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, 2005
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: 291,856,000 shares of common stock on August 3, 2005.
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, 2005 and June 30, 2004 3
Condensed Consolidated Statements of Financial Position
as of June 30, 2005 and December 31, 2004 4
Condensed Consolidated Statements of Cash Flows for the six months
ended June 30, 2005 and June 30, 2004 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: Unregistered Sales of Equity Securities and Use of Proceeds 24
Item 4: Submission of Matters to a Vote of Security Holders 24
Item 6: Exhibits 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,
2005 2004 2005 2004
------------ ----------- ------------ -----------
OPERATING REVENUE .................................... $ 1,174,112 $ 1,088,716 $ 1,956,421 $ 1,845,607
OPERATING COSTS AND EXPENSES:
Cost of services rendered and products sold .......... 745,384 697,706 1,301,707 1,242,762
Selling and administrative expenses .................. 282,504 260,128 481,488 439,438
Amortization expense ................................. 1,331 1,511 2,483 2,933
----------- ----------- ----------- -----------
Total operating costs and expenses ................... 1,029,219 959,345 1,785,678 1,685,133
----------- ----------- ----------- -----------
OPERATING INCOME ..................................... 144,893 129,371 170,743 160,474
NON-OPERATING EXPENSE (INCOME):
Interest expense ..................................... 14,401 15,007 29,980 29,938
Interest and investment income ....................... (3,226) (3,036) (12,600) (7,606)
Minority interest and other expense, net ............. 2,047 2,086 4,093 4,132
----------- ----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS BEFORE
INCOME TAXES .................................. 131,671 115,314 149,270 134,010
Provision for income taxes............................ 51,486 44,626 58,367 51,861
----------- ----------- ----------- -----------
INCOME FROM CONTINUING OPERATIONS .................... 80,185 70,688 90,903 82,149
Loss from discontinued operations, net of income taxes (384) (292) (530) (554)
----------- ----------- ----------- -----------
NET INCOME ........................................... $ 79,801 $ 70,396 $ 90,373 $ 81,595
=========== =========== =========== ===========
PER SHARE:
BASIC EARNINGS PER SHARE:
Income from continuing operations .................... $ 0.27 $ 0.24 $ 0.31 $ 0.28
Discontinued operations .............................. - - - -
----------- ----------- ----------- -----------
Basic earnings per share ............................. $ 0.27 $ 0.24 $ 0.31 $ 0.28
=========== =========== =========== ===========
SHARES ............................................... 291,634 289,887 291,400 290,843
DILUTED EARNINGS PER SHARE:
Income from continuing operations .................... $ 0.27 $ 0.24 $ 0.31 $ 0.28
Discontinued operations .............................. - - - -
----------- ----------- ----------- -----------
Diluted earnings per share ........................... $ 0.27 $ 0.24 $ 0.30 $ 0.28
=========== =========== =========== ===========
SHARES ............................................... 305,377 302,944 305,254 295,490
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 2005 2004
------------------ --------------
CURRENT ASSETS:
Cash and cash equivalents ....................................... $ 121,876 $ 256,626
Marketable securities ........................................... 109,062 103,681
Receivables, less allowance of $27,768 and $25,183, respectively 459,585 369,026
Inventories ..................................................... 77,582 66,657
Prepaid expenses and other assets ............................... 61,546 27,456
Deferred customer acquisition costs ............................. 69,192 41,574
Deferred taxes and income taxes receivable ...................... 84,157 108,780
Assets of discontinued operations ............................... 973 4,952
----------- -----------
Total Current Assets ..................................... 983,973 978,752
----------- -----------
PROPERTY AND EQUIPMENT:
At cost ...................................................... 422,255 405,655
Less: accumulated depreciation ............................... (238,138) (218,838)
----------- -----------
Net property and equipment ................................. 184,117 186,817
----------- -----------
OTHER ASSETS:
Goodwill ........................................................ 1,589,872 1,568,044
Intangible assets, primarily trade names ........................ 220,727 220,780
Notes receivable ................................................ 33,536 35,411
Long-term marketable securities ................................. 142,266 135,824
Other assets .................................................... 11,933 14,574
----------- -----------
Total Assets ............................................. $ 3,166,424 $ 3,140,202
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ................................................ $ 110,750 $ 76,053
Accrued liabilities:
Payroll and related expenses ................................. 113,307 113,366
Self-insured claims and related expenses ..................... 93,312 86,554
Income taxes payable ......................................... 22,951 152,841
Other ........................................................ 118,571 111,092
Deferred revenues ............................................... 491,087 443,238
Liabilities of discontinued operations .......................... 18,042 21,536
Current portion of long-term debt ............................... 22,116 23,247
----------- -----------
Total Current Liabilities ................................ 990,136 1,027,927
----------- -----------
LONG-TERM DEBT .................................................. 776,950 781,841
LONG-TERM LIABILITIES:
Deferred taxes ............................................... 112,075 88,100
Liabilities of discontinued operations ....................... 9,150 9,057
Other long-term obligations .................................. 156,880 141,742
----------- -----------
Total Long-Term Liabilities .............................. 278,105 238,899
----------- -----------
MINORITY INTEREST ............................................... 100,000 100,000
COMMITMENTS AND CONTINGENCIES ...................................
SHAREHOLDERS' EQUITY:
Common stock $0.01 par value, authorized 1,000,000 shares; issued
319,878 and 318,559 shares, respectively ................... 3,199 3,186
Additional paid-in capital ...................................... 1,096,955 1,083,057
Retained earnings ............................................... 238,464 212,116
Accumulated other comprehensive income .......................... 8,062 10,804
Restricted stock ................................................ (16,980) (12,857)
Treasury stock .................................................. (308,467) (304,771)
----------- -----------
Total Shareholders' Equity ............................... 1,021,233 991,535
----------- -----------
Total Liabilities and Shareholders' Equity ............... $3,166,424 $ 3,140,202
=========== ===========
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,
2005 2004
---------- ----------
CASH AND CASH EQUIVALENTS AT JANUARY 1 .................................. $256,626 $ 228,161
CASH FLOWS FROM OPERATING ACTIVITIES:
NET INCOME .............................................................. 90,373 81,595
Adjustments to reconcile net income to net cash flows from operating activities:
Loss from discontinued operations ............................... 530 554
Depreciation expense ............................................ 25,029 24,327
Amortization expense ............................................ 2,483 2,933
Change in working capital, net of acquisitions:
Receivables ................................................. (92,233) (81,111)
Inventories and other current assets ........................ (68,301) (57,695)
Accounts payable ............................................ 35,583 25,126
Deferred revenues ........................................... 47,349 40,360
Accrued liabilities ......................................... 32,093 29,200
Change in tax accounts:
Deferred income taxes ................................... 49,224 44,961
Resolution of income tax audits ......................... (131,562) -
Other, net ...................................................... 6,573 5,446
--------- ---------
NET CASH (USED FOR) PROVIDED FROM OPERATING ACTIVITIES .................. (2,859) 115,696
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Property additions ................................................ (22,328) (24,226)
Sale of equipment and other assets ................................ 1,138 1,525
Business acquisitions, net of cash acquired ....................... (19,125) (20,875)
Notes receivable, financial investments and securities ............ (11,507) (3,370)
--------- ---------
NET CASH USED FOR INVESTING ACTIVITIES .................................. (51,822) (46,946)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings of debt ................................................ 318,242 -
Payments of debt .................................................. (329,042) (17,751)
Purchase of ServiceMaster stock ................................... (16,979) (41,286)
Shareholders' dividends ........................................... (64,025) (61,314)
Other, net ........................................................ 12,064 5,648
--------- ---------
NET CASH USED FOR FINANCING ACTIVITIES .................................. (79,740) (114,703)
--------- ---------
NET CASH USED FOR OPERATING ACTIVITIES OF DISCONTINUED OPERATIONS ....... (329) (6,012)
--------- ---------
CASH DECREASE DURING THE PERIOD ......................................... (134,750) (51,965)
--------- ---------
CASH AND CASH EQUIVALENTS AT JUNE 30 .................................... $ 121,876 $ 176,196
========= =========
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 incorporated in the Form 10-K filed with the
Securities and Exchange Commission for the year ended December 31, 2004 (2004
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 treatments). Termite services using baiting systems as well as home
warranty services frequently 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. Franchised revenue (which in the aggregate represents
less than four percent of consolidated revenue) consists principally of monthly
fees based upon the franchisee's customer level revenue. Monthly fee revenue 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 seven percent and eight percent of consolidated
operating income before headquarter overheads for the three months ended June
30, 2005 and 2004, respectively, and 11 percent of consolidated operating income
before headquarter overheads for the six months ended June 30, 2005 and June 30,
2004. 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 $491 million and $443 million of deferred revenue at June 30,
2005 and December 31, 2004, respectively, which consist primarily of upfront
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.
6
TruGreen ChemLawn has significant seasonality in 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 production season).
This business incurs incremental selling expenses at the beginning of the year
that directly relate to successful sales for which the revenues are recognized
in later quarters. TruGreen ChemLawn also defers, on an interim basis,
pre-season advertising costs and annual repairs and maintenance procedures that
are performed in the first quarter. These costs are deferred and recognized in
proportion to the contract revenue over the production season, and are not
deferred beyond the calendar year-end. In the second quarter of 2005, TruGreen
ChemLawn corrected its method of allocating certain sales and marketing costs
among interim periods. This change resulted in more costs being deferred in the
second quarter, which will then be expensed over the remaining production
season. Other business segments of the Company also defer, on an interim basis,
advertising costs incurred early in the year. These costs are deferred and
recognized approximately in proportion to revenue over the balance of the year,
and are not deferred beyond the calendar year-end.
The cost of direct-response advertising at Terminix 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 2004 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 uncollectible receivables; accruals for self-insured retention limits
related to medical, workers' compensation, auto and general liability insurance
claims; accruals for home warranty and termite damage claims, the possible
outcome of outstanding litigation, income tax liabilities and deferred tax
accounts; useful lives for depreciation and amortization expense, and the
valuation of tangible and intangible assets. In 2005, there have been no changes
in the significant areas that require estimates or in the underlying
methodologies used in determining the amounts of these associated estimates.
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.
Any resulting adjustments, which could be material, are recorded in the period
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.
The goodwill and intangible assets that were added in the first six months this
year relate to tuck-in acquisitions completed by Terminix and TruGreen ChemLawn.
7
The table below summarizes the goodwill and intangible asset activity and
balances:
(In thousands) As of As of
Dec. 31, June 30,
2004 Additions Amort. 2005
------------- ------------- ----------- ------------
Goodwill(1) $1,568,044 $21,828 $ - $1,589,872
Trade names(1) 204,793 - - 204,793
Other intangible assets 45,788 2,430 - 48,218
Accumulated amortization(2) (29,801) - (2,483) (32,284)
------------- ------------- ----------- -------------
Net other intangibles 15,987 2,430 (2,483) 15,934
------------- ------------- ----------- -------------
Total $1,788,824 $24,258 $(2,483) $1,810,599
============= ============= ============= =============
(1) Not subject to amortization.
(2) Annual amortization expense of approximately $6 million in 2005 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,
2005 2004
------------- --------------
TruGreen $693,449 $681,954
Terminix 654,142 643,567
American Home Shield(1) 85,526 72,085
ARS/AMS 56,171 56,171
Other Operations(1) 100,584 114,267
------------- --------------
Total $1,589,872 $1,568,044
============= ==============
(1) In the second quarter of 2005, approximately $13 million of enterprise
goodwill was reclassified to the American Home Shield segment from the
Other Operations segment.
NOTE 6: 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 include the incremental effect related to outstanding options and
stock appreciation rights (SARS) whose market price is in excess of the grant
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 securities is added back to net income in the
numerator, while the diluted shares in the denominator include the shares
issuable upon conversion of the securities. Shares potentially issuable under
convertible securities have been considered outstanding for the three months and
six months ended June 30, 2005, as well as the three months ended June 30, 2004.
For the six months ended June 30, 2004, 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 incremental shares attributable to the assumed conversion of the
securities would have increased shares outstanding by 8.0 million shares and the
after-tax interest expense related to the convertible securities that would have
been added to net income in the numerator would have been $2.4 million.
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, 2005 Ended June 30, 2004
-------------------------------- ---------------------------------
CONTINUING OPERATIONS: Income Shares EPS Income Shares EPS
---------------------- ---------- --------- -------- ---------- --------- ----------
Basic earnings per share $80,185 291,634 $0.27 $70,688 289,887 $0.24
======== ========
Effect of dilutive securities, net of tax:
Options & SARS 5,743 5,057
Convertible Securities 1,178 8,000 1,178 8,000
---------- --------- ---------- ---------
Diluted earnings per share $81,363 305,377 $0.27 $71,866 302,944 $0.24
========== ========= ======== ========== ========= ==========
8
(In thousands, except per share data)
Six Months Six Months
Ended June 30, 2005 Ended June 30, 2004
-------------------------------- ------------------------------
CONTINUING OPERATIONS: Income Shares EPS Income Shares EPS
---------------------- ---------- --------- -------- ---------- --------- -------
Basic earnings per share $90,903 291,400 $0.31 $82,149 290,843 $0.28
======= =======
Effect of dilutive securities, net of tax:
Options & SARS 5,854 4,647
Convertible Securities 2,356 8,000 - -
---------- --------- ---------- ---------
Diluted earnings per share $93,259 305,254 $0.31 $82,149 295,490 $0.28
========== ========= ======== ========== ========= =======
NOTE 7: Beginning in 2003, the Company has been accounting for employee stock
options and stock appreciation rights in accordance with SFAS 123, "Accounting
for Stock-Based Compensation." SFAS 123 requires that stock options, stock
appreciation rights, and share grant awards be recorded at fair value and that
this value be recognized as compensation expense over the vesting period of the
award. SFAS 148 "Accounting for Stock-Based Compensation - Transition and
Disclosure, an amendment of FASB Statement No. 123", provided 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 in 2003 and later.
Employee option grants awarded prior to 2003 continue to be accounted for under
the intrinsic method of Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees", as permitted under GAAP. Compensation expense
relating to the unvested portion of these awards would have resulted in proforma
reported net income and net earnings per share as follows:
Three Months Ended Six Months Ended
June 30, June 30,
(In thousands, except per share data) 2005 2004 2005 2004
--------------------------------- ----------------------------
Net income as reported $79,801 $70,396 $90,373 $81,595
Add back: Stock-based compensation
expense included in reported net income,
net of related tax effects 598 290 1,064 539
Deduct: Stock-based compensation
expense determined under fair-value method,
net of related tax effects (1,403) (1,396) (3,009) (2,820)
--------------- --------------- ------------- ------------
Proforma net income $78,996 $69,290 $88,428 $79,314
=============== =============== ============= ============
Basic Earnings Per Share:
As reported $0.27 $0.24 $0.31 $0.28
Proforma $0.27 $0.24 $0.30 $0.27
Diluted Earnings Per Share:
As reported $0.27 $0.24 $0.30 $0.28
Proforma $0.26 $0.23 $0.30 $0.27
In December 2004, the FASB issued SFAS 123 (revised 2004), "Share-Based Payment"
(SFAS 123(R)). This Statement replaces SFAS 123, and supersedes APB Opinion No.
25. The Statement requires that compensation expense be recorded for newly
issued awards as well as the unvested portion of previously issued awards that
remain outstanding as of the effective date of this Statement. The provisions of
this Statement become effective January 1, 2006. The Company currently estimates
that the adoption of this Statement would reduce annual earnings per share by
approximately $.01 to $.02. This Statement permits the restatement of periods
prior to its adoption. Upon adopting this Statement, the Company expects to
restate prior periods as if the Statement were in effect for all periods.
9
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, 2005 and 2004 is presented in the following table:
(IN THOUSANDS)
2005 2004
---------- ----------
CASH PAID FOR OR (RECEIVED FROM):
Interest expense............................ $ 30,167 $ 29,829
Interest and investment income............. $ (10,240) $ (8,446)
Income taxes, net of refunds................ $ 139,777 $ 6,296
The increase in cash received from interest and investment income reflects a
higher level of investment income and gains realized on the investment portfolio
at American Home Shield. Cash paid for income taxes increased in 2005 as a
result of $132 million of taxes paid this year to the IRS and various states
pursuant to the Company's agreement reached in January 2005 with the IRS.
NOTE 9: Total comprehensive income was $79 million and $69 million for the three
months ended June 30, 2005 and 2004, respectively and $88 million and $80
million for the six months ended June 30, 2005 and 2004, 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 to provide for the ongoing revolving sale
of a designated pool of accounts receivable of TruGreen ChemLawn 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, 2005 and 2004, 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 $70 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 $799 million at June 30, 2005, approximately $6 million
below the level at December 31, 2004. Approximately 62 percent of the Company's
debt matures beyond five years and 52 percent beyond fifteen years. In April
2005, approximately $137 million of the Company's public debt matured. The
Company funded this debt payment with long-term financing under revolving credit
facilities.
NOTE 12: In the past several years, the Company has sold or exited various
operations of the Company. The results of these 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, 2005 for the remaining liabilities from the discontinued
operations. The remaining liabilities primarily represent obligations related to
long-term self-insurance claims and certain contractual obligations related to
international pest control operations. The Company continues to believe that the
remaining reserves are adequate.
(IN THOUSANDS) Balance at Cash Balance at
December 31, Payments June 30,
2004 or Other 2005
--------------- ----------- --------------
Remaining liabilities from
discontinued operations $30,593 $3,401 $27,192
10
NOTE 13: In the ordinary course, the Company is subject to review by domestic
and foreign taxing authorities, including the IRS. In the second quarter of
2005, the IRS commenced the audits of the Company's 2003, 2004, and 2005 fiscal
years. 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. 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, plumbing and electrical
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,
commercial cleaning, furniture repair and maid services. The segment also
includes the Company's headquarters operations, which provide various
technology, marketing, finance, legal and other support services to the business
units. Segment information is presented in the following table.
(IN THOUSANDS) Three Months Three Months Six Months Six Months
Ended June 30, Ended June 30, Ended June 30, Ended June 30,
2005 2004 2005 2004
-------------------------------------------------------------------------------- ------------------------------------------
Operating Revenue:
TruGreen $477,783 $453,710 $700,765 $678,369
Terminix 305,616 282,318 553,361 519,114
American Home Shield 144,286 133,462 255,296 236,259
ARS/AMS 203,485 179,697 362,034 333,681
Other Operations 42,942 39,529 84,965 78,184
-------------------------------------------------------------------------------- ------------------------------------------
Total Operating Revenue $1,174,112 $1,088,716 $1,956,421 $1,845,607
================================================================================ ==========================================
Operating Income (1):
TruGreen $68,603 $65,897 $60,995 $62,999
Terminix 57,246 48,483 88,011 84,737
American Home Shield 23,678 23,837 37,951 33,953
ARS/AMS 5,189 1,613 1,684 (2,035)
Other Operations (9,823) (10,459) (17,898) (19,180)
-------------------------------------------------------------------------------- ------------------------------------------
Total Operating Income $144,893 $129,371 $170,743 $160,474
================================================================================ ==========================================
(1) Presented below is a reconciliation of segment operating income to income
from continuing operations before income taxes.
(IN THOUSANDS) Three Months Three Months Six Months Six Months
Ended June 30, Ended June 30, Ended June 30, Ended June 30,
2005 2004 2005 2004
-------------------------------------------------------------------------------- ------------------------------------------
Segment Operating Income $144,893 $129,371 $170,743 $160,474
Non-operating expense (income):
Interest expense 14,401 15,007 29,980 29,938
Interest and investment income (3,226) (3,036) (12,600) (7,606)
Minority interest and other
expense, net 2,047 2,086 4,093 4,132
-------------------------------------------------------------------------------- ------------------------------------------
Income from Continuing
Operations before Income Taxes $131,671 $115,314 $149,270 $134,010
================================================================================ ==========================================
11
The combined franchise operations of ServiceMaster Clean and Merry Maids
comprised approximately four percent and three percent of the consolidated
revenue for the three months ended June 30, 2005 and 2004, respectively, and
four percent of the consolidated revenue for the six months ended June 30, 2005
and 2004. These operations comprised approximately seven percent and eight
percent of the consolidated operating income before headquarter overheads for
the three months ended June 30, 2005 and 2004, respectively, and 11 percent of
the consolidated operating income before headquarter overheads for the six
months ended June 30, 2005 and 2004.
(IN THOUSANDS) As of As of
June 30, 2005 Dec. 31, 2004
--------------------------------------------------------------------------------------------------------------------
Identifiable Assets:
TruGreen $1,060,001 $957,683
Terminix 876,768 843,272
American Home Shield 517,787 474,326
ARS/AMS 208,348 191,618
Other Operations 503,520 673,303
--------------------------------------------------------------------------------------------------------------------
Total Identifiable Assets $3,166,424 $3,140,202
====================================================================================================================
(IN THOUSANDS) As of As of
June 30, 2005 June 30, 2004
--------------------------------------------------------------------------------------------------------------------
Capital Employed: (2)
TruGreen $900,395 $895,246
Terminix 629,728 602,811
American Home Shield 193,110 144,082
ARS/AMS 89,736 93,933
Other Operations 107,330 (16,301)
--------------------------------------------------------------------------------------------------------------------
Total Capital Employed $1,920,299 $1,719,771
====================================================================================================================
(2) 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. Presented below is a
reconciliation of total segment capital employed to the most comparable
U.S. GAAP measure.
(IN THOUSANDS) As of As of
June 30, 2005 June 30, 2004
--------------------------------------------------------------------------------------------------------------------
Total Assets $3,166,424 $3,087,960
Less:
Current liabilities, excluding current portion of
long-term debt 968,020 912,007
Long-term liabilities 278,105 456,182
--------------------------------------------------------------------------------------------------------------------
Total Capital Employed $1,920,299 $1,719,771
====================================================================================================================
12
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
SECOND QUARTER 2005 COMPARED TO 2004
ServiceMaster (the "Company") reported second quarter 2005 revenue of $1.17
billion, an eight percent increase compared to 2004. The growth in revenue was
solid and well-balanced throughout the enterprise, and virtually all of the
growth was organic. Second quarter 2005 diluted earnings per share increased 13
percent to $.27, compared to $.24 in 2004. Operating income for the second
quarter increased 12 percent to $145 million compared to $129 million in 2004,
and operating income margins improved to 12.3 percent of revenue in 2005 from
11.9 percent of revenue in 2004. The increase in operating income reflects
strong double-digit profit growth at Terminix supported by the beneficial impact
of transitioning termite sales to a new bait product, an increased volume of
production at TruGreen ChemLawn, lower insurance costs at the headquarters level
due to favorable trending of prior year claims, as well as improved
profitability in both the ARS and AMS operations.
The results for the second quarter were affected by two significant costs that
are going in opposite directions: (1) Fuel Costs - Enterprise-wide, the Company
continues to be negatively impacted by significant increases in fuel costs.
Although the Company hedges approximately two-thirds of its estimated annual
fuel usage, fuel costs even net of the hedges, increased almost $4 million in
the quarter, and are expected to continue to present a challenge in the second
half of the year. The Company is piloting routing and scheduling software and
GPS technologies which would tighten routes and reduce future drive time and
fuel consumption. (2) Safety-related costs - On the positive side, the Company
continues to experience favorable results from its efforts to reduce
self-insurance costs, which include workers' compensation, auto and general
liability claims. These safety-related costs total almost $120 million annually
and had been increasing at double-digit rates in recent years. The Company
believes that it is succeeding in its efforts to create a strong safety culture
throughout the enterprise. In the first half of 2005, the Company achieved a
reduction in overall vehicle collision rates and a sharp decline in lost
employee work days. In addition, the cost of claims incurred in 2004 and prior
years continues to trend favorably in comparison to the original estimates
prepared by the Company's independent actuaries. In total, self-insurance costs,
including the effects of favorable prior year claims trending, were down
approximately $5 million during the quarter, and the Company is targeting
continued progress in the future.
The Company has re-affirmed its outlook for the year. The Company anticipates
that earnings per share growth in the second half of the year will be comparable
to the first half of the year. The Company expects revenue growth to be in the
mid- to high-single digit range and earnings per share will grow somewhat faster
than revenues. The Company's cash provided from operating activities has
consistently and significantly exceeded net income, and the Company expects this
trend to continue in 2005 even after considering the effects of the payments
related to the previously disclosed agreement with the Internal Revenue Service
(IRS).
Cost of services rendered and products sold increased seven percent for the
second quarter and decreased as a percentage of revenue to 63.5 percent in 2005
from 64.1 percent in 2004. This decrease reflects favorable trending of prior
year self-insurance claims, as well as a change in the mix of business as
Terminix and American Home Shield increased in size in relationship to the
overall business of the Company. These businesses generally operate at higher
gross margin levels than the rest of the business, but also incur relatively
higher selling and administrative expenses. Selling and administrative expenses
increased nine percent for the quarter. As a percentage of revenue, these costs
increased to 24.1 percent for the quarter in 2005 from 23.9 percent in 2004,
primarily reflecting the change in business mix described above.
Net non-operating expenses for the quarter were $13 million compared with $14
million in the prior year, primarily reflecting a modest decrease in interest
expense.
13
SEGMENT REVIEWS FOR THE SECOND QUARTER 2005 COMPARED TO 2004
The following business segment reviews should be read in conjunction with the
required footnote disclosures presented in the Notes to the Condensed
Consolidated Financial Statements. This disclosure provides a reconciliation of
segment operating income to income from continuing operations before income
taxes, with net non-operating expenses as the only reconciling item. The
Company's business segment reviews include discussions of capital employed,
which 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 Notes to the Condensed Consolidated Financial Statements
also include a reconciliation of segment capital employed to its most comparable
U.S. GAAP measure.
The TruGreen segment includes lawn care services performed under the TruGreen
ChemLawn brand name and landscape maintenance services provided under the
TruGreen LandCare brand name. The TruGreen segment reported second quarter
revenue of $478 million, five percent above the prior year. The segment reported
a four percent increase in operating income for the quarter to $69 million
compared to $66 million in 2004.
Revenue in the lawn care operations increased six percent to $357 million from
$336 million in 2004. Revenue growth resulted from improved price realization,
the recapture of some of the first quarter production that was previously
delayed, an increase in supplemental customer services, and overall customer
count growth. As previously disclosed in the Company's first quarter Form 10-Q
filing, first quarter lawn care production was adversely impacted by late snows
in several key regions. The Company recaptured approximately one-half of the
delayed production (or $4.5 million) in the second quarter, with most of the
balance now scheduled for the third quarter. Customer counts increased
approximately two percent, reflecting the impact of acquisitions, partially
offset by a modest reduction in retention rates. Year-to-date unit sales were
comparable to last year's levels as the successful expansion of the Company's
neighborhood selling efforts and direct mail programs offset a decline in
telemarketing sales due to the increased impact of "do-not-call" restrictions.
Second quarter operating income of the lawn care operations increased $5 million
and included the recapture of some of the first quarter production. A correction
in the Company's method of allocating certain sales and marketing costs among
interim periods had a $3 million favorable impact in the second quarter,
however, the Company also recognized a similar unfavorable amount representing a
higher portion of expected full year incentive compensation costs.
Second quarter revenue in the landscape maintenance business increased two
percent to $120 million, compared to $118 million in 2004. Base contract
maintenance revenue increased slightly as a higher level of new sales were
partially offset by a modest decline in customer retention. Enhancement revenue
(e.g., add-on services such as seasonal flower plantings, mulching, etc.)
increased three percent for the quarter, supported by focused sales efforts.
Second quarter operating losses for the landscape operations increased by $3
million as a result of differences in the timing of certain expenses between the
first and second quarters in 2004, as well as increased fuel and vehicle costs.
The Company continues to anticipate strong profit improvement in the landscape
operations for the second half and for the full year. Results are expected to
benefit from management's focus on key initiatives, including: enhancing the
capabilities, training and methods of the sales team, reducing workers
compensation and safety claims, and improving the scheduling and management of
labor costs.
Capital employed in the TruGreen segment increased one percent primarily
reflecting the impact of tuck-in acquisitions, offset in part by improved
working capital management.
The Terminix segment, which includes termite and pest control services, reported
an eight percent increase in second quarter revenue to $306 million, compared to
$282 million in 2004. Operating income increased 18 percent to $57 million
compared to $48 million in 2004. Strong growth in revenue from initial termite
14
applications ("termite completions") reflected a nine percent increase in
renewable unit sales resulting from an increased sales force, expanded
geographic presence, and the favorable impact of a new termite bait product
introduced in 2005, offset in part by a shift in mix toward lower priced liquid
treatments. Termite renewal revenue increased modestly, reflecting improved
pricing, partially offset by a slight decrease in customer retention. Total
termite customer counts increased one percent, reflecting the growth in unit
sales, offset in part by the decline in the rate of retention. Solid growth in
second quarter pest control revenue reflected the impact of acquisitions and a
slight increase in unit sales, partially offset by a decline in customer
retention. The strong growth in the segment's operating income reflects the
increased revenue levels, labor efficiencies in the liquid termite option
resulting from new application techniques, as well as the lower material and
labor costs associated with the new termite bait product. In addition, since
more of the total first year costs associated with this bait product are
incurred at the time of installation, less revenue and gross profit is required
to be deferred to future quarters. This timing benefit favorably impacted second
quarter operating income by approximately $5 million. Last year's second quarter
included a $6 million non-recurring, favorable termite damage claim adjustment.
Capital employed in the Terminix segment increased four percent, reflecting the
impact of acquisitions.
The American Home Shield segment, which provides home warranties to consumers
that cover heating, ventilation and air conditioning (HVAC), plumbing and other
home systems and appliances, reported an eight percent increase in revenue to
$144 million from $133 million in 2004 and operating income of $24 million,
comparable to 2004. New warranty contract sales, which are reported as earned
revenue over the subsequent twelve-month contract period, increased nine percent
for the quarter. Customer renewals, which are American Home Shield's largest
source of revenue, experienced solid double-digit growth, reflecting a larger
base of renewable customers and an overall improved customer retention rate.
Real estate sales, which are American Home Shield's second largest channel,
decreased modestly in the second quarter as a result of increased competition in
certain higher warranty usage states. Consumer sales, which are the smallest but
fastest growing channel, experienced strong double-digit growth, reflecting the
successful expansion of the targeted direct mail program. Second quarter
operating income was comparable to last year as incremental profits from the
increased revenue levels were offset by a higher rate of service claims
resulting from hotter weather than the unusually mild conditions that prevailed
throughout much of the country last year. As discussed in previous filings,
planned investments to increase market penetration and further improve customer
retention also had an impact. These claim and investment factors are also
expected to impact third quarter growth comparisons. Capital employed increased
34 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 American Home Shield segment includes approximately $274 million and
$238 million of cash, cash equivalents and marketable securities at June 30,
2005 and 2004, respectively.
The ARS/AMS segment provides direct HVAC, plumbing and electrical installation
and repair services under the brand names of ARS Service Express and Rescue
Rooter (collectively "ARS Service Express"), as well as American Mechanical
Services (AMS) for large commercial accounts. Revenue for the second quarter
increased 13 percent to $203 million in 2005 from $180 million in 2004.
Operating income increased to $5 million compared to $2 million in 2004. The
increase in revenue resulted from continued strong increases in commercial
installation revenue in the AMS operations and strong growth in ARS's HVAC
add-on-replacement sales and residential construction revenue. The growth in
HVAC replacement sales was supported by the Company's efforts to increase the
sales mix of higher priced and more energy efficient units as well as its retail
outlet initiative. These increases were partially offset by revenue declines in
both HVAC and plumbing service. A modest decline in second quarter plumbing
revenue resulted from continued declines in retail service calls, which more
than offset increases from sewer line repairs and light commercial services. The
improvement in the segment's second quarter operating income resulted from the
increased level of revenue, profit improvement efforts at underperforming
locations, and a reduced level of marketing spending, offset in part by
increased incentive compensation and fuel costs. Capital employed in this
segment decreased four percent.
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 nine percent to $43 million compared to $40 million in 2004.
On a combined basis, the ServiceMaster Clean and Merry Maids franchise
operations reported revenue growth of 10 percent and a solid increase in
operating income.
15
ServiceMaster Clean again reported double-digit growth in disaster restoration
services and modestly improved momentum in commercial cleaning. Merry Maids
continued to experience strong internal revenue growth in both the branch and
franchise operations. The segment as a whole reported a smaller second quarter
operating loss in 2005, reflecting the effects of favorable, actuarially
determined adjustments to prior year self-insurance reserves, and higher profits
from ServiceMaster Clean and Merry Maids, offset by planned increases in other
headquarter level costs and investments. Capital employed in this segment
increased, primarily reflecting the deferred tax assets recorded in the fourth
quarter of 2004 at the conclusion of the IRS reviews of the Company's federal
income taxes through the year 2002.
SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO 2004
The Company reported revenue of $1.96 billion for the six months ended June 30,
2005, a six percent increase over 2004. For the six months, all of the Company's
business segments reported increases in revenue, and consolidated organic
revenue growth totaled approximately five percent. For the six months, diluted
earnings per share were $.30 compared with $.28 in 2004. Diluted earnings per
share from continuing operations were $.31, 11 percent above the $.28 reported
in 2004 supported by the strong profit growth achieved in the second quarter.
Operating income increased six percent to $171 million compared to $160 million
in 2004, reflecting the strong profit growth achieved in the second quarter.
Cost of services rendered and products sold increased five percent for the six
months and decreased as a percentage of revenue to 66.5 percent in 2005 compared
to 67.3 percent in 2004. As discussed in the second quarter comparison, this
decrease reflects favorable trending of prior year self-insurance claims, as
well as a change in the mix of business. Selling and administrative expenses
increased ten percent and increased as a percentage of revenue to 24.6 percent
in 2005 from 23.8 percent in 2004.
Net non-operating expense decreased $5 million from 2004, primarily reflecting
higher investment income experienced on the American Home Shield investment
portfolio. It is important to note that investment gains are an integral part of
the business model at American Home Shield, and there will always be some
market-based variability in the amount of gains realized from quarter to
quarter.
KEY PERFORMANCE INDICATORS
The table below presents selected metrics related to customer counts and
customer retention for the three largest profit businesses in 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,
2005 2004
------------ ------------
TRUGREEN CHEMLAWN-
Growth in Full Program Contracts 2% 8% (a)
Customer Retention Rate 66.4% 66.8%
TERMINIX -
Growth in Pest Control Customers 4% 6%
Pest Control Customer Retention Rate 77.3% 78.6%
Growth in Termite Customers 1% -1%
Termite Customer Retention Rate 88.0% 88.7%
AMERICAN HOME SHIELD -
Growth in Warranty Contracts 5% 6%
Customer Retention Rate 55.9% 54.9%
(a) Customer count growth in 2004, excluding the impact of the Canadian
acquisition completed in April 2004, was approximately three percent.
16
SEGMENT REVIEWS FOR THE SIX MONTHS ENDED JUNE 30, 2005 COMPARED TO 2004
As discussed in the second quarter comparison, the following business segment
reviews should be read in conjunction with the required footnote disclosures
presented in the Notes to the Condensed Consolidated Financial Statements.
For the six months, the TruGreen segment reported a three percent increase in
revenue to $701 million compared to $678 million in 2004. Operating income
decreased three percent to $61 million compared to $63 million in 2004. Revenue
in the lawn care operations increased four percent to $481 million from $461
million in 2004. The increase in revenue reflects improved price realization,
solid growth in supplemental customer services, as well as the higher customer
count. The Company continues to successfully expand new sales channels, helping
to offset continued sharp declines in telemarketing. During the first half of
2005, sales from direct mail efforts increased 10 percent, while sales from our
neighborhood programs more than tripled. Implementation of best practices and
other program improvements have enabled the Company to achieve a solid increase
in the average productivity of its neighborhood sales representatives, even as
the scope of its efforts in this area have been substantially expanded. With
respect to overall pricing, a more strategic and disciplined approach, which
included reduced discounting on new sales and selectively targeted increases to
the existing customer base, has resulted in a two percent overall improvement in
price realization, up from just under one percent last year. The customer
retention rate decreased 40 basis points, as continued improvements in the U.S.
were offset by declines in Canada, which the Company believes are attributable
to unique circumstances in that market. Overall, retention rates have increased
400 basis points since 2001, and the Company is targeting, and anticipating,
meaningful additional improvement in future years. To capture that opportunity,
the Company has taken comprehensive steps to improve customer communication and
problem resolution procedures, expand quality assurance processes, and provide
focused incentives at all levels. Additionally, the previously discussed change
in sales mix is also expected to contribute to improved retention. Operating
income in the lawn care operations decreased $4 million, reflecting the first
time inclusion of $3 million of seasonal losses in the Canadian operations that
were acquired in April 2004, as well as higher fuel and fleet-related costs.
Revenue in the landscape maintenance operations increased one percent to $220
million from $217 million in 2004, reflecting a three percent increase in
enhancement revenue and a slight increase in base contract maintenance revenue.
Customer retention continues to be an area requiring improvement, but it is also
a significant and achievable opportunity, with current rates at least 10 full
percentage points below the Company's long term expectations. Retention is a top
operational priority within the landscape operations, with intensified focus on
improving customer communications and service level consistency. The level of
the operating loss of the landscape operations improved $2 million for the six
months, reflecting the favorable impact of one-time branch shut-down costs that
were incurred last year and the increased volume of higher margin enhancement
revenue.
The Terminix segment reported a seven percent increase in revenue for the six
months to $553 million compared to $519 million in 2004 and operating income
growth of four percent to $88 million compared to $85 million in 2004. For the
six months, a double-digit increase in termite completion revenue resulted from
a strong increase in renewable unit sales and, as discussed in the second
quarter comparison, the favorable impacts of a new termite bait product
introduced earlier this year. Modest growth in termite renewal revenue reflected
the impact of improved pricing, offset in part by a 70 basis point decline in
customer retention. The Company does not believe the decline in termite
retention is systemic. The Company is addressing the issue by fine-tuning the
approach to price increases and taking steps to improve problem resolution.
Solid growth in pest control revenue resulted from the impact of acquisitions
and an increase in unit sales, offset in part by a decline in retention. The
Company believes the pest retention comparisons have been adversely impacted by
the relative timing of cancellations last year, and management is working to
ensure that they are not indicative of the start of a new trend. Operating
income growth for the six months was supported by the increased revenue levels,
lower material and labor costs associated with the new termite bait product, and
labor productivity gains in the liquid termite option resulting from new
application techniques, partially offset by incremental pre-season investments
made in the first quarter to expand the sales force and re-organize the field
operations.
17
For the six months, the American Home Shield segment reported an eight percent
increase in revenue to $255 million from $236 million in 2004 and operating
income growth of 12 percent, to $38 million compared to $34 million in 2004. New
warranty contract sales, which are reported as earned revenue over the
subsequent twelve-month contract period, increased eight percent for the six
months. Double-digit growth in customer renewals resulted from an increase in
the base of customers available to renew and an overall improved customer
retention rate. The improvement in retention reflects a favorable mix in
customers renewing as well as a reduced level of non-renewal contracts due to
mortgage refinancing,. Real estate sales declined modestly for the first six
months, while an increased level of targeted direct mail solicitations resulted
in strong double-digit sales growth in the consumer sales channel. The increase
in operating income for the six months reflects favorable trending of service
claims pricing in the first quarter, offset in part by higher claim costs in the
second quarter resulting from an increased incidence of claims due to hotter
weather. In addition, the Company incurred planned investments to increase
market penetration and customer retention.
The ARS/AMS segment reported an eight percent increase in revenues for the six
months to $362 million compared to $334 million in 2004. The segment reported
operating income of $2 million in 2005 compared to an operating loss of $2
million in 2004. The growth in revenue reflected a strong increase in AMS'
commercial project revenue and double-digit growth in ARS' replacement sales and
residential new construction revenue, offset in part by a decline in core HVAC
and plumbing service call revenue. The increase in operating income for the six
months primarily reflects the increased level of revenue as well as a reduced
level of marketing spending, offset in part by increased incentive compensation
and fuel costs. At AMS, installation and retrofit project revenues and related
backlogs were both up significantly, as the commercial construction sector
continues to slowly, but steadily, recover from a cyclical downturn.
The Other Operations segment reported a nine percent increase in revenues to $85
million for the six months compared with $78 million in 2004. On a combined
basis, the ServiceMaster Clean and Merry Maids franchise operations achieved
revenue growth of 10 percent with a strong increase in operating income.
ServiceMaster Clean reported strong growth in disaster restoration services.
Merry Maids achieved very strong internal revenue growth and improving gross
profit margins in the branch operations. For the first six months, the Other
Operations segment reported a smaller operating loss in 2005, resulting from the
effects of favorable, actuarially determined adjustments to prior year
self-insurance reserves, and higher profits from ServiceMaster Clean and Merry
Maids, offset by planned increases in other headquarter level costs and
investments.
FINANCIAL POSITION AND LIQUIDITY
CASH FLOWS FROM OPERATING ACTIVITIES
Net cash used for operating activities was approximately $3 million for the six
months, compared to approximately $116 million provided from operating
activities in the prior year. The decrease in net cash flow of $119 million
primarily reflects $132 million of previously disclosed tax payments relating to
the 2005 IRS agreement. These payments represent only one part of a four part
agreement with the IRS, which also included: tax savings of $25 million that
were realized in 2004; a reduction in required estimated tax payments that would
have otherwise been due in the second half of 2005 of $45 million, and a
deferred tax annuity totaling $57 million that will be realized through 2016.
Excluding the impact of the $132 million tax payment to the IRS and various
states this year, six month cash provided by operating activities totaled $129
million, approximately $13 million more than the prior year level. This result
primarily reflects the higher level of income. Working capital usage was
comparable to last year.
Full year cash provided from operating activities is expected to remain strong,
reflecting a solid earnings base, businesses that need relatively little working
capital to fund growth in their operations, and significant annual deferred
taxes.
The significant annual cash tax benefit primarily represents a large base of
amortizable intangible assets which exist for income tax reporting purposes, but
not for book purposes. A significant portion of these assets arose in connection
with the Company's 1997 conversion from a limited partnership to a corporation.
The amortization of the tax basis will result in over $50 million of average
annual cash tax benefits through 2012 for which no corresponding income
statement benefit is recorded.
18
In the ordinary course, the Company is subject to review by domestic and foreign
taxing authorities, including the IRS. In the second quarter of 2005, the IRS
commenced the audits of the Company's 2003, 2004, and 2005 fiscal years. 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 slightly below prior year levels. The Company
anticipates approximately $50 million of capital expenditures in 2005,
reflecting investments in information systems and productivity enhancing
operating systems. The Company has no material capital commitments at this time.
Tuck-in acquisitions for the six months ended June 30, 2005 totaled $24 million,
compared with $32 million in 2004. Consideration consisted of cash payments,
seller financed notes and Company stock. In the second half of 2005, the Company
expects to continue its tuck-in acquisition program at both Terminix and
TruGreen ChemLawn, with overall acquisitions for the year at approximately the
same level as 2004.
CASH FLOWS FROM FINANCING ACTIVITIES
Cash dividends paid to shareholders totaled $64 million or $.22 per share for
the six months ended June 30, 2005. In July 2005, the Company announced the
declaration of a cash dividend of $.11 per share payable on August 31, 2005 to
shareholders of record on August 15, 2005. The timing and amount of future
dividends and related 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. There remains approximately $65 million available for repurchases
under the July 2000 authorization. The Company completed approximately $16
million in share repurchases in the six months ended June 30, 2005 at an average
price of $13.64 per share. The Company did not repurchase shares during the
second quarter as cash was used to fund peak seasonal operating needs and the
IRS payment. The Company expects to resume share repurchases in the second half
of 2005, and for the full year, repurchases are anticipated to be at a
comparable level to 2004. The actual level of future share repurchases will
depend on various factors such as the Company's commitment to maintain an
investment grade credit rating and other strategic investment opportunities.
LIQUIDITY
Cash and short and long-term marketable securities totaled approximately $373
million at June 30, 2005, compared with $496 million at December 31, 2004.
Approximately $336 million of the 2005 amount is effectively required to support
regulatory requirements at American Home Shield and for other purposes. Total
debt was $799 million at June 30, 2005, approximately $6 million lower than the
amount at December 31, 2004.
Approximately 62 percent of the Company's debt matures beyond five years and 52
percent beyond fifteen years. In April 2005, $137 million of the Company's
public debt matured. The Company funded this debt payment with long-term
financing under the existing revolving credit facilities.
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. The Company maintains a revolving credit facility
of $500 million. In May 2005, this agreement was amended to extend the maturity
date to May 2010 and reduce by 50 basis points the interest rate payable under
the facility. As of June 30, 2005, the Company had $130 million of borrowings
outstanding under this facility and had issued approximately $154 million of
letters of credit, resulting in unused commitments of approximately $216
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. The
agreement is a 364-day facility that is renewable at the option of the
purchasers. The Company may sell up to $70 million of its receivables to these
purchasers in the future and therefore would have immediate access to cash
proceeds from these sales. The amount of the eligible receivables varies during
the year
19
based on seasonality of the business and will at times limit the amount
available to the Company. During the six month period ended June 30, 2005, there
were no receivables sold to third parties under this agreement.
There have been no material changes in the Company's financing agreements since
December 31, 2004, other than as mentioned in the preceding paragraph. As
described in the Company's 2004 Annual Report, 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 an 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 dividend and share
repurchase plans in the near future. Failure by the Company to maintain these
covenants could result in the acceleration of the maturity of the debt. At June
30, 2005, the Company was in compliance with the covenants related to these debt
agreements and, based on its operating outlook for the remainder of 2005,
expects to be able to maintain compliance in the future. The Company does not
have any debt agreements that contain put rights or provide for acceleration of
maturity as a result of a change in credit rating.
The Company maintains lease facilities with banks totaling $68 million which
provide for the acquisition and development of branch properties to be leased by
the Company. At June 30, 2005, there was approximately $68 million funded under
these facilities. Approximately $15 million of these leases have been included
on the balance sheet as assets with related debt as of June 30, 2005 and
December 31, 2004. The balance of the funded amount has been treated as
operating leases. Approximately $15 million of the available facility expires in
January 2008 and the remaining $53 million expires in September 2009. The
Company has guaranteed the residual value of the properties under the leases up
to 82 percent of the fair market value at the commencement of the lease. At June
30, 2005, the Company's residual value guarantee related to the leased assets
totaled $56 million for which the Company has recorded the estimated fair value
of this guarantee (approximately $1.0 million) in the Consolidated Statements of
Financial Position.
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, 2005, there was
approximately $268 million of residual value relating to the Company's fleet and
equipment leases. The fair value guarantee of the assets under the leases is
expected to fully mitigate the Company's obligations under the agreements. The
fair value of this guarantee is not material to the Company's consolidated
financial statements.
The Company's 2004 Annual Report included disclosure of the Company's
contractual obligations and commitments as of December 31, 2004. The Company
continues to make the contractually required payments and therefore, the 2005
obligations and commitments as listed in the December 31, 2004 Annual Report
have been reduced by the required payments. During the first six months of 2005,
the Company signed a product supply agreement with minimum purchases of $17
million over the next 18 months, and has entered into various other contracts.
FINANCIAL POSITION - CONTINUING OPERATIONS
Receivables and inventories 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 at TruGreen ChemLawn and Terminix as well as annual
repairs and maintenance procedures that are performed in the first quarter at
TruGreen ChemLawn. These costs are deferred and recognized over the production
season 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. These direct and incremental selling expenses which relate to
successful sales are deferred and recognized over the production season and are
not deferred beyond the calendar year-end. The Company capitalizes sales
commissions and other direct contract acquisition costs relating to termite
baiting and pest contracts, as well as home warranty agreements. These costs
vary with and are directly related to a new sale.
20
Property and equipment was slightly lower compared to year-end levels. The
Company does not have any material capital commitments at this time.
The increase in accounts payable from year-end levels reflects peak seasonality
at several of the business units. Deferred revenue increased from year-end
levels, reflecting the significant amount of customer prepayments received in
the first quarter (pre-season) at TruGreen ChemLawn, customer payments for
termite renewals and growth in warranty contracts written at American Home
Shield, offset in part by lowered deferred revenue balances associated with the
impact of the new termite bait product. The decrease in income taxes payable
from year-end levels reflects the February 2005 federal tax payment related to
the IRS agreement.
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 $1.0 billion at June 30, 2005 and $992 million at
December 31, 2004. The increase reflects operating profits in the business
partially offset by cash dividend payments and share repurchases.
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 from year-end
levels representing collections on receivables. The remaining liabilities
primarily represent obligations related to long-term self-insurance claims and
certain potential contractual obligations related to international pest control
operations.
FORWARD-LOOKING STATEMENTS
THE COMPANY'S FORM 10-Q FILING 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; CHANGES IN THE SOURCE AND INTENSITY OF COMPETITION
IN THE MARKETS SERVED BY THE COMPANY; LABOR SHORTAGES OR INCREASES IN WAGE
RATES; UNEXPECTED INCREASES IN OPERATING COSTS, SUCH AS HIGHER INSURANCE
PREMIUMS, SELF INSURANCE AND HEALTH CARE CLAIM COSTS; HIGHER FUEL PRICES;
CHANGES IN THE TYPES OR MIX OF THE COMPANY'S SERVICE OFFERINGS OR PRODUCTS;
INCREASED GOVERNMENTAL REGULATION, INCLUDING TELEMARKETING AND ENVIRONMENTAL
RESTRICTIONS; GENERAL ECONOMIC CONDITIONS IN THE UNITED STATES, ESPECIALLY AS
THEY MAY AFFECT HOME SALES OR CONSUMER SPENDING LEVELS; 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, self-insurance and 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 percent 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 percent to a variable rate based on LIBOR (7.0
percent average rate during the six months ended June 30, 2005).
The Company generally maintains the majority of its debt at fixed rates. After
the effect of the interest rate swap agreements, approximately 60 percent of
total debt at June 30, 2005 was at a fixed rate. With respect to other
obligations, the payments on the approximately $68 million of funding
outstanding under the Company's real estate operating lease facilities as well
as its fleet and equipment operating leases (approximately $268 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, 2005, a one
rating category improvement in the Company's credit ratings would reduce pre-tax
annual expense by approximately $0.5 million. A one rating category reduction in
the Company's credit ratings would increase pre-tax expense on an annualized
basis by approximately $1.0 million.
The following table summarizes information about the Company's fixed rate debt
as of December 31, 2004, 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 $673 million at December 31,
2004.
Expected Maturity Date
-------------------------------------
There-
(In millions) 2005 2006 2007 2008 2009 after Total
-------------------- ------ ------- ------- ------ ------- -------- -------
Fixed rate
debt $160 $13 $62 $10 $21 $359 $625
Avg. rate 8.0% 6.4% 7.0% 5.8% 7.9% 7.5% 7.5%
===========================================================================
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 percent 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: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
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, 2005 under its share repurchase
authorization. The Company did not make any share repurchases during the three
months ended June 30, 2005. 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 Share Plan Plan
-------------------------------------------------------------------------------------------------------------------------
April 1, 2005 through
April 30, 2005 - $ - - $65,000,000
May 1, 2005 through
May 31, 2005 - $ - - $65,000,000
June 1, 2005 through
June 30, 2005 - $ - - $65,000,000
---------------------------------------------------------
Total - $ - -
=========================================================
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The Company's 2005 Annual Meeting of Shareholders ("Annual Meeting") was
held on May 6, 2005 in Downers Grove, Illinois.
(b) The following persons were elected as Class of 2008 directors:
NAME VOTES FOR VOTES WITHHELD BROKER NON-VOTES
---- --------- -------------- ----------------
Louis J. Giuliano 248,283,360 3,489,530 N/A
Roberto R. Herencia 248,578,830 3,194,060 N/A
Betty Jane Hess 248,707,923 3,064,967 N/A
Jonathan P. Ward 246,497,625 5,275,265 N/A
The following person was elected as Class of 2006 director:
NAME VOTES FOR VOTES WITHHELD BROKER NON-VOTES
---- --------- -------------- ----------------
Eileen A. Kamerick 248,834,095 2,938,795 N/A
The following person was elected as Class of 2007 director:
NAME VOTES FOR VOTES WITHHELD BROKER NON-VOTES
---- --------- -------------- ----------------
Coleman H. Peterson 248,741,037 3,031,853 N/A
24
No votes were cast for any other nominee for directors. The Class of 2006
continuing in office are: John L. Carl, Dallen W. Peterson and David Wessner.
The Class of 2007 continuing in office are: Brian Griffiths, Sidney E. Harris
and James D. McLennan. As reported on the Company's current report on Form 8-K
filed with the Securities and Exchange Commission on August 2, 2005, the Board
of Directors elected J. Patrick Spainhour to the Class of 2006 on July 27, 2005.
(c) The shareholders also voted on two proposals at the Annual Meeting. The
following table shows the vote tabulation for the shares represented at the
meeting:
PROPOSAL VOTES FOR VOTES AGAINST VOTES ABSTAINED BROKER NON-VOTES
-------- --------- ------------- --------------- ----------------
Proposal to amend 245,557,738 5,146,714 1,068,438 N/A
the Company's
Amended and
Restated Certificate
of Incorporation
Ratification of 245,355,689 5,521,480 895,721 N/A
Deloitte & Touche
as independent
auditor
ITEM 6: EXHIBITS
EXHIBIT NO. DESCRIPTION OF EXHIBIT
----------- ----------------------
4.1 Amendment No. 1 dated as of May 6, 2005 to $500,000,000 Credit
Agreement dated as of May 19, 2004 among the The ServiceMaster
Company, the lenders, JPMorgan Chase Bank, N.A. and Bank of
America, N.A. as syndication agents, SunTrust Bank as
administrative agent, and U.S. Bank National Association and
Wachovia Bank, N.A. as documentation agents, is incorporated by
reference to Exhibit 4.1 to the Company's current report on Form
8-K dated May 12, 2005
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
25
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, 2005
THE SERVICEMASTER COMPANY
(Registrant)
By: /S/ ERNEST J. MROZEK
----------------------------
Ernest J. Mrozek
President and Chief Financial Officer
26