should benefit by approximately
$.03 per share from non-recurring items recorded in the fourth quarter of 2003
at Terminix and American Home Shield related to the recognition of certain
contract renewal revenues. Overall, the Company expects growth in income from
operating activities in the second half of the year, after considering the
factor costs, investments and non-recurring items discussed above. However, this
growth is projected to be offset at the earnings per share level by a reduced
amount of investment gains at American Home Shield (due to softer prevailing
market conditions) and a higher consolidated effective tax rate.
Cost of services rendered and products sold increased six percent for the second
quarter and increased as a percentage of revenue to 64.1 percent in 2004 from
63.8 percent in 2003. This increase primarily reflects the impact of the
aforementioned increased chemical expense in the lawn care operations of
TruGreen. Selling and administrative expenses increased five percent for the
quarter. As a percentage of revenue, these costs decreased to 23.9 percent for
the quarter in 2004 from 24.0 percent in 2003.
13
Net non-operating expense decreased $1.5 million from 2003, primarily reflecting
savings resulting from interest rate swap agreements entered into at the end of
2003 and early 2004. Higher investment income from securities gains in the
American Home Shield investment portfolio were offset by a decline in investment
income in an employee deferred compensation trust. Related to the deferred
compensation trust, there was a corresponding reduction in compensation expense
within operating income.
SEGMENT REVIEW
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. The TruGreen segment reported a four percent
increase in second quarter revenue to $454 million compared to $434 million in
2003. The segment's operating income was $66 million compared to $68 million in
2003.
Revenue in the lawn care operations grew six percent over 2003. The comparison
to last year is impacted by the timing of lawn care production, with more
favorable weather conditions early this year resulting in a greater level of
production being completed in the first quarter. An eight percent growth in
customer counts was supported by continued significant improvement in customer
retention and acquisitions, partially offset by a modest decline in new sales.
In April, TruGreen ChemLawn acquired the assets of Greenspace Services Limited
("Greenspace"), Canada's largest professional lawn care service company.
Excluding the effects of the Greenspace acquisition, customer counts increased
three percent. The gains in customer retention were geographically broad based
and resulted from concerted management focus including the impact of using
better materials for more visible results, improving customer communication and
problem resolution procedures, focused incentive compensation structures at all
levels, and favorable weather conditions. The lawn care operations continued to
make very meaningful progress in diversifying their sales channels; placing less
reliance on telemarketing and more emphasis on direct mail, neighborhood
selling, and other efforts. As a result of the enactment of the National Do Not
Call Registry last fall, the Company's telemarketing sales for the six months
have declined over 10 percent, consistent with management's expectations. This
loss has been mostly offset by increases in direct mail and neighborhood sales
efforts. Overall, year-to-date sales were down less than four percent. The new
sales channels are more costly than telemarketing, but they are also expected to
produce customers with higher retention rates. Second quarter operating income
of the lawn care operations decreased $4 million and included the aforementioned
$6 million increase in material expense, offset in part by profits from the
Greenspace acquisition.
Second quarter revenue in the landscape maintenance business was consistent with
2003. Base contract maintenance revenues were flat as increases from new sales
were offset by lower customer retention. Enhancement revenues (e.g. add-on
services such as seasonal flower plantings) continued to experience solid
growth, reflecting focused sales efforts and an improving economy. This business
achieved modest operating profits in the quarter, a significant improvement over
the operating losses incurred last year. This reflects controlled overhead
spending and a stronger mix of higher margin enhancement revenues. Key areas of
management focus include strengthening the sales team and the maintenance base,
continuing to increase enhancement revenues, and improving operating consistency
through better process disciplines, especially in labor management and in the
pricing and bidding of new work.
Capital employed in the TruGreen segment decreased 16 percent reflecting the
impact of the impairment charge recorded in the third quarter of 2003, offset in
part by acquisitions. Capital employed is a non-U.S. GAAP measure that is
defined as the segment's total assets less liabilities, exclusive of debt
balances. The Company believes this information is useful to investors in
helping them compute return on capital measures and therefore better understand
the performance of the Company's business segments.
The Terminix segment, which includes termite and pest control services, reported
an eight percent increase in second quarter revenue to $282 million, compared to
$261 million in 2003 and operating income growth of 16 percent to $48 million
compared to $42 million in 2003. Strong growth in termite renewal revenue
reflected improved pricing, slightly offset by a modest decline in customers
available to renew coming out of last year's weather-plagued termite swarm.
Terminix also reported strong growth in revenue from termite completions, which
resulted from a strong increase in unit sales and improved price realization. As
previously disclosed, with the improved efficacy of liquid termite treatments,
the Company is providing consumers with the choice of receiving termite services
through baiting systems or liquid treatments. With this enhanced
14
termite offering, the Company is expecting, and has experienced, a shift in the
mix of its termite customer base from baiting systems to liquid treatments. This
change in mix is generally proceeding in line with management's expectations,
but at a slightly slower pace. By offering consumers a choice in treatments and
by tightening controls over price discounting, Terminix has been able to
increase the average price realized for each of the two treatment alternatives,
thus offsetting the adverse, short-term revenue and profit impacts of the mix
shift. Solid growth in pest control revenue was supported by continued strong
improvements in retention. The conversion from monthly to quarterly service is
progressing well and management is focused on realizing the resulting labor
efficiencies and improvements in customer satisfaction. The growth in operating
income reflected good cost controls and favorable leveraging of the strong
revenue growth. In both the second quarter of 2004 and 2003, the Terminix
operations experienced favorable trending in damage claim costs associated with
its acquired Sears termite customer base resulting in a comparable level
(approximately $6 million) of reduced expense in both periods.
In the third quarter, the Company anticipates termite completion revenues to be
down as a result of the deferred effects of the mix shift from bait to liquid. A
portion of bait completion sales revenue is required to be deferred and
recognized in subsequent quarters as periodic inspections of the bait systems
occur. In 2004, Terminix had less bait sales during the swarm season, resulting
in less deferred revenue to be recognized in quarters subsequent to the swarm.
This revenue reduction, as well as increased factor costs, will impair third
quarter profit comparisons. However, the Company believes that Terminix is
making good overall progress and expects it to achieve solid full year growth in
revenues and profits. Capital employed in the Terminix segment increased four
percent to $603 million, reflecting the impact of acquisitions and growth in the
business.
The American Home Shield (AHS) segment, which provides home warranties to
consumers that cover heating, ventilation and air conditioning (HVAC), plumbing
and other home systems and appliances, reported a six percent increase in
revenue to $133 million from $126 million in 2003 and operating income of $24
million compared to $23 million in 2003. Contract sales, which are reflected as
earned revenues over the subsequent twelve month contract period, increased 10
percent for the second quarter. Strong new sales growth in the
direct-to-consumer channel was supported by an increase in direct mail
solicitations, which were delayed last year. The real estate channel showed
improved momentum with a solid growth in sales for the second quarter. AHS'
pilot program to expand sales in under-penetrated markets, launched at the end
of the first quarter in two major cities, has performed well and will be
expanded in the third quarter. Management is focused on expanding the sales
force in these markets, and replicating high performing account executives
through increased up-front training and marketing support. Renewal revenues also
increased despite a modest decline in retention rates. Part of management's
strategic efforts to increase customer satisfaction and retention includes the
implementation of pilot programs in two states designed to improve the clarity
of coverage and ease of use of the product. As had been anticipated, second
quarter operating income grew less rapidly than revenue as the favorable effects
of revenue growth were partially offset by a lower level of favorable trending
in prior year contract cost activity than was realized in the second quarter of
2003, and as a result of current expenditures in the previously discussed real
estate market penetration and customer retention initiatives. The Company also
anticipates declines in AHS' margins in the second half of 2004 as a result of
the aforementioned strategic investments.
Capital employed increased 21 percent reflecting volume growth in the business
resulting in a higher level of cash and marketable securities balances. The
calculation of capital employed for the AHS segment includes approximately $238
million and $196 million of cash, cash equivalents and marketable securities at
June 30, 2004 and 2003, respectively.
The ARS/AMS segment provides direct HVAC and plumbing installation and repair
services under the ARS Service Express, Rescue Rooter, and American Mechanical
Services (for large commercial accounts) brand names. Second quarter segment
revenue of $180 million increased four percent. Excluding the effects of
discontinued branches, revenue grew seven percent. The segment reported
operating income of $2 million compared with operating income of $4 million in
2003. All three major categories of service (HVAC, plumbing and construction)
achieved revenue growth in the second quarter, an improvement over recent
unfavorable trends. HVAC revenue increased modestly, reflecting continued growth
in add-on-replacement work and a more favorable mix of higher-end,
high-efficiency units. Partially offsetting this growth was a reduced level of
core service calls, due in part to cooler seasonal temperatures in key parts of
the country. Plumbing revenue also increased modestly, reflecting strong
15
increases in sewer line repair and commercial initiatives, partially offset by
continued softness in core residential service calls. Residential construction
and commercial project revenues reported strong increases in revenue for the
quarter. The decrease in the segment's profitability reflects increased
marketing, fuel and insurance costs at ARS, as well as lower margins at AMS due
to cyclically depressed industry conditions in commercial real estate. Capital
employed decreased 76 percent reflecting the impact of the impairment charge
recorded in the third quarter of 2003.
The Other Operations segment includes the Company's ServiceMaster Clean and
Merry Maids operations as well as its headquarters functions. Revenue in this
segment increased six percent to $40 million compared to $37 million in 2003,
primarily reflecting continued strong growth in disaster restoration services at
ServiceMaster Clean and improved internal growth at Merry Maids. The Merry Maids
branches have shown improving momentum with a steady increase in the revenue
growth rate for the last several months, with July internal growth exceeding
eight percent. The reduction in the segment's operating loss for the quarter
reflects an increase in profits in the combined franchise operations and lower
overhead spending, which more than offset increased variable compensation and
insurance-related costs at the headquarters level. Capital employed in this
segment increased 39% primarily reflecting the Company's increase in cash levels
for the twelve months ended June 30, 2004.
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO JUNE 30, 2003
CONSOLIDATED REVIEW
The Company reported revenue of $1.85 billion for the six months ended June 30,
2004, a six percent increase over 2003. For the six months, diluted earnings per
share was $.28 compared with $.23 in 2003. Diluted earnings per share from
continuing operations was $.28, 17 percent above the $.24 reported in 2003.
Operating income increased seven percent to $160 million compared to $150
million in 2003. For the six months, all of the Company's business segments
reported increases in revenue with meaningful improvements in growth rate
trends. Substantially all of the six percent reported revenue growth was derived
from internal sources as the impact of acquisitions was offset by a decrease in
revenue related to operations shut-down in 2003. Most segments also reported
solid increases in profits for the six month period, led by solid double-digit
increases in Terminix and the lawn care operations of TruGreen. The cost
controls and the focus on improved efficiencies that were evident throughout the
enterprise during the second half of last year remained firmly in place, helping
the Company to offset large increases in certain key costs such as variable
compensation, insurance and fuel.
Cost of services rendered and products sold increased six percent for the six
months and as a percentage of revenue was 67.3 in both 2004 and 2003. Selling
and administrative expenses increased six percent and decreased as a percentage
of revenue to 23.8 percent in 2004 from 23.9 percent in 2003.
Net non-operating expense decreased $6 million from 2003, reflecting higher
investment income from securities gains in the American Home Shield investment
portfolio, as well as the favorable impact from interest rate swap agreements
entered into at the end of 2003 and early 2004.
16
KEY PERFORMANCE INDICATORS
The table below presents selected metrics related to customer counts and
customer retention for the three most profitable 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,
2004 2003
---------- --------
TRUGREEN CHEMLAWN-
Growth in Full Program Contracts 8% 2%
Customer Retention Rate 66.8% 64.1%
TERMINIX -
Growth in Pest Control Customers 6% 1%
Pest Control Customer Retention Rate 79.3% 75.8%
Growth in Termite Customers -1% -2%
Termite Customer Retention Rate 88.7% 88.6%
AMERICAN HOME SHIELD -
Growth in Warranty Contracts 6% 9%
Customer Retention Rate 54.9% 55.1% *
* Restated to conform with the 2004 calculation.
SEGMENT REVIEW
For the six months, the TruGreen segment reported a six percent increase in
revenue to $678 million compared to $639 million in 2003. Operating income
increased six percent to $63 million compared to $59 million in 2003.
Revenue in the lawn care operations increased nine percent over 2003 and
operating income grew 11 percent, or $7 million, for the six months. The strong
revenue growth reflects increased production levels and higher customer counts,
supported by improved retention rates and acquisitions, and more favorable
weather conditions during the first quarter, partially offset by a modest
decrease in new sales. As discussed in the second quarter comparison, TruGreen
ChemLawn acquired the assets of Greenspace in April and for the six months this
acquisition represented three percent of the revenue growth of the lawn care
operations. Customer counts increased eight percent over last year reflecting
the impacts of continued improvement in customer retention, acquisitions, and a
higher base of customers to start the year, partially offset by a modest
decrease in new sales. The Company continues to diversify its sales channels to
place less reliance on telemarketing, while more emphasis is being placed on
direct mail, neighborhood selling and other efforts. The customer retention
rates included in the Key Performance Indicators reflect a strong 270 basis
point improvement in TruGreen ChemLawn's retention. The increase in operating
income for the six months reflects higher revenues and labor and cost
efficiencies partially offset by higher marketing costs and the change in
estimate for allocating interim material costs that was discussed in the second
quarter comparison.
Revenue in the landscape maintenance business was consistent with prior year
levels reflecting stronger enhancement sales volume and a comparable level of
base contract maintenance revenue, offset by higher snow removal revenue in the
first quarter of 2003. Operating income of the landscape maintenance operations
declined by $3 million primarily reflecting a reduction in higher margin snow
removal volume, higher insurance and labor-related costs as well as $1.6 million
of branch consolidation costs incurred in the first six months of 2004.
The Terminix segment reported a seven percent increase in revenue for the six
months to $519 million compared to $486 million in 2003 and operating income
growth of 12 percent to $85 million compared to $75 million in 2003. The revenue
increase was supported by improved pricing on termite renewal contracts. Termite
completion revenue grew, reflecting a solid increase in volume following last
year's weak termite swarm season and improved price realization, offset by the
mix shift from the higher priced
17
bait product to lower priced liquid treatments. Unit sales growth in pest
control has been challenging, however there continues to be very significant
improvement in the pest control retention rate. The 350 basis point improvement
in pest control retention reflects the impacts of continued management focus and
incentive programs, as well as an improving economy. The growth in operating
income was driven by improved efficiency from an improved termite swarm season
compared to last year.
For the six months the American Home Shield segment reported a seven percent
increase in revenue to $236 million from $220 million in 2003 and operating
income growth of eight percent, to $34 million compared to $31 million in 2003.
Contract sales, which are reflected as earned revenue over the subsequent twelve
month contract period, increased nine percent for the six months. Sales in the
direct-to-consumer channel showed strong growth and were favorably impacted by
the timing of sales as direct mail solicitations last year were delayed. In
addition, the Company continues to expand its marketing efforts with premier
mortgage lenders and financial institutions. American Home Shield experienced
more moderate growth in its real estate and renewal channels, with the growth in
renewal sales being supported by an increase in renewable customers, partially
offset by less favorable retention rates. The growth in operating income was
consistent with the revenue growth rate. Current year contract costs continue to
trend favorably, with per unit cost decreases partially offsetting volume
growth.
The ARS/AMS segment reported a three percent increase in revenues for the six
months to $334 million. Excluding the effects of discontinued branches, revenue
growth was six percent. The segment reported an operating loss of $2 million
compared to operating income of $3 million in 2003. The growth in revenue
reflected strong increases in residential new construction and commercial
project revenue, offset by declines in HVAC service revenue. Plumbing revenue
increased less than one percent for the six month period. Within ARS, meaningful
progress has been made on specific initiatives to improve brand differentiation
(through such measures as on-time arrival guarantee), expand sewer line repair
revenue, and increase the average sales ticket prices on replacement HVAC sales.
As noted in the second quarter comparison, this business achieved revenue growth
in all three major categories of service during the second quarter, reversing
the unfavorable trends experienced over the prior several quarters. At AMS,
project bidding activity is increasing and contract pricing has shown initial
signs of improvement. The segment's decline in profitability for the six months
was a result of higher sales, advertising and insurance related costs at ARS, as
well as lower margins at AMS due to depressed industry conditions in commercial
real estate. Additionally, profitability was negatively impacted by a modest
revenue mix shift to the relatively lower margin construction business.
The Other Operations segment reported a six percent increase in revenues to $78
million for the six months compared with $74 million in 2003. The combined
ServiceMaster Clean and Merry Maids franchise operations reported revenue growth
of eight percent and a solid increase in operating income. ServiceMaster Clean
continued to experience strong increases in domestic disaster restoration
services as well as solid growth in its international operations. At Merry
Maids, a better economy and improved sales processes have driven a steady
increase in internal revenue growth in both the branch and franchise operations.
The segment's operating loss increased slightly over the prior year reflecting
increased profits in the combined franchise operations, partially offset by
increased insurance costs as well as a higher level of variable compensation
expense at the headquarters level.
FINANCIAL POSITION AND LIQUIDITY
CASH FLOWS FROM OPERATING ACTIVITIES
Net cash provided by operating activities totaled $116 million for the six
months, approximately $55 million more than last year's level. The majority of
the increase was realized in the first quarter and reflects reduced working
capital usage and an increased level of profits. The improvement in working
capital reflects a lower rate of cash outflows in early 2004 relating to
incentive compensation earned in 2003, combined with an increased level of
non-cash accruals for 2004 incentives, reflecting a return to more normal
incentive rates. Additionally, the Company experienced favorable impacts from
the timing and magnitude of other payments, partially offset by earlier spending
on certain full year marketing and advertising initiatives. For the full year
2004, the Company expects cash from operating activities to increase at a rate
consistent with earnings growth and to continue to substantially exceed net
income.
18
The Company receives a significant annual cash benefit from deferred income
taxes. Much of this benefit is due to a large base of tax deductible intangible
assets which exist for income tax reporting purposes but not for book purposes,
a significant portion of which arose in connection with the Company's 1997
conversion from a limited partnership to a corporation. In the ordinary course,
the Company is subject to review by domestic and foreign taxing authorities,
including the Internal Revenue Service ("IRS"). From 1986 through 1997 most
operations of the Company were conducted in partnership form, free of federal
corporate income tax. During that period, the Company was not reviewed by the
IRS. In 1997 the Company converted from partnership to corporate form. In 2003,
the IRS commenced an examination of the Company's consolidated income tax
returns for 2002, 2001 and 2000. The Company expects the IRS' examination to be
in its final stages in late 2004 and completed in early 2005. As with any review
of this nature, the outcome of the IRS examination is not known at this time.
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures, which include recurring capital needs and information
technology projects, were above prior year levels. The Company anticipates
approximately $50 million of capital expenditures in 2004 reflecting systems
enhancements and other initiatives. The Company has no material capital
commitments at this time.
Tuck-in acquisitions for the six months ended June 30, 2004 totaled $32 million,
compared with $21 million in 2003. Consideration consisted of cash payments and
seller financed notes. The increase in acquisitions reflects TruGreen ChemLawn's
purchase of Greenspace as well as the resumption of tuck-in acquisition activity
at Terminix. The Company continues to expect acquisitions for the full year to
increase significantly over last year's level, utilizing approximately $50
million in cash and note financing.
CASH FLOWS FROM FINANCING ACTIVITIES
Cash dividends paid to shareholders totaled $61 million or $.21 per share for
the six months ended June 30, 2004. In July 2004, the Company paid a third
quarter cash dividend of $.11 per share, a 4.8 percent increase in the quarterly
dividend amount compared to the $.105 per share paid in the second quarter. The
Company records its dividend liability on the record date.
The ServiceMaster Company and its Board of Directors review dividend policy and
other capital structure objectives on a regular basis. As part of this review,
it was determined that prevailing corporate best practice in the United States
is to have dividends declared in the same quarter that they are paid. To achieve
this result, it will be necessary to slightly modify the Company's historic
pattern of dividend declaration and payment dates. The Company plans to continue
to pay its dividends quarterly, with the payment schedule for each quarter
pushed back one month, to the end of November, February, May and August. This
change would become effective for the fourth quarter 2004 dividend payment,
which was previously expected to be paid in October, and would now be declared
in October and paid in November.
In 2003, the Company recorded its 33rd consecutive year of annual growth in its
dividend payment. As a result of the $.11 per share dividend paid in July 2004,
the Company is on track to continue this consecutive growth trend for 2004. The
timing and amount of future dividend increases are at the discretion of the
Board of Directors and will depend on, among other things, the Company's capital
structure objectives and cash requirements.
In July 2000, the Board of Directors authorized $350 million for share
repurchases. For the six months ended June 30, 2004, the Company repurchased
approximately $41 million of its shares with almost all of that activity
occurring in the first quarter. There remains approximately $104 million
available for repurchases under the July 2000 authorization. The Company's
current expectation is that full year 2004 repurchases will approximate last
year's level. The actual level of repurchases will be based on operating trends
and business acquisition opportunities, and will be consistent with the
Company's strategy to retain its investment grade status.
LIQUIDITY
Cash and short and long-term marketable securities totaled approximately $361
million at June 30, 2004, with approximately $276 million of that amount
required to support regulatory requirements at American Home Shield and for
other purposes. Total debt was $816 million at June 30, 2004, slightly below the
prior year end
19
amount and the lowest level since March of 1997. Approximately 65 percent of the
Company's debt matures beyond five years and 35 percent beyond fifteen years.
The Company's next public debt maturity of approximately $138 million is in
April 2005. The Company has both the intent and ability to pay this debt with
other long term financing.
Management believes that funds generated from operating activities and other
existing resources will continue to be adequate to satisfy ongoing working
capital needs of the Company. During the second quarter of 2004, the Company
replaced its previous $490 million credit facility with a new five-year
revolving credit facility for $500 million expiring in May 2009. As of June 30,
2004, the Company had issued approximately $154 million of letters of credit
under this facility and had unused commitments of approximately $346 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 arrangement enabling it to sell, on a revolving
basis, certain receivables to unrelated third party purchasers. At June 30,
2004, 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 receivables to these
purchasers in the future and therefore has immediate access to cash proceeds
from these sales. The amount of the eligible receivables varies during the year
based on seasonality of the business and will at times limit the amount
available to the Company.
As described in the Company's latest Annual Report to Shareholders, the Company
is party to a number of debt agreements that 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, 2004, the Company was in compliance with the covenants related
to these debt agreements and based on its operating outlook for the remainder of
2004, expects to be able to maintain compliance in the future.
The Company maintains operating lease facilities with banks with approximately
$95 million of total availability which provide for the acquisition and
development of branch properties to be leased by the Company. There are residual
value guarantees of these properties for up to 82 percent of their fair market
value. At June 30, 2004, there was approximately $73 million funded under these
facilities. Approximately $20 million of these leases have been included on the
balance sheet as assets with related debt as of June 30, 2004 and December 31,
2003. Of the $95 million available, $80 million expires in October 2004 and $15
million expires in January 2008. The Company intends to refinance the existing
facility which expires in October 2004. If the Company does not refinance the
facility it may be required to purchase the leased assets which total
approximately $53 million.
The majority of the Company's fleet and some equipment are leased through
operating leases. The lease terms are non-cancelable for the first twelve month
term, and then are month-to-month, cancelable at the Company's option. There are
residual value guarantees (ranging from 70 percent to 87 percent depending on
the agreement) on these vehicles and equipment, which historically have not
resulted in significant net payments to the lessors. At June 30, 2004, there was
approximately $248 million of residual value relating to the Company's fleet and
equipment leases.
The Company's 2003 Annual Report included disclosure of the Company's
contractual obligations and commitments as of December 31, 2003. The Company
continues to make the contractually required payments and therefore, the 2004
obligations and commitments as listed in the December 31, 2003 Annual Report
have been reduced by the required payments. The Company's Board of Directors has
authorized commitments for telecommunication services. These agreements, which
are in the process of being finalized, total approximately $30 million to be
paid over the next three years.
FINANCIAL POSITION - CONTINUING OPERATIONS
Receivables increased from year-end levels, reflecting general business growth
and increased seasonal activity. Prepaid expenses and other assets increased
from year end primarily reflecting preseason advertising costs and annual
repairs and maintenance procedures that are performed in the first quarter at
TruGreen ChemLawn and advertising at Terminix. These costs are deferred and
recognized over the production season
20
and are not deferred beyond the calendar year end. Deferred customer acquisition
costs increased reflecting the seasonality in the lawn care operations. In the
winter and early spring, this business sells a series of lawn applications to
customers which are rendered primarily in March through October. The lawn care
operations incur incremental selling expenses at the beginning of the year that
directly relate to successful sales in which the revenue will be recognized in
later quarters. These costs are deferred and recognized over the production
season and are not deferred beyond the calendar year-end. Property and equipment
increased slightly from year-end levels, reflecting general business growth.
Income taxes payable at June 30, 2004 reflects the Company's 2004 estimated
federal tax payment expected to be made in the third quarter. Deferred revenue
increased from year-end levels, reflecting the impact from the seasonal volume
of termite baiting sales and strong growth in customer prepayments at TruGreen
ChemLawn. The Company does not have any material capital commitments at this
time.
The Company has minority investors in Terminix. This minority ownership reflects
an interest issued to Allied Bruce Terminix Companies in connection with the
acquisition of its business in 2001. This equity security is convertible into
eight million ServiceMaster common shares. The ServiceMaster shares are
considered in the shares used for the calculation of diluted earnings per share.
Total shareholders' equity was $804 million at June 30, 2004 and $817 million at
December 31, 2003. The decrease primarily reflects earnings in the business
offset by cash dividend payments and share repurchases.
Dividends paid in 2003 on the Company's common stock were not taxable to
shareholders as dividend income for federal income tax purposes, but instead
were treated as a non-taxable return of capital. Under federal tax rules,
dividends are considered taxable only when paid out of current or accumulated
earnings and profits as defined under federal tax laws. As a result of its
December 1997 reincorporation, the Company only began generating corporate
earnings and profits for tax purposes in 1998. Since 1998, earnings and profits
for tax purposes have been reduced by dividend payments, amortization of
intangible assets for tax reporting, deductions relating to business closures
and the timing of certain other tax-related items. The Company currently expects
that approximately 70 percent of its 2004 dividends on common stock will be
taxable as dividend income for federal income tax purposes. The Company
currently expects that the taxable portion of its dividend income will grow to
be fully taxable by the year 2007.
FINANCIAL POSITION - DISCONTINUED OPERATIONS
The assets and liabilities related to discontinued businesses have been
classified in separate captions on the Consolidated Statements of Financial
Position. Assets from the discontinued operations have declined slightly from
year-end levels representing collections on receivables. The remaining
liabilities primarily represent obligations related to long-term self-insurance
claims.
FORWARD-LOOKING STATEMENTS
THE COMPANY'S ANNUAL REPORT CONTAINS OR INCORPORATES BY REFERENCE STATEMENTS
CONCERNING FUTURE RESULTS AND OTHER MATTERS THAT MAY BE DEEMED TO BE
"FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995. THE COMPANY INTENDS THAT THESE FORWARD-LOOKING
STATEMENTS, WHICH LOOK FORWARD IN TIME AND INCLUDE EVERYTHING OTHER THAN
HISTORICAL INFORMATION, BE SUBJECT TO THE SAFE HARBORS CREATED BY SUCH
LEGISLATION. THE COMPANY NOTES THAT THESE FORWARD-LOOKING STATEMENTS INVOLVE
RISKS AND UNCERTAINTIES THAT COULD AFFECT ITS RESULTS OF OPERATIONS, FINANCIAL
CONDITION OR CASH FLOWS. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN A FORWARD-LOOKING STATEMENT
INCLUDE THE FOLLOWING (AMONG OTHERS): WEATHER CONDITIONS THAT AFFECT THE DEMAND
FOR THE COMPANY'S SERVICES; COMPETITION IN THE MARKETS SERVED BY THE COMPANY;
LABOR SHORTAGES OR INCREASES IN WAGE RATES; UNEXPECTED INCREASES IN OPERATING
COSTS, SUCH AS HIGHER INSURANCE AND SELF INSURANCE AND HEALTH CARE COSTS; HIGHER
FUEL PRICES; INCREASED GOVERNMENTAL REGULATION INCLUDING TELEMARKETING; GENERAL
ECONOMIC CONDITIONS IN THE UNITED STATES, ESPECIALLY AS THEY MAY AFFECT HOME
SALES OR CONSUMER SPENDING LEVELS; TIME AND EXPENSES ASSOCIATED WITH INTEGRATING
AND WINDING DOWN BUSINESSES; AND OTHER FACTORS DESCRIBED FROM TIME TO TIME IN
DOCUMENTS FILED BY THE COMPANY WITH THE SECURITIES AND EXCHANGE COMMISSION.
21
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The economy and its impact on discretionary consumer spending, labor wages, fuel
prices, insurance costs and medical inflation rates could be significant to
future operating earnings.
The Company does not hold or issue financial instruments for trading or
speculative purposes. The Company has entered into specific financial
arrangements, primarily fuel hedges, 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 derivative financial
instrument transactions is not material to the Company's financial statements.
In December 2003 and January 2004, the Company entered into interest rate swap
agreements with a total notional amount of $165 million. Under the terms of
these agreements, the Company pays a floating rate of interest (based on a
specified spread over six-month LIBOR) on the notional amount and the Company
receives a fixed rate of interest at 7.88% on the notional amount. The impact of
these swap transactions was to convert $165 million of the Company's debt from a
fixed rate of 7.88% to a variable rate based on LIBOR.
The Company generally maintains the majority of its debt at fixed rates. After
the effect of the interest swap agreements, approximately 78 percent of total
debt at June 30, 2004 was at a fixed rate. With respect to other obligations,
the payments on the approximately $73 million of funding outstanding under the
Company's real estate operating lease facilities as well as its fleet and
equipment operating leases (approximately $248 million in residual value) are
tied to floating interest rates. The Company's exposure to interest expense
based on floating rates is partially offset by floating rate investment income
earned on cash and marketable securities. The Company believes its overall
exposure to interest rate fluctuations is not material to its overall results of
operations.
The Company has several debt and lease agreements where the interest rate or
rent payable under the agreements automatically adjusts based on changes in the
Company's credit ratings. While the Company is not currently expecting a change
in its credit ratings, based on amounts outstanding at June 30, 2004, a one
rating category improvement in the Company's credit ratings would reduce annual
pre-tax expense by approximately $0.8 million. A one rating category reduction
in the Company's credit ratings would increase pre-tax expense on an annualized
basis by approximately $0.9 million.
The following table summarizes information about the Company's fixed rate debt
as of December 31, 2003, including the principal cash payments and related
weighted-average interest rates by expected maturity dates. The fair-value of
the Company's fixed rate debt was approximately $862 million at December 31,
2003.
Expected Maturity Date
-------------------------------------
There-
(In millions) 2004 2005 2006 2007 2008 after Total
-------------------- ------ ------- ------- ------ ------- -------- -------
Fixed rate debt $28 $151 $12 $60 $8 $540 $799
Avg. rate 4.8% 8.3% 6.0% 6.7% 6.1% 7.7% 7.6%
-------------------- ------ ------- ------- ------ ------- -------- -------
As previously discussed, the Company has entered into interest rate swap
agreements, the impact of which was to convert $165 million of the Company's
2009 maturity debt from a fixed rate of 7.88% to a variable rate based on LIBOR.
22
CONTROLS AND PROCEDURES
The Company's Chairman and Chief Executive Officer, Jonathan P. Ward, and the
Company's President and Chief Financial Officer, Ernest J. Mrozek, have
evaluated the Company's disclosure controls and procedures as of the end of the
period covered by this report.
The Company's disclosure controls and procedures include a roll-up of financial
and non-financial reporting that is consolidated in the principal executive
office of the Company in Downers Grove, Illinois. The reporting process is
designed to ensure that information required to be disclosed by the Company in
the reports that it files with or submits to the Securities and Exchange
Commission is recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange Commission's rules and forms.
Messrs. Ward and Mrozek have concluded that both the design and operation of the
Company's disclosure controls and procedures are effective.
There were no changes in the Company's internal control over financial reporting
that occurred during the Company's most recent fiscal quarter that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
23
PART II. OTHER INFORMATION
ITEM 2: CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY
SECURITIES
SHARE REPURCHASES:
In July 2000, the Board of Directors authorized $350 million for share
repurchases. The following table summarizes the Company's common stock share
repurchases for the three months ended June 30, 2004 under its share repurchase
authorization. Decisions relating to any future share repurchases will depend on
various factors such as the Company's commitment to maintain investment grade
credit ratings and other strategic investment opportunities.
Total Approximate
Number Dollar Value
of Shares of Shares that
Purchased as May Yet be
Total Number Average Price Part of Publicly Purchased
of Shares Paid per Announced Under the
Purchased (a) Share Plan Plan
- ---------------------------------------------------------------------------------------------------------------------
April 1, 2004 through
April 30, 2004 - $ - - $ 104,000,000
May 1, 2004 through
May 31, 2004 530 $ 11.85 530 $ 104,000,000
June 1, 2004 through
June 30, 2004 - $ - - $ 104,000,000
---------------------------------------------------------
Total 530 $ 11.85 530
=========================================================
(a) Does not include 2,321 shares acquired from employees in connection with the
settlement of income tax and related withholding obligations arising from the
exercise of stock options or vesting of restricted stock grants.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The Company's 2004 Annual Meeting of Shareholders ("Annual Meeting") was
held on April 30, 2004 in Downers Grove, Illinois.
(b) The following persons were elected as Class of 2007 directors:
NAME VOTES FOR VOTES WITHHELD BROKER NON-VOTES
- ---------------- ----------- -------------- ----------------
Brian Griffiths 236,437,014 13,077,337 N/A
Sidney E. Harris 240,437,841 9,076,510 N/A
James D. McLennan 240,303,451 9,210,900 N/A
No votes were cast for any other nominee for directors. The Class of 2005
continuing in office are: Paul W. Berezny, Jr., Roberto R. Herencia, Betty Jane
Scheihing and Jonathan P. Ward. The Class of 2006 continuing in office are: John
L. Carl, Herbert P. Hess, Dallen W. Peterson and David K. Wessner.
Subsequent to the Annual Meeting, Herbert P. Hess retired from the Board of
Directors and the Board of Directors elected Coleman H. Peterson to the Class of
2005.
(c) The shareholders also voted on three proposals at the Annual Meeting. The
following table shows the vote tabulation for the shares represented at the
meeting:
24
Votes Votes Votes Broker
Proposal For Against Abstained Non-Votes
- --------------------------------------------------------------------------------------------------------------------
Ratification of Deloitte & Touche's
selection as independent auditor 242,865,722 5,486,433 1,162,135 N/A
Approval of the ServiceMaster 2004
Employee Stock Purchase Plan 185,065,463 9,473,614 3,651,130 51,324,144
Shareholder proposal relating to
Rights Plan 122,904,731 71,864,739 3,420,728 51,324,153
ITEM 6(A): EXHIBITS
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- ----------- ----------------------
4.1 $500,000,000 Credit Agreement among the ServiceMaster Company,
the lenders, JPMorgan Chase Bank and Bank of America N.A. as
syndication agents, SunTrust Bank as administrative agent, and
U.S. Bank and Wachovia Bank N.A. as documentation agents dated as
of May 19, 2004
31.1 Certification of Chief Executive Officer Pursuant to Rule 13a -
14(a) or 15d - 14(a), as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Officer Pursuant to Rule 13a -
14(a) or 15d - 14(a), as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
32.1 Certification of Chief Executive Officer Pursuant to Section 1350
of Chapter 63 of Title 18 of the United States Code, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer Pursuant to Section 1350
of Chapter 63 of Title 18 of the United States Code, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
ITEM 6(B): REPORTS ON FORM 8-K
A report on Form 8-K was furnished on April 28, 2004. The purpose of the report
was to provide under Item 12, the press release issued by the Company on April
28, 2004 announcing the financial results for the first quarter of 2004.
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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 9, 2004
THE SERVICEMASTER COMPANY
(Registrant)
By: /S/ ERNEST J. MROZEK
------------------------------------------------------
Ernest J. Mrozek
President and Chief Financial Officer
26