UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
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X QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES
_ EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 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
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THE SERVICEMASTER COMPANY
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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Delaware 36-3858106
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
3250 LACEY ROAD, STE. 600, DOWNERS GROVE, ILLINOIS O 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
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Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes X No
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Indicate by check mark whether the registrant is a shell company (as defined in
Exchange Act Rule 12b-2).
Yes No X
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Indicate the number of shares outstanding of each of the issuer's classes of
common stock: 290,674,000 shares of common stock on October 28, 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 nine months ended September 30, 2005 and September 30, 2004 3
Condensed Consolidated Statements of Financial Position
as of September 30, 2005 and December 31, 2004 4
Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2005 and September 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 23
Item 4: Controls and Procedures 24
PART II. OTHER INFORMATION
Item 2: Unregistered Sales of Equity Securities and Use of Proceeds 25
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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2005 2004 2005 2004
---------------- ----------------- -------------- -----------------
OPERATING REVENUE $ 1,133,549 $ 1,053,867 $ 3,089,970 $ 2,899,474
OPERATING COSTS AND EXPENSES:
Cost of services rendered and products sold 743,593 686,992 2,045,300 1,929,754
Selling and administrative expenses 256,584 240,546 738,072 679,984
Amortization expense 1,443 1,503 3,926 4,436
---------------- ----------------- -------------- ------------------
Total operating costs and expenses 1,001,620 929,041 2,787,298 2,614,174
---------------- ----------------- -------------- ------------------
OPERATING INCOME 131,929 124,826 302,672 285,300
NON-OPERATING EXPENSE (INCOME):
Interest expense 13,749 15,210 43,729 45,148
Interest and investment income (5,516) (3,913) (18,116) (11,519)
Minority interest and other expense, net 2,080 2,047 6,173 6,179
---------------- ----------------- -------------- ------------------
INCOME FROM CONTINUING OPERATIONS
BEFORE INCOME TAXES 121,616 111,482 270,886 245,492
Provision for income taxes 46,553 43,139 104,920 95,000
---------------- ----------------- -------------- ------------------
INCOME FROM CONTINUING OPERATIONS 75,063 68,343 165,966 150,492
Income (loss) from discontinued operations,
net of income taxes 6,524 (619) 5,994 (1,173)
---------------- ----------------- -------------- ------------------
NET INCOME $ 81,587 $ 67,724 $ 171,960 $ 149,319
================ ================= ============== ==================
PER SHARE:
Basic Earnings Per Share:
Income from continuing operations $ 0.26 $ 0.24 $ 0.57 $ 0.52
Income (loss) from discontinued operations 0.02 -- 0.02 --
---------------- ----------------- -------------- ------------------
Basic earnings per share $ 0.28 $ 0.23 $ 0.59 $ 0.51
================ ================= ============== ==================
SHARES 291,474 290,258 291,426 290,647
Diluted Earnings Per Share:
Income from continuing operations $ 0.25 $ 0.23 $ 0.56 $ 0.51
Income (loss) from discontinued operations 0.02 -- 0.02 --
---------------- ----------------- -------------- ------------------
Diluted earnings per share $ 0.27 $ 0.23 $ 0.57 $ 0.50
================ ================= ============== ==================
SHARES 305,239 303,336 305,250 303,437
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 SEPT. 30, AS OF DEC. 31,
ASSETS 2005 2004
---------------- ----------------
CURRENT ASSETS:
Cash and cash equivalents $ 122,646 $ 256,626
Marketable securities 108,455 103,681
Receivables, less allowance of $24,510 and $25,183, respectively 481,562 369,026
Inventories 77,867 66,657
Prepaid expenses and other assets 41,031 27,456
Deferred customer acquisition costs 49,945 41,574
Deferred taxes 59,606 108,780
Assets of discontinued operations 776 4,952
------------------- ---------------------
Total Current Assets 941,888 978,752
------------------- ---------------------
PROPERTY AND EQUIPMENT:
At cost 432,436 405,655
Less: accumulated depreciation (248,161) (218,838)
------------------- ---------------------
Net property and equipment 184,275 186,817
------------------- ---------------------
OTHER ASSETS:
Goodwill 1,597,707 1,568,044
Intangible assets, primarily trade names 230,811 220,780
Notes receivable 32,365 35,411
Long-term marketable securities 148,139 135,824
Other assets 10,812 14,574
------------------- ---------------------
Total Assets $ 3,145,997 $ 3,140,202
=================== =====================
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 115,442 $ 76,053
Accrued liabilities:
Payroll and related expenses 118,335 113,366
Self-insured claims and related expenses 100,474 86,554
Income taxes payable 28,936 152,841
Other 109,038 111,092
Deferred revenues 449,475 443,238
Liabilities of discontinued operations 6,652 21,536
Current portion of long-term debt 19,186 23,247
------------------- ---------------------
Total Current Liabilities 947,538 1,027,927
------------------- ---------------------
LONG-TERM DEBT 749,567 781,841
LONG-TERM LIABILITIES:
Deferred taxes 131,118 88,100
Liabilities of discontinued operations 8,858 9,057
Other long-term obligations 157,217 141,742
------------------- ---------------------
Total Long-Term Liabilities 297,193 238,899
------------------- ---------------------
MINORITY INTEREST 100,000 100,000
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Common stock $0.01 par value, authorized 1,000,000 shares; issued
321,079 and 318,559 shares, respectively 3,211 3,186
Additional paid-in capital 1,109,574 1,083,057
Retained earnings 287,958 212,116
Accumulated other comprehensive income 9,301 10,804
Restricted stock (unearned compensation) (16,143) (12,857)
Treasury stock (342,202) (304,771)
------------------- ---------------------
Total Shareholders' Equity 1,051,699 991,535
------------------- ---------------------
Total Liabilities and Shareholders' Equity $ 3,145,997 $ 3,140,202
=================== =====================
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
4
THE SERVICEMASTER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
2005 2004
(IN THOUSANDS) --------------- -----------------
CASH AND CASH EQUIVALENTS AT JANUARY 1 $ 256,626 $ 228,161
CASH FLOWS FROM OPERATING ACTIVITIES:
NET INCOME 171,960 149,319
Adjustments to reconcile net income to net cash flows from
operating activities:
(Income) loss from discontinued operations (5,994) 1,173
Depreciation expense 37,643 36,658
Amortization expense 3,926 4,436
Change in working capital, net of acquisitions:
Receivables (113,425) (90,238)
Inventories and other current assets (27,477) (14,696)
Accounts payable 40,274 5,432
Deferred revenues 5,453 7,569
Accrued liabilities 28,898 53,400
Change in tax accounts:
Deferred income taxes 93,459 82,450
Payment relating to income tax audits (131,146) --
Other, net 8,906 5,540
-------------- ---------------
NET CASH PROVIDED FROM OPERATING ACTIVITIES 112,477 241,043
-------------- ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Property additions (35,270) (39,903)
Sale of equipment and other assets 2,044 7,271
Business acquisitions, net of cash acquired (27,342) (26,519)
Notes receivable, financial investments and securities (13,492) (32,505)
-------------- ---------------
NET CASH USED FOR INVESTING ACTIVITIES (74,060) (91,656)
-------------- ---------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings of debt 108,299 --
Payments of debt (157,371) (29,778)
Purchase of ServiceMaster stock (51,305) (55,482)
Shareholders' dividends (96,118) (93,336)
Other, net 25,040 11,737
-------------- ---------------
NET CASH USED FOR FINANCING ACTIVITIES (171,455) (166,859)
-------------- ---------------
NET CASH USED FOR OPERATING ACTIVITIES OF DISCONTINUED OPERATIONS (942) (7,959)
-------------- ---------------
CASH DECREASE DURING THE PERIOD (133,980) (25,431)
-------------- ---------------
CASH AND CASH EQUIVALENTS AT SEPTEMBER 30 $ 122,646 $ 202,730
=============== =================
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. The Company has franchise agreements in its TruGreen
ChemLawn, Terminix, ServiceMaster Clean, Merry Maids, Amerispec and Furniture
Medic businesses. 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
September 30, 2005 and 2004, respectively, and nine percent of consolidated
operating income before headquarter overheads for the nine months ended
September 30, 2005 and September 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 $449 million and $443 million of deferred revenue at September
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.
6
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 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. On an interim basis, TruGreen ChemLawn defers these
incremental selling expenses, 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. 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 was a correction in
estimating the accrual for termite damage claims. The Company recorded $8
million of adjustments through September 2005 in order to increase the accrual
relating to prior years termite damage claims. There have been no other 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 increase in goodwill and intangible assets relates to tuck-in acquisitions
completed throughout the first nine months by Terminix and TruGreen ChemLawn, as
well as the acquisition of a distributorship by ServiceMaster Clean in the third
quarter.
7
The table below summarizes the goodwill and intangible asset activity and
balances:
(IN THOUSANDS)
AS OF AS OF
DEC. 31, SEPT. 30,
2004 ADDITIONS AMORT. 2005
------------------ ----------------- -------------- -----------------
Not Amortized:
Goodwill $ 1,568,044 $ 29,663 $ -- $ 1,597,707
Trade names & other 204,793 10,700 -- 215,493
Amortized:
Other intangible assets 45,788 3,257 -- 49,045
Accumulated amortization(1) (29,801) -- (3,926) (33,727)
---------------- ----------------- -------------- -----------------
Net other intangibles 15,987 3,257 (3,926) 15,318
---------------- ----------------- -------------- -----------------
Total $ 1,788,824 $ 43,620 $ (3,926) $ 1,828,518
================ ================= ============== =================
(1) Annual amortization expense of approximately $5 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) SEPT. 30, DEC. 31,
2005 2004
------------------------ -------------------
TruGreen $ 696,847 $ 681,954
Terminix 657,827 643,567
American Home Shield(1) 85,526 72,085
ARS/AMS 56,171 56,171
Other Operations(1) 101,336 114,267
------------------ -------------------
Total $ 1,597,707 $ 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.
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 SEPT. 30, 2005 ENDED SEPT. 30, 2004
--------------------------------------- ----------------------------------------
CONTINUING OPERATIONS: Income Shares EPS Income Shares EPS
---------------------- ------------ -------- --------- ------------ ---------- --------
Basic earnings per share $ 75,063 291,474 $ 0.26 $ 68,343 290,258 $ 0.24
========= ========
Effect of dilutive securities, net of tax:
Options & SARS 5,765 5,078
Convertible Securities 1,178 8,000 1,178 8,000
---------- -------- ----------- ----------
Diluted earnings per share $ 76,241 305,239 $ 0.25 $ 69,521 303,336 $ 0.23
========== ======== ========= =========== ========== ========
8
(IN THOUSANDS, EXCEPT PER SHARE DATA) NINE MONTHS NINE MONTHS
ENDED SEPT. 30, 2005 ENDED SEPT. 30, 2004
-------------------------------------- ----------------------------------------
CONTINUING OPERATIONS: Income Shares EPS Income Shares EPS
---------------------- ------------ -------- -------- ----------- ----------- ---------
Basic earnings per share $ 165,966 291,426 $ 0.57 $ 150,492 290,647 $ 0.52
======== =========
Effect of dilutive securities, net of tax:
Options & SARS 5,824 4,790
Convertible Securities 3,534 8,000 3,534 8,000
---------- -------- ---------- -----------
Diluted earnings per share $ 169,500 305,250 $ 0.56 $ 154,026 303,437 $ 0.51
========== ======== ======== ========== =========== =========
NOTE 7: Beginning in 2003, the Company began 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 NINE MONTHS ENDED
SEPT. 30, SEPT. 30,
(IN THOUSANDS, EXCEPT PER SHARE DATA) 2005 2004 2005 2004
--------------- --------------- -------------- -------------
Net income as reported $ 81,587 $ 67,724 $ 171,960 $ 149,319
Add back: Stock-based compensation
expense included in reported net income,
net of related tax effects 620 291 1,685 830
Deduct: Stock-based compensation
expense determined under fair-value method,
net of related tax effects (1,380) (1,396) (4,389) (4,216)
--------------- --------------- -------------- -------------
Proforma net income $ 80,827 $ 66,619 $ 169,256 $ 145,933
=============== =============== ============== ==============
Basic Earnings Per Share:
As reported $ 0.28 $ 0.23 $ 0.59 $ 0.51
Proforma $ 0.28 $ 0.23 $ 0.58 $ 0.50
Diluted Earnings Per Share:
As reported $ 0.27 $ 0.23 $ 0.57 $ 0.50
Proforma $ 0.27 $ 0.22 $ 0.57 $ 0.49
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 nine
months ended September 30, 2005 and 2004 is presented in the following table:
(IN THOUSANDS)
CASH PAID FOR OR (RECEIVED FROM): 2005 2004
--------------------------------- ---- ----
Interest expense $ 54,784 $ 52,836
Interest and investment income (15,725) (12,713)
Income taxes, net of refunds 141,496 11,796
The increase in cash received from interest and investment income reflects a
higher level of investment income and gains realized on the growing investment
portfolio at American Home Shield. Cash paid for income taxes increased in 2005
as a result of $131 million of taxes paid this year to the IRS and various
states pursuant to the Company's agreement with the Internal Revenue Service
(IRS) that was reached in January 2005. Acquisitions for the nine months ended
September 30, 2005 totaled $44 million, compared with $41 million in 2004.
Consideration consisted of cash payments, seller financed notes and Company
stock.
NOTE 9: Total comprehensive income was $83 million and $66 million for the three
months ended September 30, 2005 and 2004, respectively and $170 million and $146
million for the nine months ended September 30, 2005 and 2004, respectively.
Total comprehensive income primarily includes 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 nine months ended September 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 source
of liquidity. 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 that will, at times, limit
the amount available to the Company.
NOTE 11: Total debt was $769 million at September 30, 2005, approximately $36
million below the level at December 31, 2004. Approximately 60 percent of the
Company's debt matures beyond five years and 50 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 nine months
ended September 30, 2005 for the remaining liabilities from the discontinued
operations, with $11 million of the decrease during this period reflecting the
favorable conclusion of certain obligations related to the previously sold
international pest control operations. The remaining liabilities primarily
represent obligations related to long-term self-insurance claims. The Company
continues to believe that the remaining reserves are adequate.
10
(IN THOUSANDS) BALANCE AT CASH BALANCE AT
DECEMBER 31, PAYMENTS INCOME/ SEPT. 30,
2004 OR OTHER (EXPENSE) 2005
------------------ -------------- -------------- ------------------
Remaining liabilities from
discontinued operations $ 30,593 $ 5,517 $ 9,566 $ 15,510
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 tax returns for 2003, 2004,
and 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. 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 franchised and Company-owned operations of ServiceMaster
Clean, Furniture Medic and Merry Maids, which provide disaster restoration,
commercial cleaning, carpet and upholstery 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 NINE MONTHS NINE MONTHS
ENDED SEPT. 30, ENDED SEPT. 30, ENDED SEPT. 30, ENDED SEPT. 30,
2005 2004 2005 2004
------------------ ----------------- ------------------ -------------------
Operating Revenue:
TruGreen $ 458,643 $ 438,474 $ 1,159,408 $ 1,116,843
Terminix 266,986 253,235 820,347 772,349
American Home Shield 154,599 137,961 409,895 374,220
ARS/AMS 208,057 181,097 570,091 514,778
Other Operations 45,264 43,100 130,229 121,284
----------------------------- ------------------ ----------------- ------------------ -------------------
Total Operating Revenue $ 1,133,549 $ 1,053,867 $ 3,089,970 $ 2,899,474
============================= ================== ================= ================== ===================
Operating Income (1):
TruGreen $ 79,413 $ 79,983 $ 140,408 $ 142,982
Terminix 34,060 26,695 122,071 111,432
American Home Shield 22,851 23,433 60,802 57,386
ARS/AMS 4,864 4,302 6,548 2,267
Other Operations (9,259) (9,587) (27,157) (28,767)
----------------------------- ------------------ ----------------- ------------------ -------------------
Total Operating Income $ 131,929 $ 124,826 $ 302,672 $ 285,300
============================= ================== ================= ================== ===================
(1) Presented below is a reconciliation of segment operating income to income
from continuing operations before income taxes.
11
(IN THOUSANDS) THREE MONTHS THREE MONTHS NINE MONTHS NINE MONTHS
ENDED SEPT. 30, ENDED SEPT. 30, ENDED SEPT. 30, ENDED SEPT. 30,
2005 2004 2005 2004
------------------- ------------------ ----------------- -----------------
Segment Operating Income $ 131,929 $ 124,826 $ 302,672 $ 285,300
Non-operating expense (income):
Interest expense 13,749 15,210 43,729 45,148
Interest and investment income (5,516) (3,913) (18,116) (11,519)
Minority interest and other
expense, net 2,080 2,047 6,173 6,179
--------------------------------- --------------------- ------------------ ----------------- -----------------
Income from Continuing
Operations before Income Taxes $ 121,616 $ 111,482 $ 270,886 $ 245,492
================================= ===================== ================== ================= =================
(IN THOUSANDS) AS OF AS OF
SEPT. 30, 2005 DEC. 31, 2004
------------------------ -----------------------
Identifiable Assets:
TruGreen $ 1,020,617 $ 957,683
Terminix 873,704 843,272
American Home Shield 532,719 474,326
ARS/AMS 221,623 191,618
Other Operations 497,334 673,303
------------------------------------------------------------- ------------------------ -----------------------
Total Identifiable Assets $ 3,145,997 $ 3,140,202
============================================================= ======================== =======================
(IN THOUSANDS) AS OF AS OF
SEPT. 30, 2005 SEPT. 30, 2004
----------------------- ----------------------
Capital Employed: (2)
TruGreen $ 919,870 $ 899,813
Terminix 634,164 617,342
American Home Shield 202,152 162,734
ARS/AMS 98,053 96,615
Other Operations 66,213 (33,873)
------------------------------------------------------------- ----------------------- ----------------------
Total Capital Employed $ 1,920,452 $ 1,742,631
============================================================= ======================= ======================
(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
SEPT. 30, 2005 SEPT. 30, 2004
------------------------ ---------------------------
Total Assets $ 3,145,997 $ 3,094,820
Less:
Current liabilities, excluding current portion of
long-term debt 928,352 875,796
Long-term liabilities 297,193 476,393
-------------------------------------------------------------- ------------------------ ---------------------------
Total Capital Employed $ 1,920,452 $ 1,742,631
============================================================== ======================== ===========================
12
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
THIRD QUARTER 2005 COMPARED TO 2004
ServiceMaster (the "Company") reported third quarter 2005 revenue of $1.13
billion, an eight percent increase compared to 2004. Every business segment
achieved solid increases in revenue, and substantially all of the growth was
organic. Third quarter diluted earnings per share were $.27 compared with $.23
in 2004. Diluted earnings per share from continuing operations increased nine
percent to $.25, compared to $.23 in 2004. Operating income for the third
quarter increased six percent to $132 million compared to $125 million in 2004.
The increase in operating income primarily reflects strong double-digit profit
growth at Terminix supported by improved labor and material cost efficiencies
from a new liquid termite perimeter treatment technique and a new termite bait
product, improved profitability in the ARS operations, and continued
safety-related savings. These factors offset higher fuel costs, which impact the
enterprise's entire fleet as well as petroleum-based fertilizer used at TruGreen
ChemLawn, much higher claim costs at American Home Shield which resulted from
hotter weather conditions, as well as continued investments in certain strategic
initiatives.
The enterprise's results continued to be affected by two significant costs that
are trending in opposite directions. (1) Fuel Costs - The Company's large fleet,
with annual consumption of over 35 million gallons, continues to be negatively
impacted by significant increases in oil prices, which have also adversely
impacted fertilizer costs at TruGreen ChemLawn. Although the Company hedges
approximately two-thirds of its estimated annual fuel usage, even net of the
hedges, fuel costs increased over $5 million in the third quarter and
approximately $12 million for the first nine months. The Company expects this
trend to continue and anticipates that it will be absorbing over $.03 per share
of incremental costs due to this factor in 2005. At current price levels, a
similar incremental impact would be expected in 2006. The Company is piloting
GPS and routing and scheduling technologies which would tighten routes and
reduce drive time and fuel consumption. The Company is also starting to evaluate
the use of hybrid trucks. These have a longer runway, but if viable, would have
an even more significant impact on fuel consumption. (2) Safety-related costs -
On the positive side, the Company continues to experience favorable results from
its efforts to reduce safety and insurance related costs, which include workers'
compensation, auto and general liability claims. As previously disclosed, this
once rapidly escalating cost has already started to recede. Through the first
nine months of 2005, the Company has achieved a reduction in overall vehicle
collisions 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, safety and insurance related costs, including the effects
of favorable prior year claims trending, were down over $5 million during the
third quarter and $12 million for the first nine months. The Company is still
well short of its long term safety targets, and is anticipating continued
progress in the future.
The Company has re-affirmed its outlook for the year. The Company continues to
expect annual revenue growth to be in the mid to high single digit range and
that 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). Instability in gas
and oil prices combined with increasing interest rates are currently having a
negative effect on consumer confidence. It is too early for the Company to
determine whether these trends will continue and how they will affect spending
patterns in 2006, but the Company is closely monitoring these factors.
13
Cost of services rendered and products sold increased eight percent for the
third quarter and increased as a percentage of revenue to 65.6 percent in 2005
from 65.2 percent in 2004. This increase primarily reflects the growth in the
ARS/AMS segment as these operations generally have lower gross margin levels
relative to the rest of the enterprise, as well as the impact of higher fuel
costs, offset in part by favorable trending of prior year self-insured claims.
Selling and administrative expenses increased seven percent for the quarter. As
a percentage of revenue, these costs decreased to 22.6 percent for the quarter
in 2005 from 22.8 percent in 2004.
Net non-operating expenses were reduced by approximately $3 million in the third
quarter. Approximately one-half of this decrease was due to lower interest
expense resulting from the repayment of fixed rate debt in April, with the
balance attributable to income and realized gains from the growing American Home
Shield investment portfolio.
The income from discontinued operations, net of income taxes for the third
quarter and nine months ended September 30, 2005 primarily reflects the
favorable conclusion of certain obligations related to previously sold
international pest control operations.
SEGMENT REVIEWS FOR THE THIRD 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 third quarter
revenue of $459 million, five percent above the prior year. The segment reported
a one percent decrease in operating income for the quarter to $79 million
compared to $80 million in 2004. The 2004 results included a non-recurring
pre-tax gain of $4 million from the sale of a support facility.
Revenue in the lawn care operations increased five percent to $341 million from
$325 million in 2004. Year-to-date unit sales increased modestly from last
year's levels as 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. This successful expansion of new sales channels,
combined with a two percent improvement in price realization and approximately
two percent growth in supplemental services (e.g., seeding and aeration),
generated mid single digit revenue growth in the quarter. Third quarter
operating income of the lawn care operations declined $2 million, primarily as a
result of last year's $4 million non-recurring gain from the sale of a support
facility, and differences in the timing of certain expenses between interim
periods. Improved labor productivity and other cost controls helped offset the
impact of higher fuel and fertilizer costs.
Third quarter revenue in the landscape maintenance business increased three
percent to $117 million, compared to $114 million in 2004. Base contract
maintenance revenue increased three percent despite a decline in customer
retention. Enhancement revenue (e.g., add-on services such as seasonal flower
plantings, mulching, etc.), which accounts for approximately one-third of this
business' revenue, also increased three percent for the quarter. Although this
rate of growth is still modest relative to the Company's long-term expectations
for this business, management is encouraged by its steady
14
improvement. The Company believes the trend of improvement should continue into
the fourth quarter and into 2006 and beyond, as it develops a systematically
stronger sales organization, with an expanded team that is better qualified,
trained and equipped to realize the substantial growth potential in this
business. Third quarter operating losses for the landscape operations improved
by $1 million reflecting improvements in labor, material and safety-related
costs, and a favorable reduction in acquisition related reserves, offset in part
by higher fuel prices.
Capital employed in the TruGreen segment increased two 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
a five percent increase in third quarter revenue to $267 million, compared to
$253 million in 2004. Operating income increased 28 percent to $34 million
compared to $27 million in 2004. This unit achieved solid growth in revenue from
initial termite applications ("termite completions") as an increase in unit
sales was supported by a larger sales force and expanded geographic presence. A
strong increase in termite renewal revenue resulted from improved pricing,
partially offset by a decrease in customer retention. Solid growth in third
quarter pest control revenue reflected the impact of acquisitions, offset in
part by lower customer retention. As previously disclosed, there have been two
successful innovations on the termite side of the business this year. In March,
the Company introduced a new bait option which utilizes an active termiticide
from day one, and provides meaningful labor and material cost advantages over
the prior offering. Labor efficiencies are also being realized in the Company's
liquid option as a result of the new perimeter treatment technique. The strong
growth in the segment's operating income reflects these labor and material cost
savings, and lower current year damage claims expense. Combined, these more than
offset the effects of a $4 million correction to the accrual related to prior
years termite damage claims and the effects of higher fuel costs. Capital
employed in the Terminix segment increased three percent, reflecting the impact
of tuck-in 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 a 12 percent increase in revenue to $155
million from $138 million in 2004 and a two percent decrease in operating income
to $23 million. New warranty contract sales, which are reported as earned
revenue over the subsequent twelve-month contract period, increased nine percent
for the quarter. A solid increase in customer renewals, which are American Home
Shield's largest source of revenue, was supported by a larger base of renewable
customers and an overall improved customer retention rate. American Home
Shield's second largest channel, real estate sales, has shown initial
improvements in momentum and a modest increase in sales for the quarter.
Consumer sales, the Company's fastest growing channel, experienced strong
double-digit growth driven by an increased level of targeted direct mail. Third
quarter operating income declined modestly as incremental profits from the
increased revenue levels were more than offset by approximately $11 million of
higher air conditioning claim costs relating to both an increased rate of claims
per contract as well as a higher cost per claim, resulting from hotter weather
compared to the generally mild conditions that prevailed last year. In addition,
the Company made planned investments in initiatives to increase market
penetration and further improve customer retention. Operating income comparisons
to last year were positively impacted by a $5.5 million cumulative negative
adjustment to deferred revenue and operating income that was reported in the
third quarter of 2004. Capital employed increased 24 percent reflecting volume
growth in the business resulting in a higher level of marketable securities
balances. The calculation of capital employed for the American Home Shield
segment includes approximately $279 million and $261 million of cash, cash
equivalents and marketable securities at September 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 third quarter
increased 15 percent to $208 million in 2005 from $181 million in 2004.
Operating income increased to $5 million from $4 million in 2004. The segment's
revenue growth consisted of very strong
15
increases in commercial project revenue in the AMS operations, continued strong
growth in ARS' HVAC replacement sales and residential new construction
installations, and a slight increase in HVAC service 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, continued growth in ARS'
retail outlet initiative, as well as the favorable impact of hotter weather
conditions across most of the country. In the third quarter, plumbing service
revenue decreased modestly, resulting from continued declines in retail service
calls, which more than offset increases from sewer line repairs and light
commercial services. The increase in the segment's third quarter operating
income resulted from the increased level of revenue, a more favorable mix of
replacement sales, and reductions in insurance and marketing expenses. This was
offset in part by a provision for loss contracts at an AMS location, higher
incentive compensation, and increased fuel costs. Capital employed in this
segment increased one 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 five percent to $45 million compared to $43 million in 2004.
On a combined basis, the ServiceMaster Clean and Merry Maids franchise
operations reported revenue growth of six percent and a solid increase in
operating income. ServiceMaster Clean continued to achieve double-digit growth
in disaster restoration services along with improved momentum in commercial
cleaning. Merry Maids continued to experience strong internal revenue growth in
its branch operations. The segment as a whole reported a slightly smaller third
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 changes in deferred tax accounts that were
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.
NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO 2004
The Company reported revenue of $3.09 billion for the nine months ended
September 30, 2005, a seven percent increase over 2004, with approximately six
percent of the growth from organic sources. For the nine months, diluted
earnings per share were $.57 compared with $.50 in 2004. Diluted earnings per
share from continuing operations were $.56, 10 percent above the $.51 reported
in 2004. Operating income increased six percent to $303 million compared to $285
million in 2004. Operating income margins were comparable to 2004, reflecting
higher margins at Terminix, improved profitability in the ARS and TruGreen
LandCare operations, and reduced safety-related costs throughout the enterprise,
offset in part by higher fuel costs, and increased claim costs at American Home
Shield due to hotter weather conditions, as well as continued investments in
certain strategic initiatives.
Cost of services rendered and products sold increased six percent for the nine
months and decreased as a percentage of revenue to 66.2 percent in 2005 compared
to 66.6 percent in 2004. The decrease as a percentage of revenue primarily
reflects the impact of continued favorable trending of prior year self-insurance
claims, offset in part by increased fuel costs. Selling and administrative
expenses increased nine percent and increased as a percentage of revenue to 23.9
percent in 2005 from 23.5 percent in 2004.
Net non-operating expense decreased $8 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.
16
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 SEPTEMBER 30,
2005 2004
-------------- -------------
TRUGREEN CHEMLAWN-
Growth in Full Program Contracts 1% 7%
Customer Retention Rate 64.1% 64.8%
TERMINIX -
Growth in Pest Control Customers 4% 6%
Pest Control Customer Retention Rate 77.7% 78.4%
Growth in Termite Customers 0% -1%
Termite Customer Retention Rate 87.3% 88.1%
AMERICAN HOME SHIELD -
Growth in Warranty Contracts 6% 5%
Customer Retention Rate 56.5% 55.0%
SEGMENT REVIEWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO 2004
As discussed in the third 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 nine months, the TruGreen segment reported revenue of $1.2 billion, four
percent above the prior year. Operating income decreased two percent to $140
million compared to $143 million in 2004, which included a pre-tax gain of $4
million from the sale of a support facility.
Revenue in the lawn care operations increased five percent to $822 million from
$786 million in 2004. The increase in revenue reflects improved price
realization, growth in supplemental customer services, as well as the higher
customer count. The lawn care operations have continued to successfully
diversify their sales channels through increased emphasis on neighborhood
selling, direct mail and other efforts. Expansion of these new sales channels
have helped offset continued declines in telemarketing sales, which have been
adversely impacted by "do-not-call" restrictions. Year-to-date sales from direct
mail efforts have increased over 13 percent, while sales from neighborhood
programs have more than tripled to almost 300,000 customers. With respect to
overall pricing, the lawn care operations have achieved a two percent overall
improvement in price realization this year through disciplined efforts to reduce
discounting on new sales and strategically targeted price increases to the
existing customer base. The customer retention rate decreased 70 basis points,
as improvements in the U.S. were offset by declines in Canada. The circumstances
in Canada are unique, and included the combination of five acquired brands into
one at the beginning of this year, as well as tightened application regulations
in certain markets. Despite this recent decline, overall retention rates have
increased 400 basis points over the last four years and the Company is
targeting, and anticipating, meaningful additional improvement in the future. To
capture that opportunity, the Company has taken comprehensive steps to improve
customer communication and problem resolution procedures, expand quality
assurance processes, and provide
17
focused incentives at all levels. For the nine months, operating income in the
lawn care operations decreased $6 million. This comparison was adversely
impacted by the gain in 2004 from the sale of a support facility, increased fuel
costs this year, the first time inclusion of $3 million of seasonal losses in
the Canadian operations that were acquired in April 2004, and the timing of
certain expenses between quarters. These factors more than offset the
incremental profits from increased revenues and reduced safety-related costs for
the nine months.
Revenue in the landscape maintenance operations increased two percent to $337
million from $331 million in 2004. The level of the operating loss of the
landscape operations improved $3 million for the nine months, reflecting
improvements in labor, material and safety-related costs and the favorable
impact of one-time branch shut-down costs that were incurred last year,
partially offset by higher fuel prices. The Company continues to anticipate
improvement in the operating results of the landscape operations for the fourth
quarter and for the full year. Results are expected to benefit from management's
focus on key initiatives, including: improving the scheduling and management of
labor costs, enhancing the capabilities, training and methods of the sales team,
and reducing workers compensation and safety claims.
The Terminix segment reported a six percent increase in revenue for the nine
months to $820 million compared to $772 million in 2004 and operating income
growth of 10 percent to $122 million compared to $111 million in 2004. For the
nine months, strong growth in termite completion revenue was supported by both
an increase in unit sales, despite a relatively weak termite swarm season,
resulting from an expanded sales force and geographic presence, as well as the
favorable impact of a new termite bait product introduced in 2005. Solid growth
in termite renewal revenue reflected the impact of improved pricing, offset in
part by an 80 basis point decline in customer retention. 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 is taking
comprehensive steps to reverse the trend in retention in both the termite and
pest operations and realize improvements over the next few years, which the
Company believes could be in the 300 basis point range. Key actions include more
strategic pricing practices, improved problem resolution procedures, and more
extensive communication and follow up with customers. Operating income growth
for the nine months was supported by the higher revenue levels as well as
improved labor and material cost efficiencies resulting from the new liquid
termite perimeter treatment technique and the new termite bait product, offset
in part by incremental pre-season investments made in the first quarter to
expand the sales force and re-organize the field operations. In addition, since
more of the total first year costs associated with the new termite 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 this year's second quarter operating income but did not have a
significant net impact on the third quarter. During the first nine months,
Terminix recorded approximately $8 million of incremental damage claim expense
due to a correction in the estimated prior years reserve levels. Last year,
Terminix recorded a $6 million favorable but non recurring adjustment in the
second quarter.
For the nine months, the American Home Shield segment reported a 10 percent
increase in revenue to $410 million from $374 million in 2004 and operating
income growth of six percent, to $61 million compared to $57 million in 2004.
New warranty contract sales, which are reported as earned revenue over the
subsequent twelve-month contract period, increased nine percent for the first
nine months. Real estate sales increased slightly for the first nine months,
while an increased level of targeted direct mail solicitations resulted in
strong double-digit sales growth in the consumer sales channel. Customer
renewals increased at a double-digit rate, resulting 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
refinancings. As noted in the third quarter comparison, incremental operating
income from the increased revenue levels was offset in part by higher claim
costs due to hotter weather conditions this year and investments in initiatives
to increase market penetration and improve customer retention. Additionally, the
operating income comparison to last year was positively impacted by a $5.5
million cumulative
18
negative adjustment to deferred revenue and operating income that was reported
in the third quarter of 2004.
The ARS/AMS segment reported an 11 percent increase in revenues for the nine
months to $570 million compared to $515 million in 2004. The segment reported
operating income of $7 million in 2005 compared to $2 million in 2004. The
increase in revenue resulted from very strong growth in AMS' commercial project
revenue and double-digit increases in ARS' HVAC replacement sales and
residential new construction installations. These increases were partially
offset by declines in core HVAC and plumbing service call revenue. For the nine
months, the increase in operating income was supported by the higher volume of
revenue, lower insurance costs and a reduced level of marketing spending, offset
in part by a provision for loss contracts at an AMS location and increased
incentive compensation and fuel costs. At AMS, installation and retrofit project
revenue and related backlogs increased at double-digit rates, as the commercial
construction sector continues to steadily recover from a cyclical downturn.
The Other Operations segment reported a seven percent increase in revenues to
$130 million for the nine months compared with $121 million in 2004. On a
combined basis, the ServiceMaster Clean and Merry Maids franchise operations
achieved revenue growth of eight percent with a strong increase in operating
income. ServiceMaster Clean reported strong growth in disaster restoration
services, while Merry Maids achieved very strong internal revenue growth and
improving gross profit margins in the branch operations. For the first nine
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 provided from operating activities was $112 million for the nine
months, compared to $241 million in the prior year. The decrease in net cash
flow of $129 million primarily reflects $131 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 in 2005 of $45 million, and a deferred tax annuity totaling $57 million
that will be realized through 2016. Approximately one half of the expected $45
million reduction in estimated tax payments was realized as an offset to taxes
payable in the third quarter. Excluding the impact of the $131 million tax
payment to the IRS and various states this year, nine month cash provided by
operating activities totaled $243 million, slightly more than the prior year
level. This result primarily reflects a higher level of income offset by an
increase in working capital usage resulting from increased incentive payments
made early in the year relating to 2004 performance.
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 recoveries of
deferred tax assets.
The significant annual cash tax benefit that results from the recovery of
deferred tax assets primarily is associated with 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.
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 tax returns. As with
any review of this nature, the outcome of the IRS examination is not known at
this time.
19
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.
Acquisitions for the nine months ended September 30, 2005 totaled $44 million,
compared with $41 million in 2004. Consideration consisted of cash payments,
seller financed notes and Company stock. The Company expects overall
acquisitions for the year to be at approximately the same level as in 2004.
CASH FLOWS FROM FINANCING ACTIVITIES
Cash dividends paid to shareholders totaled $96 million or $.33 per share for
the nine months ended September 30, 2005. In October 2005, the Company announced
the declaration of a cash dividend of $.11 per share payable on November 30,
2005 to shareholders of record on November 14, 2005. The timing and amount of
future dividends and related increases are at the discretion of the Board of
Directors and will depend, among other things, on 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 $30 million available for repurchases
under the July 2000 authorization. The Company completed approximately $51
million in share repurchases in the nine months ended September 30, 2005 at an
average price of $13.61 per share. The Company expects share repurchases for the
full year to be approximately $10 million higher than the level in 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 $379
million at September 30, 2005, compared with $496 million at December 31, 2004.
This decrease reflects the previously disclosed tax payments relating to the
2005 IRS agreement. Approximately $354 million of the 2005 amount is effectively
required to support regulatory requirements at American Home Shield and for
other purposes. Total debt was $769 million at September 30, 2005, approximately
$36 million lower than the amount at December 31, 2004.
Approximately 60 percent of the Company's debt matures beyond five years and 50
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 September 30, 2005, the Company had $90 million of
borrowings outstanding under this facility and had issued approximately $142
million of letters of credit, resulting in unused commitments of approximately
$268 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 based on seasonality of the business and will at times limit the amount
available to the Company. During the nine month period ended September 30, 2005,
there were no receivables sold to third parties under this agreement.
20
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
September 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 September 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 September 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
September 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 September 30, 2005,
there was approximately $270 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 nine 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 totaling approximately $10 million.
FINANCIAL POSITION - CONTINUING OPERATIONS
Receivables increased from year-end levels, reflecting general business growth
and increased seasonal activity. Inventories increased from year-end levels,
reflecting a new vendor relationship at Terminix, as well as 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 costs
of annual repair 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
21
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.
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 seasonality and
solid business growth at several of the business units. Deferred revenue
increased from year-end levels, reflecting growth in contracts written at
American Home Shield and the impact from the seasonal volume of the new termite
bait product partially offset by a decrease from year-end 2004 levels in
customer prepayment balances for lawn care services. 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 $1.1 billion at September 30, 2005 and $992
million at December 31, 2004. The increase reflects operating profits from 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 Condensed Consolidated Statements of
Financial Position. Assets of the discontinued operations have declined from
year-end levels representing collections on receivables. Liabilities of
discontinued operations decreased from year-end levels resulting from the
favorable conclusion of certain obligations related to the previously sold
international pest control operations. The remaining liabilities primarily
represent obligations related to long-term self-insurance claims.
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.
22
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 (7.2
percent average rate during the nine months ended September 30, 2005).
The Company generally maintains the majority of its debt at fixed rates. After
the effect of the interest rate swap agreements, approximately 63 percent of
total debt at September 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 $270 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 September 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 $0.9 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.
23
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.
24
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 September 30, 2005 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 SHARE PLAN PLAN
--------------------------------------------------------------------------------------------------------------------
July 1, 2005 through
July 31, 2005 -- $ -- -- $65,000,000
August 1, 2005 through
August 31, 2005 1,275,588 $ 13.65 1,275,588 $48,000,000
September 1, 2005 through
September 30, 2005 1,324,200 $ 13.54 1,324,200 $30,000,000
------------------------------------------------------
Total 2,599,788 $ 13.60 2,599,788
=======================================================
ITEM 6: EXHIBITS
EXHIBIT NO. DESCRIPTION OF EXHIBIT
----------- ----------------------
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: November 4, 2005
THE SERVICEMASTER COMPANY
(Registrant)
By: /S/ ERNEST J. MROZEK
---------------------
Ernest J. Mrozek
President and Chief Financial Officer
26