UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
X QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
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THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2003
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: 295,172,000 shares of common stock on November 5, 2003.
TABLE OF CONTENTS
Page
NO.
THE SERVICEMASTER COMPANY (Registrant) -
PART I. FINANCIAL INFORMATION
Item 1: Financial Statements
Condensed Consolidated Statements of Income for the three and nine
months ended September 30, 2003 and September 30, 2002 3
Condensed Consolidated Statements of Financial Position
as of September 30, 2003 and December 31, 2002 4
Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2003 and September 30, 2002 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 1: Legal Proceedings 24
Item 6: Exhibits and Reports on Form 8-K 24
Signature 25
PART I. FINANCIAL INFORMATION
THE SERVICEMASTER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Three Months Ended Nine Months Ended
September 30, September 30,
2003 2002 2003 2002
----------- ----------- ----------- -----------
OPERATING REVENUE ............................................. $ 1,018,263 $ 987,757 $ 2,762,076 $ 2,713,490
OPERATING COSTS AND EXPENSES:
Cost of services rendered and products sold ................... 670,321 664,646 1,844,558 1,835,892
Selling and administrative expenses ........................... 221,105 197,612 637,362 576,861
Amortization expense .......................................... 1,126 2,126 4,488 6,432
Charge for impaired assets .................................... 480,670 - 480,670 -
----------- ----------- ----------- -----------
Total operating costs and expenses ............................ 1,373,222 864,384 2,967,078 2,419,185
----------- ----------- ----------- -----------
OPERATING INCOME (LOSS) ....................................... (354,959) 123,373 (205,002) 294,305
NON-OPERATING EXPENSE (INCOME):
Interest expense .............................................. 16,285 17,030 49,223 76,678
Interest and investment income ................................ (1,857) (405) (6,201) (5,303)
Minority interest and other expense, net ...................... 1,986 1,905 6,104 5,489
----------- ----------- ----------- -----------
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE
INCOME TAXES .............................................. (371,373) 104,843 (254,128) 217,441
Provision for income taxes, 2003 includes a $98 million
benefit relating to the impairment charge ................. (54,847) 38,828 (8,774) 79,424
----------- ----------- ----------- -----------
INCOME (LOSS) FROM CONTINUING OPERATIONS ...................... (316,526) 66,015 (245,354) 138,017
Income (loss) from discontinued operations, net of income taxes (1,440) 2,068 (2,387) 4,210
----------- ----------- ----------- -----------
NET INCOME (LOSS) ............................................. $ (317,966) $ 68,083 $ (247,741) $ 142,227
=========== =========== =========== ===========
PER SHARE:
BASIC EARNINGS PER SHARE:
Income (loss) from continuing operations ...................... $ (1.08) $ 0.22 $ (0.83) $ 0.46
Discontinued operations, net .................................. - .01 (0.01) .01
----------- ----------- ----------- -----------
$ (1.08) $ 0.23 $ (0.84) $ 0.47
=========== =========== =========== ===========
SHARES ........................................................ 294,119 301,093 296,233 300,805
DILUTED EARNINGS PER SHARE:
Income (loss) from continuing operations ...................... $ (1.08) $ 0.21 $ (0.83) $ 0.45
Discontinued operations, net .................................. - .01 (0.01) .01
----------- ----------- ----------- -----------
$ (1.08) $ 0.22 $ (0.84) $ 0.46
=========== =========== =========== ===========
SHARES ........................................................ 294,119 313,649 296,233 315,155
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
3
THE SERVICEMASTER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (UNAUDITED)
(IN THOUSANDS)
As of Sept. 30, As of Dec. 31,
ASSETS 2003 2002
----------- -----------
CURRENT ASSETS:
Cash and cash equivalents ....................................... $ 171,242 $ 227,177
Marketable securities ........................................... 90,039 75,194
Receivables, less allowance of $28,401 and $27,616, respectively 388,828 322,954
Inventories ..................................................... 77,116 67,187
Prepaid expenses and other assets ............................... 42,762 38,879
Deferred customer acquisition costs ............................. 52,028 48,419
Deferred taxes and income taxes receivable ...................... 103,335 123,100
Assets of discontinued operations ............................... 2,523 22,586
----------- -----------
Total Current Assets ..................................... 927,873 925,496
----------- -----------
PROPERTY AND EQUIPMENT:
At cost ...................................................... 392,672 388,582
Less: accumulated depreciation ............................... (211,719) (200,027)
----------- -----------
Net property and equipment ................................. 180,953 188,555
----------- -----------
OTHER ASSETS:
Goodwill ........................................................ 1,508,982 1,919,780
Intangible assets, primarily trade names ........................ 217,026 257,781
Notes receivable ................................................ 54,841 55,770
Long-term securities and other assets ........................... 85,398 67,556
----------- -----------
Total Assets ............................................. $ 2,975,073 $ 3,414,938
=========== ===========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ................................................ $ 85,107 $ 90,876
Accrued liabilities:
Payroll and related expenses ................................. 96,036 97,819
Self-insured claims and related expenses ..................... 75,873 83,225
Other ........................................................ 97,298 102,095
Deferred revenues ............................................... 394,338 397,290
Liabilities of discontinued operations .......................... 20,471 36,624
Current portion of long-term debt ............................... 29,503 31,135
----------- -----------
Total Current Liabilities ................................ 798,626 839,064
----------- -----------
LONG-TERM DEBT .................................................. 795,964 804,340
LONG-TERM LIABILITIES:
Deferred taxes ............................................. 278,147 312,500
Liabilities of discontinued operations ..................... 32,307 30,682
Other long-term obligations ................................ 126,044 109,343
----------- -----------
Total Long-Term Liabilities ............................. 436,498 452,525
----------- -----------
MINORITY INTEREST ............................................... 100,309 100,309
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Common stock $0.01 par value, authorized 1 billion shares; issued
317,059 and 316,024 shares, respectively ................... 3,170 3,160
Additional paid-in capital ...................................... 1,056,396 1,054,272
Retained earnings ............................................... 14,338 355,893
Accumulated other comprehensive income (loss) ................... 5,062 (849)
Restricted stock ................................................ (4,509) (1,988)
Treasury stock .................................................. (230,781) (191,788)
----------- -----------
Total Shareholders' Equity ............................... 843,676 1,218,700
----------- -----------
Total Liabilities and Shareholders' Equity ............... $ 2,975,073 $ 3,414,938
=========== ===========
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
4
THE SERVICEMASTER COMPANY
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(IN THOUSANDS)
Nine Months Ended
September 30,
2003 2002
---------- ---------
CASH AND CASH EQUIVALENTS AT JANUARY 1 .................................... $ 227,177 $ 402,642
CASH FLOWS FROM OPERATIONS:
NET INCOME (LOSS) ......................................................... (247,741) 142,227
Adjustments to reconcile net income to net cash flows from operations:
(Income) loss from discontinued operations ........................ 2,387 (4,210)
Charge for impaired assets, net of tax ............................ 383,152 -
Depreciation expense .............................................. 36,972 35,932
Amortization expense .............................................. 4,488 6,432
Deferred income tax expense ....................................... 81,500 69,990
Change in working capital, net of acquisitions:
Receivables ................................................... (71,876) (49,015)
Inventories and other current assets .......................... (16,495) (31,196)
Accounts payable .............................................. (5,665) (1,433)
Deferred revenues ............................................. (2,488) 34,222
Accrued liabilities ........................................... (443) 27,349
Other, net .................................................... 2,156 12,640
--------- ---------
NET CASH PROVIDED FROM OPERATIONS ......................................... 165,947 242,938
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Property additions .................................................. (30,059) (41,352)
Sale of equipment and other assets .................................. 8,581 1,976
Business acquisitions, net of cash acquired ......................... (24,297) (10,132)
Notes receivable, financial investments and securities .............. (15,155) (1,512)
Proceeds from business sales ........................................ 21,300 30,500
--------- ---------
NET CASH USED FOR INVESTING ACTIVITIES .................................... (39,630) (20,520)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net payments of debt ................................................ (24,802) (338,129)
Purchase of ServiceMaster stock ..................................... (56,768) (14,529)
Shareholders' dividends ............................................. (93,814) (91,374)
Other, net .......................................................... 11,392 15,385
--------- ---------
NET CASH USED FOR FINANCING ACTIVITIES .................................... (163,992) (428,647)
--------- ---------
CASH USED FOR DISCONTINUED OPERATIONS ..................................... (18,260) (26,120)
--------- ---------
CASH DECREASE DURING THE PERIOD ........................................... (55,935) (232,349)
--------- ---------
CASH AND CASH EQUIVALENTS AT SEPTEMBER 30 ................................. $ 171,242 $ 170,293
========= =========
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 suggests that the quarterly condensed
consolidated financial statements be read in conjunction with the consolidated
financial statements and the notes thereto included in the Company's latest
Annual Report to Shareholders and the Annual Report to the Securities and
Exchange Commission on Form 10-K for the year ended December 31, 2002. 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), 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 stations, as
well as through non-baiting methods (e.g., fumigation or liquid treatment).
Termite services using baiting stations as well as home warranty services
typically are sold through annual contracts for a one-time, upfront payment.
Direct costs of these contracts (ongoing service costs for termite completions
and claim costs for warranty contracts) are expensed as incurred. The Company
recognizes revenue over the life of these contracts in proportion to the
expected direct costs. Revenue from trade name licensing arrangements is
recognized when earned. Franchised revenues (which in the aggregate represent
approximately three percent of consolidated revenue) consist principally of
continuing monthly fees based upon the franchisee revenue. Monthly fee revenue
is recognized when the related franchise revenue is reported from the franchisee
and collectibility is assured and all material services or conditions relating
to the sale have been substantially performed. Total franchise fee income
(excluding trade name licensing) represented 3.0 percent and 8.4 percent of
consolidated operating income (loss) for the three months ended September 30,
2003 and 2002, respectively and 14.8 percent and 9.7 percent for the nine months
ended September 30, 2003 and 2002, respectively. The portion of total franchise
fee income related to initial fees received from the sale of a franchise were
immaterial to the Company's consolidated financial statements for all periods.
Customer acquisition costs, which are incremental and direct costs of obtaining
the customer, are deferred and amortized over the life of the contract in
proportion to revenue recognized. These costs include sales commissions and
direct selling costs which can be shown to have resulted in a successful sale.
TruGreen ChemLawn has significant seasonality to its business. In the winter and
early spring, this business sells a series of lawn applications to customers
which are rendered primarily in March through October. The Company incurs and
defers incremental selling expenses at the beginning of the year that directly
relate to successful sales for which the revenues will be recognized in later
quarters. This business 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 approximately in
proportion to the contract revenue over the production season, and are not
deferred beyond the calendar year-end.
6
As noted above, TruGreen's pre-season advertising costs are deferred and
recognized approximately in proportion to the contract revenue over the year.
Terminix also defers its advertising costs in the first quarter and recognizes
the expense over the year. These costs are not deferred beyond the calendar
year-end. The cost of direct-response advertising at Terminix is capitalized and
amortized over its expected period of future benefits. This direct-response
advertising consists primarily of direct-mail promotions, for which the cost is
capitalized and amortized over the one-year customer contract life.
The preparation of the financial statements requires management to make certain
estimates and assumptions required under GAAP which may differ materially from
the actual results. Disclosures in the 2002 Annual Report presented the
significant areas that require the use of management's estimates and discussed
how management formed its judgment. The areas discussed included the allowance
for receivables, accruals for self-insured retention limits related to medical,
workers compensation, auto and general liability insurance, the possible outcome
of litigation and the useful lives for depreciation and amortization expense and
the valuation of tangible and intangible assets. In 2003, there have been no
changes in the significant areas that require estimates or in the methodologies
which underlie these estimates. As discussed in Note 5, in the third quarter of
2003, the Company recorded a charge to reduce the value of its goodwill and
intangible assets.
NOTE 4: The Company carries insurance policies on insurable risks which it
believes to be appropriate. The Company generally has self-insured retention
limits and has obtained fully insured layers of coverage above such self-insured
retention limits. Accruals for self-insurance losses are made based on the
Company's claims experience and actuarial assumptions. The Company has certain
liabilities with respect to existing or potential claims, lawsuits, and other
proceedings. The Company accrues for these liabilities when it is probable that
future costs will be incurred and such costs can be reasonably estimated. Any
resulting adjustments, which could be material, are reflected in the period
identified.
NOTE 5: In accordance with Statement of Financial Accounting Standards (SFAS)
142 "Goodwill and Other Intangible Assets", the Company discontinued the
amortization of goodwill and indefinite lived intangible assets effective
January 1, 2002. 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. The fair value of goodwill and other intangible assets has been
determined after reviewing several valuation techniques and primarily utilizing
the present value of future cash flows. The Company's annual assessment date is
in the fourth quarter. However, based on recent events such as certain branch
closures in American Residential Services (ARS) and the sale of Trees Inc., as
well as underlying trends in the Company's HVAC, plumbing and commercial
landscape businesses, management concluded in the third quarter that the
operations were not expected to able to generate the necessary cash flows to
support the current value of goodwill and intangible assets. In the beginning of
2003, management believed that the significant declines in these businesses were
an anomaly and that the operations, with an anticipated good summer season,
would show ongoing improvement which would validate the amount of goodwill and
intangible assets on the financial statements. However, these recent events
coupled with the earlier decline have caused management to conclude that the
businesses are unlikely to meet previous projections which supported the
valuation of the intangibles and therefore, an impairment charge is necessary at
this time. The Company had discussed such events and trends in previous press
releases and periodic filings with the Securities and Exchange Commission.
A valuation was performed during the third quarter of 2003 which incorporated
third quarter 2003 performance. Based on the evaluation, it was determined that
the fair value of the Company's goodwill and intangible assets was less than
their carrying value. The Company used an independent valuation firm to confirm
the Company's assessment of the fair value of its goodwill and other intangible
assets. In the third quarter of 2003, the Company recorded a non-cash impairment
charge totaling $481 million pre-tax or $383 million net of tax. The charge
consisted of $224 million at American Residential Services, $68 million at
American Mechanical Services and $189 million at TruGreen Landcare. The
impairment charge included a portion of goodwill that was not deductible for tax
purposes, resulting in a tax benefit of $98 million, or approximately 20 percent
of the pre-tax charge amount. The following table summarizes the goodwill and
intangible asset activity and balances:
7
(IN THOUSANDS) As of As of
Dec. 31, Reclass- Impairment Sept. 30,
2002 Additions ification (3) Charges Amort. 2003
------------- ------------- ------------ --------------- ----------- -------------
Goodwill(1) $1,919,780 $30,597 $4,816 $(446,211) $ - $ 1,508,982
Trade names(1) 238,550 - - (33,757) - 204,793
Other intangible assets 78,284 3,008 (38,554) (6,008) - 36,730
Accumulated amortization(2) (59,053) - 33,738 5,306 (4,488) (24,497)
------------- ------------- ------------ --------------- ----------- -------------
Net other intangibles 19,231 3,008 (4,816) (702) (4,488) 12,233
------------- ------------- ------------ --------------- ----------- -------------
Total $2,177,561 $33,605 $ - $ (480,670) $(4,488) $1,726,008
============= ============= ============ =============== =========== =============
(1) Not subject to amortization.
(2) Annual amortization expense of approximately $6 million in 2003 is expected
to decline over the next five years.
(3) In the first quarter, the Company reviewed its intangible balances and
removed the fully amortized assets as well as the related accumulated
amortized balance on the financial statements. During this process certain
reclassifications between categories were made.
The table below presents, by segment, the goodwill that is not subject to
amortization:
(IN THOUSANDS) Sept. 30, Dec. 31,
2003 2002
------------- --------------
TruGreen $647,936 $780,043
Terminix 620,200 618,055
American Home Shield 72,085 72,085
ARS/AMS 56,171 337,491
Other Operations 112,590 112,106
------------- --------------
Total $1,508,982 $1,919,780
============= ==============
NOTE 6: Basic earnings per share is computed by dividing income available to
common stockholders by the weighted-average number of shares outstanding for the
period. The weighted-average common shares for the diluted earnings per share
calculation includes the incremental effect related to outstanding options whose
market price is in excess of the exercise price. Shares potentially issuable
under convertible securities have been considered outstanding in the diluted
earnings per share calculations if their impact is dilutive. In computing
diluted earnings per share, the after-tax interest expense related to
convertible debentures is added back to net income in the numerator, while the
diluted shares in the denominator include the shares issuable upon conversion of
the debentures. Due to the losses incurred for the three and nine months ended
September 30, 2003, the denominator does not include the effects of share
equivalents as it would result in a less dilutive computation. As a result,
diluted earnings per share are the same as basic earnings per share.
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 September 30, 2003 Ended September 30, 2002
-------------------------------- ------------------------------
Income
CONTINUING OPERATIONS: (Loss) Shares EPS Income Shares EPS
---------------------- ---------- --------- -------- ---------- --------- -------
Basic earnings per share $(316,526) 294,119 $(1.08) $66,015 301,093 $0.22
======= =====
Effect of dilutive securities, net of tax:
Options - 4,356
Convertible securities - - 1,195 8,200
---------- --------- ---------- ---------
Diluted earnings per share $(316,526) 294,119 $(1.08) $67,210 313,649 $0.21
========== ========= ======== ========== ========= =======
8
Nine Months Nine Months
Ended September 30, 2003 Ended September 30, 2002
-------------------------------- ------------------------------
Income
CONTINUING OPERATIONS: (Loss) Shares EPS Income Shares EPS
---------------------- ---------- --------- -------- ---------- --------- -------
Basic earnings per share $(245,354) 296,233 $(0.83) $138,017 300,805 $0.46
======= =====
Effect of dilutive securities, net of tax:
Options - 6,150
Convertible securities - - 3,585 8,200
---------- --------- ---------- ---------
Diluted earnings per share $(245,354) 296,233 $(0.83) $141,602 315,155 $0.45
========== ========= ======== ========== ========= =======
NOTE 7: In 2003, the Company adopted SFAS 145, "Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical
Corrections". The primary impact to the Company of SFAS 145 is that it rescinds
SFAS 4 which required all material gains and losses from the extinguishment of
debt to be classified as extraordinary items. SFAS 145 requires that the more
restrictive criteria of Accounting Principles Board Opinion No. 30 be used to
determine whether such gains or losses are extraordinary. In the second quarter
of 2002, the Company recorded an extraordinary loss of $.03 per diluted share
($15 million pre-tax, $9 million after-tax) from the early extinguishment of
debt. As a result of the Company's adoption of SFAS 145 in 2003, this loss has
been reclassified into interest expense, thereby reducing the previously
reported 2002 diluted earnings per share from continuing operations by the same
amount.
Beginning in 2003, the Company is accounting for employee stock options as
compensation expense in accordance with SFAS 123, "Accounting for Stock-Based
Compensation." SFAS 148 "Accounting for Stock-Based Compensation - Transition
and Disclosure, an amendment of FASB Statement No. 123", provides alternative
methods of transitioning to the fair value based method of accounting for
employee stock options as compensation expense. The Company is using the
"prospective method" of SFAS 148 and is expensing the fair value of new employee
option grants awarded subsequent to 2002. If the Company continues its
historical pattern of option granting, the impact is expected to be
approximately $.005 per share in 2003, growing to approximately $.03 per share
over five years.
Prior to 2003, the Company accounted for employee share options under the
intrinsic method of Accounting Principles Board Opinion No. 25, as permitted
under GAAP. Had compensation expense for employee options been determined under
the fair value based method of SFAS 123, proforma reported net income and net
earnings per share would reflect the following:
Three Months Ended Nine Months Ended
September 30, September 30,
(IN THOUSANDS, EXCEPT PER SHARE DATA) 2003 2002 2003 2002
-------------------------------------------------------------------
Net income (loss) as reported $(317,966) $68,083 $(247,741) $142,227
Add back: Stock-based compensation
expense included in reported net income,
net of related tax effects 233 - 710 -
Deduct: Stock-based compensation
expense determined under fair value
method, net of related tax effects (1,922) (1,894) (5,683) (5,682)
--------------- --------------- ------------- ------------
Proforma net income (loss) $(319,655) $66,189 $(252,714) $136,545
=============== =============== ============= ============
Basic Earnings Per Share:
As reported $(1.08) $0.23 $(0.84) $0.47
Proforma $(1.09) $0.22 $(0.85) $0.45
Diluted Earnings Per Share:
As reported $(1.08) $0.22 $(0.84) $0.46
Proforma $(1.09) $0.21 $(0.85) $0.44
NOTE 8: In January 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities" (FIN 46). Under this
Interpretation, certain entities known as "Variable Interest Entities" (VIE)
must be consolidated by the "primary beneficiary" of the entity. The primary
beneficiary is generally
9
defined as having the majority of the risks and rewards arising from the VIE.
For VIE's in which a significant (but not majority) variable interest is held,
certain disclosures are required. The original effective date for FIN 46 was
deferred and the Company is now required to apply the requirements of FIN 46
starting with its fourth quarter 2003 financial statements. The Company is
presently assessing the impact of this Interpretation; however, it is not
expected to have a material impact on the Consolidated Financial Statements.
Based on information as of September 30, 2003, adoption of FIN 46 in 2003 could
result in approximately $53 million of real estate operating leases being
included on the balance sheet as assets with associated debt.
NOTE 9: 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, 2003 and 2002 is presented in the following table:
(IN THOUSANDS)
2003 2002
------------ ------------
CASH PAID OR (RECEIVED) FOR:
Interest expense.................. $ 53,698 $ 83,751
Interest and dividend income...... $ (6,365) $ (8,195)
Income taxes...................... $ 6,081 $ 36,629
The 2002 interest paid includes $15 million (pre-tax) related to the early
extinguishment of debt. The remaining decrease in interest paid reflects reduced
debt levels and lower interest rates in 2003. The tax payment in 2002 resulted
from the gain on the sale of the Management Services business.
NOTE 10: Total comprehensive income (loss) was ($317) million and $71 million
for the three months ended September 30, 2003 and 2002, respectively and ($242)
million and $142 million for the nine months ended September 30, 2003 and 2002,
respectively. Total comprehensive income (loss) includes primarily net income,
changes in unrealized gains and losses on marketable securities and foreign
currency translation balances.
NOTE 11: The Company has an agreement which provides 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. At September 30, 2003 and 2002, there were no receivables sold to
third parties under this agreement. However, the Company may sell its
receivables in the future, which would provide an additional funding source. The
agreement is a 364-day facility that is renewable at the option of the
purchasers. The Company may sell up to $65 million of its receivables to these
purchasers in the future and therefore has immediate access to cash proceeds
from these sales. The amount of the eligible receivables varies during the year
based on seasonality of the business and will at times limit the amount
available to the Company.
NOTE 12: In September 2003, the Company sold the assets and related operational
obligations of Trees, Inc., the utility line clearing operations of TruGreen
LandCare, to an independent subsidiary of Asplundh Subsidiary Holdings, Inc.,
for approximately $20 million in cash. The impact of the sale was not material
to the Company's Consolidated Financial Statements for 2003. The results of the
utility line clearing operations of Trees, Inc. have been reclassified as
"Discontinued Operations" and are not included in continuing operations. Prior
year earnings per share from continuing operations in the quarter and nine
months were reduced $.01 to reflect the reclassification of the divested utility
line clearing business as discontinued operations.
In October 2001, the Company's Board of Directors approved a series of strategic
actions, which were the culmination of an extensive portfolio review process
that was initiated in the first quarter of 2001. As part of this portfolio
review, the Company sold or exited certain non-strategic or under-performing
businesses in the fourth quarter of 2001 and third quarter of 2002. The results
of these discontinued business units have been separately classified as
"Discontinued Operations" in the accompanying financial statements. The Company
continues to carry certain assets on its financial statements relating to these
operations.
10
Management's intent is to collect the outstanding receivables. The Company
believes that the remaining assets are presented at their net realizable value.
In addition, reserves and accrual balances remain on the financial statements
relating to these operations. Cash payments in the first nine months of 2003
include an adjustment to the sales price of a prior year disposition, which was
expensed in 2002. The remaining balances are outlined in the table below.
In the fourth quarter of 2001, the Company recorded a charge for asset
impairments and other items which included accruals for residual value
guarantees on leased properties, severance for former executives and terminated
employees, and other costs.
The table below summarizes the activity during the nine months ended September
30, 2003 for the remaining liabilities from the discontinued operations and the
reserves for items recorded in the fourth quarter of 2001. The Company believes
that the remaining reserves continue to be adequate and reasonable.
(IN THOUSANDS) Balance at Cash Balance at
December 31, Payments Income/ Sept. 30,
2002 or Other (Expense) 2003
--------------- ----------- ------------- -------------
Remaining liabilities from
discontinued operations
LandCare Construction $14,000 $6,600 $ - $7,400
LandCare utility line
clearing business (1) 6,300 N/A N/A 11,800
Certified Systems, Inc. 13,600 1,900 11,700
Management Services 1,600 1,200 400
International businesses 21,400 10,300 (1,000) 12,100
Other 10,400 1,000 9,400
Reserves related to strategic
actions in the fourth
quarter of 2001 $15,500 $2,700 $900 $11,900
(1) In September 2003, the Company sold the assets and related operational
obligations of Trees, Inc., the utility line clearing operations of
TruGreen LandCare. The Company retained certain liabilities in connection
with the sold operations.
NOTE 13: In the ordinary course, the Company is subject to review by domestic
and foreign taxing authorities, including the Internal Revenue Service ("IRS").
From 1986 through 1997 most operations of the Company were conducted in
partnership form, free of federal corporate income tax. In 1997 the Company
converted from partnership to corporate form. During that period, the Company
was not reviewed by the IRS. In 2003, the IRS notified the Company of its intent
to examine the Company's consolidated income tax returns for 2002, 2001 and
2000. The Company expects the IRS to complete its examination in early 2005. As
with any review of this nature, the outcome of the IRS examination is not known
at this time. The Company believes it has recorded the appropriate tax
provision, tax liabilities and deferred tax accounts.
NOTE 14: The business of the Company is conducted through five operating
segments: TruGreen, Terminix, American Home Shield, ARS/AMS and Other
Operations. In accordance with SFAS 131, the Company's reportable segments are
strategic business units that offer different services. The TruGreen segment
provides residential and commercial lawn care and landscaping services through
the TruGreen ChemLawn and TruGreen LandCare companies. The Terminix segment
provides termite and pest control services to residential and commercial
customers. The American Home Shield segment provides home warranties to
consumers that cover HVAC, plumbing and other home systems and appliances. This
segment also includes home inspection services provided by AmeriSpec. The
ARS/AMS segment provides HVAC and plumbing installation and repair services
provided under the ARS Service Express, American Mechanical Services and Rescue
Rooter brand names. The Other Operations segment includes the franchise
operations of ServiceMaster Clean and Merry Maids, which provide disaster
restoration and cleaning services as well as the Company's headquarters
operations which provides various technology, marketing, finance and other
support services to the business units. Segment information is presented below.
11
(IN THOUSANDS) Three Months Three Months Nine Months Nine Months
Ended Sept. 30, Ended Sept. 30, Ended Sept. 30, Ended Sept. 30,
2003 2002 2003 2002
------------------------------------------------------------------------------------------------------------------------------
Operating Revenue:
TruGreen $418,106 $395,811 $1,056,943 $1,015,766
Terminix 246,714 235,414 733,208 712,339
American Home Shield 132,096 121,639 352,469 323,995
ARS/AMS 181,538 192,721 505,948 549,891
Other Operations 39,809 42,172 113,508 111,499
------------------------------------------------------------------------------------------------------------------------------
Total Operating Revenue $1,018,263 $987,757 $2,762,076 $2,713,490
==============================================================================================================================
Operating Income (Loss):
TruGreen (1) $(117,148) $74,582 $(57,739) $145,586
Terminix 32,461 25,359 107,886 107,584
American Home Shield 21,602 19,715 52,923 40,904
ARS/AMS (1) (284,482) 7,736 (281,814) 15,041
Other Operations (7,392) (4,019) (26,258) (14,810)
------------------------------------------------------------------------------------------------------------------------------
Total Operating Income (Loss) (1) $(354,959) $123,373 $(205,002) $294,305
==============================================================================================================================
(1) In the third quarter of 2003, the Company recorded a non-cash, pre-tax
impairment charge of $481 million related to its goodwill and intangible
assets. Approximately $189 million of the charge is associated with the
TruGreen LandCare operations reported in the TruGreen segment, and the
remaining $292 million relates to the ARS/AMS segment.
As of As of
Sept. 30, 2003 Dec. 31, 2002
---------------------------------------------------------------------------------------------------
Identifiable Assets:
TruGreen $960,694 $1,053,099
Terminix 835,241 841,437
American Home Shield 413,499 376,059
ARS/AMS 189,470 489,366
Other Operations (and discontinued businesses) 576,169 654,977
---------------------------------------------------------------------------------------------------
Total Identifiable Assets $2,975,073 $3,414,938
===================================================================================================
12
MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
RESULTS OF OPERATIONS
THIRD QUARTER 2003 COMPARED TO THIRD QUARTER 2002
CONSOLIDATED REVIEW
Revenue for the third quarter of 2003 was $1.02 billion, three percent above
2002. The Company reported a net loss from continuing operations in 2003 of
($317) million and a loss from discontinued operations of ($1) million. The
third quarter net loss of ($318) million in 2003 compared with net income of $68
million in 2002 and diluted earnings per share was a ($1.08) loss in 2003 and
$.22 in 2002.
Diluted earnings per share from continuing operations for the quarter was a
($1.08) loss in 2003 compared with $.21 in 2002. The diluted earnings per share
for 2003 includes a non-cash impairment charge of $1.30 per share ($481 million
pre-tax, $383 million after-tax). The prior year earnings per share from
continuing operations for the quarter were reduced $.01 to reflect the
reclassification of the divested utility line clearing business as discontinued
operations. Operating income for the third quarter 2003 was a loss of ($355)
million, compared with income of $123 million in 2002. The 2003 figure includes
the $481 million non-cash impairment charge. The increase in operating income
before the charge reflects a strong profit increase at Terminix, increased lawn
care production at TruGreen, continued growth at American Home Shield, offset by
the impact of the impairment charge and reduced profitability in TruGreen's
landscaping operations and the American Mechanical Services operations.
In the third quarter, the Company recorded a non-cash impairment charge
associated with the goodwill and intangible assets at its American Residential
Services (ARS), American Mechanical Services (AMS) and TruGreen LandCare
business units of $481 million pre-tax which is $383 million after-tax or $1.30
per share. In accordance with Statement of Financial Accounting Standards (SFAS)
142 "Goodwill and Other Intangible Assets", 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. Based on recent events and underlying trends in
its HVAC, plumbing and commercial landscape business, the Company determined
these businesses were unlikely to meet previous management projections. In the
beginning of 2003, management believed that the significant declines in these
businesses were an anomaly and that the operations, with an anticipated good
summer season, would show ongoing improvement which would validate the amount of
goodwill and intangible assets on the financial statements. However, these
recent events coupled with the earlier decline have caused management to
conclude that the businesses are unlikely to meet previous projections which
supported the valuation of the intangibles and therefore, an impairment charge
is necessary at this time. The Company had discussed such events and trends in
previous press releases and periodic filings with the Securities and Exchange
Commission. In the second quarter of 2003, the Company's Form 10-Q stated that
management may complete an assessment of goodwill and other intangible assets
relating to the ARS and AMS businesses in the third quarter. The Company
announced the sale of its utility line clearing operations of TruGreen LandCare
in the third quarter of 2003. This operation, which reported approximately $90
million in revenue and was profitable in 2002, had experienced significant
declines in profitability in subsequent quarters. This sale, combined with
declining profitability in the base maintenance business, led to the impairment
charge.
Nonetheless, a number of the Company's businesses showed encouraging signs in
the third quarter. Customer counts at TruGreen ChemLawn increased four percent
relative to last year and its operating income was at the highest level of any
quarter in the last three years. Terminix is turning around a difficult year as
lead flow is returning back to normal. American Home Shield and the franchise
businesses continued to produce strong results. The Company reported earnings
growth at ARS as operating income increased approximately $2 million over the
prior year. The improvement in these businesses contributed $.03 a share to
earnings per share. However, lower earnings at TruGreen LandCare and AMS offset
this growth by $.02 a share relative to last year as well as increased
investments in enterprise initiatives. While these trends may provide momentum
going into the fourth quarter and 2004, the Company continues to expect margin
pressures from various costs such as insurance costs. Insurance costs have
increased
13
approximately $.03 a share in 2003 and the Company would expect another $.03 a
share of increases in 2004. Management has also reduced variable compensation
significantly in 2003 as a result corresponding to support its financial
results, which are expected to need funding in 2004.
Based on the Company's current performance and market conditions, the Company
believes that its earnings per share for the fourth quarter will be
approximately $.08 to $.09. The Company plans to give guidance for 2004 when it
reports full year 2003 results in February 2004.
Cost of services rendered and products sold increased one percent for the
quarter and decreased as a percentage of revenue to 65.8 percent in 2003 from
67.3 percent in 2002. This decrease reflects a change in the mix of the business
as American Home Shield, TruGreen ChemLawn and Terminix 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 incur
somewhat higher selling and administrative expenses as a percentage of revenue.
Selling and administrative expenses increased 12 percent and increased as a
percentage of revenue to 21.7 percent for the quarter in 2003 from 20.0 percent
in 2002. The increase in selling and administrative expenses primarily reflects
the change in business mix described above, as well as increased expenditures on
sales and marketing.
Net interest expense decreased $2 million from 2002, reflecting lower interest
expense resulting from reduced rates and higher investment income. The
comparability of the effective tax rate is impacted by the impairment charge
recorded in the third quarter of 2003 and the use of prior year net operating
losses in 2002. The effective tax rate for 2003 and 2002 was 15 percent and 37
percent, respectively. The impairment charge recorded in 2003 included a portion
of goodwill that was not deductible for tax purposes resulting in a tax benefit
of $98 million, or approximately 20 percent of the pre-tax impairment charge of
$481 million, while the 2002 rate included the one-time benefit from utilizing
the prior year net operating losses of the ServiceMaster Home Service Center
operations which resulted in a reduction in the tax provision of approximately
$2 million.
SEGMENT REVIEW
The TruGreen segment includes lawn care operations performed under the TruGreen
ChemLawn brand name and landscape maintenance services provided under the
TruGreen LandCare brand name. As discussed in Note 12 in the Notes to Condensed
Consolidated Financial Statements, during the third quarter of 2003, the Company
sold the assets and related operational obligations of the utility line clearing
operations of TruGreen LandCare for approximately $20 million in cash. The
impact of this sale was not material to the Company's consolidated financial
statements for 2003. The results of the sold utility line clearing operations
have been reclassified as discontinued operations and are not included in
continuing operations. The TruGreen segment reported a six percent increase in
third quarter revenue to $418 million compared to $396 million in 2002. For the
third quarter of 2003 the segment reported an operating loss of ($117) million
compared with operating income of $75 million in the prior year. During the
third quarter of 2003, the Company recorded a non-cash impairment charge of $189
million pre-tax relating to goodwill and intangible assets of its TruGreen
LandCare operations. For a further discussion on the impairment charge see Note
5 in the Notes to Condensed Consolidated Financial Statements. The decrease in
segment operating income primarily reflects the impact of the impairment charge
as well as increased labor and insurance costs in the landscape maintenance
operations, partially offset by solid growth in the lawn care operations. Third
quarter revenue in the lawn care operations increased seven percent with
customer counts up over four percent supported by tuck-in acquisitions and
stronger ancillary sales and increased production levels. In the lawn care
operations, operating income showed solid growth reflecting the larger customer
base and increased production, however, margins declined primarily due to
increased selling and marketing costs as well as increased insurance costs. In
the landscape maintenance business, revenue increased one percent, reflecting
slight growth in the core maintenance business and a flat level of enhancement
sales which include higher priced discretionary services such as seasonal flower
plantings. Operating income margins in the landscaping business declined
reflecting the impact of the impairment charge as well as increased direct labor
costs and higher insurance costs. Capital employed in the TruGreen segment
decreased 13 percent to $906 million at September 30, 2003 compared with $1.04
billion at September 30, 2002, primarily reflecting the impact of the impairment
charge, partially offset by tuck-in acquisitions. Capital employed is defined as
the segment's total assets less liabilities, exclusive of debt balances. The
14
Company believes these figures are useful to investors in helping them compute
return on capital measures and therefore better understand the performance of
the Company's business segments.
The Terminix segment, which includes termite and pest control services, reported
a five percent increase in third quarter revenue to $247 million from $235
million in 2002 and 28 percent growth in operating income to $32 million
compared with $25 million in 2002. Revenue growth was supported by higher
revenue from termite renewals, new termite contracts, as well as pest control.
This growth reflected higher unit pricing, as well as an increase in the mix of
higher priced bait services within the renewal base. Operating income margins
increased from 2002 reflecting reduced labor and material costs as a percentage
of revenue in the quarter. Capital employed at September 30, 2003 was $589
million, slightly below $594 million at September 30, 2002.
The American Home Shield (AHS) segment, which provides home warranties to
consumers that cover HVAC, plumbing and other home systems and appliances,
reported a nine percent increase in revenue to $132 million from $122 million in
2002 and 10 percent growth in operating income to $22 million compared with $20
million in 2002. The revenue increase reflected strong growth in contract
renewals throughout the year. Sales of new contracts in the quarter increased by
double-digit rates in all three of the primary sales channels: real estate,
direct-to-consumer, and existing customer renewals. Operating margins improved
as mild weather conditions in several regions resulted in a lower claims rate as
well as favorable development of prior year claims. Capital employed increased
31 percent to $128 million at September 30, 2003 compared to $98 million at
September 30, 2002, reflecting volume growth in the business requiring a higher
level of investment. The calculation of capital employed for the AHS segment
includes approximately $154 million and $128 million of cash, cash equivalents
and marketable securities at September 30, 2003 and 2002, respectively. The
interest and gains/losses on these investments are reported below operating
income as non-operating income/expense.
The ARS/AMS segment provides direct HVAC and plumbing installation and repair
services under the ARS Service Express, Rescue Rooter, and American Mechanical
Services (for large commercial accounts) brand names. Revenue for the third
quarter totaled $182 million in 2003, a decrease of six percent from $193
million in 2002. In the third quarter of 2003 the segment reported an operating
loss of ($284) million compared with $8 million of operating income in 2002.
During the third quarter of 2003, the Company recorded a non-cash impairment
charge of $292 million pre-tax relating to goodwill and intangible assets of its
ARS/AMS segment. For a further discussion on the impairment charge see Note 5 in
the Notes to Condensed Consolidated Financial Statements. Economic conditions
and cooler weather have affected this business along with the entire HVAC and
plumbing industries. The decline in revenue reflects a reduced level of HVAC
construction revenue in both the residential and commercial sectors, as well as
decreases in the plumbing and HVAC service lines, partially offset by modest
improvement in HVAC add-on/replacement activity. Operating income margins in the
third quarter declined primarily reflecting the impact of the impairment charge,
reduced revenue levels as well as increased sales and marketing expenditures.
These factors were partially offset by improved service center gross margins and
strong control of indirect costs. Higher operating income in the ARS business
was supported by margins from operations which improved 170 basis points due to
pricing initiatives, cost controls, and the closures of under performing
branches. Lower earnings at AMS offset this growth leading to lower
profitability in the segment overall. Despite increased levels of bidding
activity and backlog at AMS, the contracts are characterized by lower margins
and longer duration, thereby reducing the near-term profit opportunity. Capital
employed decreased 77 percent to $94 million at September 30, 2003 compared with
$407 million at September 30, 2002, reflecting the impact of the impairment
charge as well as lower working capital.
The Other Operations segment includes the Company's ServiceMaster Clean, Merry
Maids, and international operations as well as its headquarters functions. The
segment reported revenue of $40 million in 2003 compared with $42 million in
2002. In 2002 the Company recorded a $6 million licensing fee related to the
Company's former Terminix United Kingdom operations. The franchise operations
reported solid growth reflecting the impact of acquisitions at Merry Maids and
growth in disaster restoration services at ServiceMaster Clean. This segment
reported an operating loss of ($7) million in 2003 compared with a loss of ($4)
million in 2002, reflecting continued solid growth in positive operating profit
in the combined franchise operations offset by increased expenditures related to
marketing, technology, and regulatory/compliance initiatives as well as the
impact of the license fee received in 2002. Capital
15
employed in this segment decreased to $52 million at September 30, 2003 from $69
million at September 30, 2002 reflecting the wind-down of discontinued
operations.
RESULTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO SEPTEMBER 30, 2002
CONSOLIDATED REVIEW
Revenue for the nine months of 2003 increased two percent to $2.76 billion. The
Company reported a net loss from continuing operations in 2003 of ($245) million
and a loss from discontinued operations of ($2) million. The nine month net loss
of ($248) million compared with net income of $142 million in 2002 and diluted
earnings per share was a ($.84) loss in 2003 and $.46 in 2002.
Diluted earnings per share from continuing operations for the nine months was a
($.83) loss in 2003 compared with $.45 in 2002. The 2003 results include the
non-cash impairment charge of $1.29 for the nine months ($481 million pre-tax,
$383 million after-tax) that was discussed in the third quarter comparison. In
the second quarter of 2002, the Company recorded an extraordinary loss of $.03
per diluted share ($15 million pre-tax, $9 million after-tax) from the early
extinguishment of debt. As a result of the Company's adoption of SFAS 145,
"Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13 and Technical Corrections", this loss was reclassified into interest
expense in 2003, thereby reducing the previously reported nine month 2002
diluted earnings per share from continuing operations by $.03. In addition, the
2002 earnings per share from continuing operations for the nine months was
reduced $.01 to reflect the reclassification of the divested utility line
clearing operations to discontinued operations.
Operating income for the nine months of 2003 was a loss of ($205) million,
compared to income of $294 million in 2002. Included in the 2003 amount is the
$481 million non-cash impairment charge. The decline in operating income before
the charge reflects decreased profitability in the landscaping operations of
TruGreen and the AMS operations and increased spending on marketing, technology
and compliance initiatives at the headquarters level, partially offset by
continued strong growth at American Home Shield.
Cost of services rendered and products sold increased slightly for the nine
months and decreased as a percentage of revenue to 66.8 percent in 2003 from
67.7 percent in 2002 reflecting the business mix shift described in the third
quarter discussion. Selling and administrative expenses increased 10 percent and
increased as a percentage of revenue to 23.1 percent in 2003 from 21.3 percent
in 2002 as a result of the change in the mix of the business and increased
expenditures relating to sales and marketing, enterprise-wide technology, and
regulatory/compliance initiatives.
Net interest expense for the nine months decreased $28 million from 2002,
reflecting the reclassification of the $15 million pre-tax extraordinary loss in
2002 into interest expense as well as lower interest expense resulting from
reduced interest rates and debt levels. The effective tax rate for 2003 and 2002
was three percent and 37 percent, respectively. As discussed in the third
quarter comparison, the tax provision in 2003 included a $98 million benefit
related to the pre-tax impairment charge of $481 million and the 2002 provision
included the one-time benefit from utilizing the prior year net operating losses
of the ServiceMaster Home Service Center operations which resulted in a
reduction in the tax provision of approximately $7 million.
KEY PERFORMANCE INDICATORS
The table below presents selected metrics related to customer counts and
customer retention for the three most profitable businesses of the Company.
These measures are presented on a rolling, twelve-month basis in order to avoid
seasonal anomalies.
16
KEY PERFORMANCE INDICATORS
As of September 30,
2003 2002
--------- ----------
TRUGREEN CHEMLAWN -
Growth in Full Program Contracts 4% 2%
Customer Retention Rate 62.2% 62.4%
TERMINIX -
Growth in Pest Control Customers 2% 11%
Pest Control Customer Retention Rate 76.7% 76.7%
Growth in Termite Customers -2% 8%
Termite Customer Retention Rate 88.0% 89.5%
AMERICAN HOME SHIELD -
Growth in Warranty Contracts 8% 16%
Customer Retention Rate 53.3% 53.0%
SEGMENT REVIEW
For the nine months, the TruGreen segment reported revenue of $1.06 billion in
2003, a four percent increase over 2002. The segment reported an operating loss
of ($58) million compared to operating income of $146 million in 2002. As noted
in the third quarter comparison, the 2003 results include a $189 million pre-tax
charge relating to goodwill and intangible asset impairment. In the lawn care
operations, revenue increased five percent over 2002 reflecting growth in the
number of customers, which has been supported by tuck-in acquisitions, as well
as the realization of price increases. TruGreen ChemLawn has responded to
increasing restrictions on telemarketing by broadening its marketing approach
through increased expenditures on direct mail and other advertising. This year
the Company has more than doubled its sales through non-telemarketing channels,
which now comprise approximately 20 percent of new sales volume. Telemarketing
is a cost effective sales channel relative to other channels, so the Company has
experienced an increase in its sales and marketing costs as a result of this
shift. As the Company continues to reduce its dependency on telemarketing, there
will be a change in the timing of when new customers are obtained. Typically,
telemarketing is a preseason activity that is particularly heavy in January and
February. Therefore, the shift to more non-telemarketing sales will move the
addition of new customers from preseason activity to sales which are "in season"
from direct mail and other channels. The Company expects to experience a slight
decline in lawn care customer counts during the first quarter of 2004 and an
increase later in the year (March - May). The rolling twelve-month retention
rate has declined slightly from 2002. Surveys indicate that cancellations due to
economic reasons have increased relative to the prior year whereas those due to
quality issues have decreased. Operating income margins in the lawn care
operations declined in 2003 compared with 2002, reflecting the higher sales and
marketing costs discussed above as well as increased insurance costs. For the
fourth quarter, the Company expects growth in both revenue and operating income
in the lawn care operations based on the higher customer count, a strong
production schedule, and a deeper penetration in southern markets where the
Company benefits from a longer production season. Revenue in the landscape
maintenance business increased two percent for the nine months, reflecting a
significant increase in first quarter snow removal revenue, partially offset by
a decline in the level of enhancement sales, which have been impacted by the
weak economy. Operating income margins in the landscaping operations declined in
2003 reflecting the impact of the impairment charge as well as a decreased level
of higher margin enhancement sales, increased insurance costs and higher sales
expenditures.
The Terminix segment reported a three percent increase in revenue for the nine
months to $733 million from $712 million in 2002 and operating income of $108
million, consistent with the prior year. The growth in revenue reflects an
increase in higher priced bait contracts in the renewal base. Adverse cooler
temperatures earlier in the year that impacted many regions of the country
significantly impeded the development of the termite swarm and other pest
activity. As a result, the number of termite customers declined compared to last
year. Retention rates are comparable to the prior year for pest control while
17
termite retention rates have declined. Operating income margins have decreased
reflecting the reduction of new termite sales activity, implementation costs
associated with the unit's new information system, as well as increased
insurance costs. This decline was offset in part by lower damage claims in its
acquired Sears termite customer base. The Company will be entering 2004 with an
enhanced segmented termite offer for consumers. This offer will provide
consumers with the choice of receiving termite services through baiting stations
or liquid treatments. The Company believes that providing consumers a choice in
services will increase the number of sales leads closed and result in improved
price realization on the bait product. The Company expects the mix of its
termite customers to move from 85 percent bait and 15 percent liquid at the
beginning of 2004 to 40 percent bait and 60 percent liquid by the end of the
year. The lifetime values of the Company's liquid and bait termite customers are
comparable, however the earnings cycles are different with liquid customers
having less first year profitability and more in subsequent years.
The American Home Shield segment reported a nine percent increase in revenue to
$352 million for the nine months from $324 million in 2002 and a 29 percent
increase in operating income to $53 million compared to $41 million in 2002. The
increase in revenue reflects strong double-digit growth in renewal contracts
throughout the year. Retention rates have improved in spite of increased
mortgage refinancing activity, which has resulted in an increase in
cancellations in channels where the customer's warranty payment is included in
the mortgage statement. Operating margins improved as mild weather conditions in
several regions resulted in a lower claims rate as well as favorable development
of prior year claims. Next year, if there is a return to more normalized weather
conditions, the Company expects some margin pressure in the American Home Shield
business.
The ARS/AMS segment reported revenue for the nine months of $506 million in
2003, a decrease of eight percent from $550 million in 2002. For the nine months
the segment reported an operating loss of ($282) million in 2003 compared with
$15 million of operating income in 2002. As noted in the third quarter
comparison, the 2003 results include a $292 million pre-tax charge relating to
goodwill and intangible asset impairment. The decrease in revenue primarily
reflects a significant reduction in HVAC construction activity as well as lower
plumbing and HVAC repair volume, partially offset by an increase in
add-on/replacement HVAC activity. The add-on/replacement increase is important
as the transaction includes the sale of a piece of equipment, which carries with
it a higher price point and total margin. For the nine months operating margins
declined primarily reflecting the impact of the impairment charge as well as a
decrease in revenue and increased expenditures in sales and marketing.
The Other Operations segment reported segment revenue of $114 million in 2003
compared with $111 million in 2002, reflecting increases in both the
ServiceMaster Clean and Merry Maids businesses. This was partially offset by the
impact of a $6 million licensing fee recorded in 2002 related to the Company's
former Terminix United Kingdom operations. For the nine months, this segment
reported an operating loss of ($26) million in 2003 compared with a loss of
($15) million in 2002, reflecting continued growth in profits of the combined
franchise operations, offset by higher costs related to marketing, technology,
and compliance initiatives incurred at the headquarters level as well as the
impact of the license fee received in 2002.
FINANCIAL POSITION AND LIQUIDITY
Net cash flow provided from operations for the quarter was $108 million, $8
million more than the same quarter last year. The Company experienced solid
working capital management throughout the business. Net cash provided from
operations for the nine months totaled $166 million, compared with $243 million
in the previous year. The majority of the difference compared with the prior
year was experienced in the first quarter and is largely attributed to a higher
level of working capital usage. Several items impact the year over year
comparison of the cash flows from operations, with the largest component being
approximately $37 million in lower deferred revenue, primarily associated with
customer prepayments in TruGreen ChemLawn (approximately $19 million). In
addition, deferred revenue growth at Terminix decreased reflecting reduced sales
growth. TruGreen ChemLawn typically receives prepayments from certain customers
for the full season in the fourth and first quarters. In preparation for the
2003 season, prepayment programs were launched earlier than the prior year
resulting in an acceleration of prepayments (and cash flow) from the first
quarter to the fourth quarter, relative to the prior year. The Company has also
lowered the prepayment discount it offers customers that resulted in fewer
customers prepaying overall.
18
The Company believes the margin benefit from a lower discount outweighed the
benefit from receiving payments earlier. The reduction in cash flows for the
nine months also relates to receivable collections. Although many businesses
continued to show improvements in receivables management in 2003, there was not
the same level of incremental improvement that was experienced in 2002 when both
TruGreen LandCare and ARS made substantial improvements in their receivable
levels. The cash flow comparison was also impacted by the timing of insurance,
bonus and vendor payments, with an increased level of payments in 2003 compared
to 2002. Consistent with historical patterns, the last quarter of the year is
expected to experience stronger cash flow and the Company still anticipates its
cash from operations for the year to be significantly in excess of its net
income. Management expects that funds generated from operations and other
existing resources will continue to be adequate to satisfy ongoing working
capital needs of the Company.
Cash and marketable securities totaled $261 million at September 30, 2003,
approximately $41 million below the level at the beginning of the year.
Approximately $154 million of the current year amount was at American Home
Shield supporting regulatory requirements. The Company believes the cash balance
will build throughout the end of the year due to the seasonally high levels of
cash flows generated in the fourth quarter. During 2002, the Company completed
its debt reduction program announced in October 2001. As a result of strong cash
flows and the net proceeds received from the Company's 2001 dispositions, total
debt has been reduced and represents the Company's lowest debt level in six
years. Total debt at the end of the third quarter was $825 million, down
slightly from the year-end level of $835 million. The 2002 debt reduction
program also enabled the Company to lengthen its maturity profile by focusing
debt reductions on shorter maturities. Approximately 68 percent of the Company's
debt now matures beyond five years and 42 percent beyond fifteen years. The
Company's next significant debt maturity is not until 2005.
The Company maintains a three-year revolving credit facility for $490 million,
which will expire in December 2004. As of September 30, 2003 the Company had no
borrowings outstanding, but had issued approximately $149 million of letters of
credit under the facility and, therefore, had unused commitments of
approximately $341 million. The Company also has $550 million of senior
unsecured debt and equity securities available for issuance under an effective
shelf registration statement. In addition, the Company has an arrangement
enabling it to sell, on a revolving basis, certain receivables to unrelated
third party purchasers. At September 30, 2003, there were no receivables
outstanding that had been sold to third parties. The agreement is a 364-day
facility that is renewable at the option of the purchasers. The Company may sell
up to $65 million of its eligible receivables to these purchasers in the future
and therefore has immediate access to cash proceeds from these sales. The amount
of eligible receivables varies during the year based on seasonality of the
business and will at times limit the amount available to the Company. The
Company also maintains lease facilities with banks totaling $95 million that
provide for the acquisition and development of properties to be leased by the
Company. There are residual value guarantees of these properties up to 82
percent of the fair market value of the properties. At September 30, 2003, there
was approximately $73 million funded under these facilities. Of the $95 million
in facilities, $80 million expires in October 2004 and $15 million expires in
January 2008. Approximately $20 million of these leases that involve constructed
properties have been included on the balance sheet as assets with related debt
as of September 30, 2003 and $15 million as of December 31, 2002. Lastly, the
majority of the Company's vehicle fleet is leased through operating leases. The
lease terms are non-cancelable for the first twelve-month term, and then are
month-to-month leases, cancelable at the Company's option. There are residual
value guarantees (ranging from 70 percent to 87 percent of original value at
lease inception, declining over the life of the lease) on these vehicles, which
historically have not resulted in significant net payments to the lessors. At
September 30, 2003, there was approximately $270 million of residual value
relating to the Company's fleet.
The following table presents the Company's obligations and commitments:
2004 and 2006 and 2008 and
(IN MILLIONS) TOTAL 2003 2005 2007 LATER YEARS
---------------------------------------------------------------------------------------------
Debt balances $825 $8 $181 $71 $565
Non-cancelable operating leases 292 20 126 83 63
---------------------------------------------------------------------------------------------
Total amount $1,117 $28 $307 $154 $628
=============================================================================================
19
There have been no material changes in the terms of the Company's financing
agreements since December 31, 2002. As described in the Company's latest Annual
Report to Shareholders, the Company is party to a number of debt agreements that
require it to maintain certain financial and other covenants, including
limitations on indebtedness and interest coverage ratio. In addition, under
certain circumstances, the agreements may limit the Company's ability to pay
dividends and repurchase shares of common stock. These limitations are not
expected to be a factor in the Company's future dividend and share repurchase
plans. Failure by the Company to maintain these covenants could result in the
acceleration of the maturity of the debt. At September 30, 2003, the Company was
in compliance with the covenants related to these debt agreements and based on
its operating outlook for the remainder of 2003, expects to be able to maintain
compliance in the future. The non-cash impairment charge associated with
goodwill and other intangible assets recorded in the quarter do not affect the
Company's compliance with its lending arrangements and its covenants are not
affected by unusual non-cash charges.
The assets and liabilities relating to the discontinued operations have been
classified in separate captions on the Condensed Consolidated Statements of
Financial Position. Assets of the discontinued operations have declined
reflecting cash collections on receivables. The liabilities from discontinued
operations have declined as a result of a cash adjustment to the selling price
of the 2001 disposition of the Company's European pest control and property
services operations as well as certain other payments.
Receivables and inventories increased from year-end levels, reflecting general
business growth and increased seasonal activity. Days sales outstanding improved
in the majority of the companies. Prepaid expenses and other assets increased
modestly from year-end primarily reflecting pre-season advertising costs and
annual repairs and maintenance procedures that are performed in the first
quarter at TruGreen ChemLawn. 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. Deferred customer acquisition costs
increased slightly reflecting the seasonality in the lawn care operations. In
the winter and early spring, this business sells a series of lawn applications
to customers that are rendered primarily in March through October. The lawn care
operations incur and defer incremental selling expenses at the beginning of the
year that directly relate to successful sales in which the revenues will be
recognized in later quarters. 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. Deferred revenues decreased from year-end
reflecting increased volume in termite baiting contracts that was offset by a
decrease in customer prepayment balances for lawn care services.
Capital expenditures, which include recurring capital needs and information
technology projects, are below prior year levels. In the prior year, there was a
significant payment relating to the residual value guarantees for leases on
assisted living facilities that were subsequently sold. The Company has no
material capital commitments at this time. Tuck-in acquisitions for the nine
months ended September 30, 2003 and 2002 were $30.9 million and $13.9 million,
respectively. The consideration consisted of cash payments and seller financed
notes. The 2003 acquisitions occurred primarily at TruGreen ChemLawn.
Total shareholders' equity was $844 million at September 30, 2003 and $1.22
billion at December 31, 2002. The decrease reflects earnings in the business
offset by the aforementioned charge for impaired assets, cash dividends, and
share repurchases. Cash dividends paid directly to shareholders totaled $94
million or $.315 per share and $91 million or $.305 per share for the nine
months ended September 30, 2003 and 2002 respectively. In October 2003, the
Company paid a fourth quarter cash dividend of $.105 per share (compared to
$.105 per share paid last year) and declared a first quarter cash dividend of
$.105 per share payable on January 30, 2004. The fourth quarter dividend payment
resulted in an annual payment for 2003 of $.42 per share, a 2.4% increase over
2002. This year is the 33rd consecutive year of annual growth in dividends for
the Company. The Company approves its actual dividend payment on a quarterly
basis and periodically reviews its dividend policy, share repurchase program and
other capital structure objectives. Through the first nine months of 2003, the
Company has repurchased $57 million of its shares and anticipates purchasing $15
to $20 million of additional shares in the last quarter of 2003. Decisions
relating to any future share repurchases will take various factors into
consideration such as the Company's desire to maintain investment grade ratings,
general business conditions, and other strategic investment opportunities.
20
FORWARD LOOKING STATEMENTS
THE COMPANY'S FORM 10-Q FILING CONTAINS 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): EXTREME WEATHER
CONDITIONS THAT AFFECT THE DEMAND FOR THE COMPANY'S SERVICES; COMPETITION IN THE
MARKETS SERVED BY THE COMPANY; LABOR SHORTAGES OR INCREASES IN WAGE RATES;
UNEXPECTED INCREASES IN OPERATING COSTS, SUCH AS HIGHER INSURANCE, HEALTH CARE
OR FUEL PRICES; INCREASED GOVERNMENTAL REGULATION OF TELEMARKETING; GENERAL
ECONOMIC CONDITIONS IN THE UNITED STATES, ESPECIALLY AS THEY MAY AFFECT HOME
SALES OR CONSUMER SPENDING LEVELS; TIME AND EXPENSES ASSOCIATED WITH INTEGRATING
AND WINDING DOWN BUSINESSES; AND OTHER FACTORS DESCRIBED FROM TIME TO TIME IN
DOCUMENTS FILED BY THE COMPANY WITH THE SECURITIES AND EXCHANGE COMMISSION.
21
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
The economy and its impact on discretionary consumer spending, labor wages, fuel
costs, 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 in the normal course of business to manage certain market risks,
with a policy of matching positions and limiting the terms of contracts to
relatively short durations. The effect of financial instrument transactions is
not material to the Company's financial statements.
The Company generally maintains the majority of its debt at fixed rates (over
95% of total debt at December 31, 2002 and September 30, 2003) and, therefore,
its exposure to interest rate fluctuations is not significant to the Company's
results of operations. The payments on the approximately $73 million of funding
outstanding under the Company's real estate operating lease facilities as well
as its cancelable vehicle fleet and equipment operating leases are tied to
floating interest rates. However, the Company does not expect interest rate
fluctuations to be significant to the Company's results of operations.
The Company has several debt and lease agreements where the interest rate or
rent payable under the agreements automatically adjust 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, 2003, a one
rating category improvement in the Company's credit ratings would reduce expense
on an annualized basis by approximately $0.7 million. A one rating category
reduction in the Company's credit ratings would increase expense on an
annualized basis by approximately $1.4 million.
The following table summarizes information about the Company's fixed rate debt
instruments as of December 31, 2002 and presents the principal cash flows and
related weighted-average interest rates by expected maturity dates. The fair
value of the Company's fixed rate debt was approximately $880 million at
December 31, 2002.
Expected Maturity Date
--------------------------
There-
(In millions) 2003 2004 2005 2006 2007 after Total
--------------------------------------------------------------------------------
Fixed rate debt $31 $24 $151 $11 $59 $559 $835
Avg. Rate 4.2% 4.8% 8.2% 6.0% 6.7% 7.5% 7.2%
================================================================================
22
CONTROLS AND PROCEDURES
The Company's Chairman and Chief Executive Officer, Jonathan P. Ward, and the
Company's Chief Financial Officer, Steven C. Preston, have evaluated the
Company's disclosure controls and procedures as of the end of the period covered
by this report.
Messrs. Ward and Preston have concluded that the Company's disclosure controls
and procedures provide reasonable assurance that the Company can meet its
disclosure obligations. The Company's disclosure controls and procedures are
based upon 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 Commission is recorded, processed, summarized and reported within the time
periods specified in the Commission's rules and forms.
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 1: LEGAL PROCEEDINGS
As previously disclosed in the Company's Form 10-Q for the quarter ended March
31, 2003, The Terminix International Company Limited Partnership, a subsidiary
of the Company, and the Office of the Attorney General of the State of New York
have been involved in discussions regarding Terminix's compliance with Article
33 of the New York Environmental Conservation Law regulating the application of
pesticides. Pursuant to the entry of a supplemental consent order entered
September 24, 2003, the parties settled this matter. Without admitting
liability, Terminix agreed to pay the State $759,000 and the State agreed to
release Terminix from its allegations as to the disputed claims.
ITEM 6(A): 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
ITEM 6(B): REPORTS ON FORM 8-K
A report on Form 8-K was furnished on November 5, 2003. The purpose of the
report was to provide under Item 12, the press release issued by the Company on
November 5, 2003 announcing the preliminary financial results for the third
quarter of 2003.
A report on Form 8-K was furnished on November 5, 2003 reporting under Item 12.
The purpose of the report was to restate previously reported quarterly
consolidated statements of income and quarterly business segment disclosures to
reflect the reclassification to discontinued operations of the Company's sold
utility line clearing business.
A report on Form 8-K was furnished on September 17, 2003. The purpose of the
report was to provide under Item 5, the press release issued by the Company on
September 16, 2003 announcing the simultaneous webcast of the Company's Investor
Meeting on September 17, 2003.
A report on Form 8-K was furnished on September 17, 2003 reporting under Item 9.
The purpose of the report was to provide under Item 7, the presentation made by
the Company at its Investor Meeting on September 17, 2003. The presentation
provides a strategic outlook of the business as provided by the business leaders
of the Company.
A report on Form 8-K was furnished on August 5, 2003. The purpose of the report
was to provide under Item 12, the press release issued by the Company on August
5, 2003 announcing the preliminary financial results for the second quarter of
2003.
24
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 14, 2003
THE SERVICEMASTER COMPANY
(Registrant)
By: /S/STEVEN C. PRESTON
----------------------------------------------------
Steven C. Preston
Executive Vice President and Chief Financial Officer
25