Mac-Gray Corporation
Notes to Condensed Consolidated Financial Statements (unaudited)
(In thousands, except per share data)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. The unaudited interim condensed consolidated financial statements do not include all information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America. In the opinion of the management of Mac-Gray Corporation (the “Company” or “Mac-Gray”), the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting of normal, recurring adjustments), which are necessary to present fairly the Company’s financial position, the results of its operations, and its cash flows. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s 2005 audited consolidated financial statements filed with the Securities and Exchange Commission in its Annual Report on Form 10-K/A for the year ended December 31, 2005. The results for interim periods are not necessarily indicative of the results to be expected for the full year.
The Company generates the majority of its revenue from card and coin-operated laundry equipment located in 40 states throughout the United States, as well as the District of Columbia. The Company’s principal customer base is the multi-unit housing market, which consists of apartments, condominium units, colleges and universities, military bases, hotels and motels. The Company also sells the MicroFridge® product lines, kitchen appliances and sells, services and leases commercial laundry equipment to commercial laundromats and institutions. The majority of the Company’s purchases of laundry equipment are from one supplier. The Company also derives a small portion of its revenue from card/coin-operated reprographic equipment.
2. Acquisitions
On July 7, 2006, the Company acquired the laundry facilities management assets of a regional operator in Southern New England. On May 23, 2006, the Company acquired the laundry facilities management assets of a regional operator in the Pennsylvania area. On January 20, 2006, the Company acquired the laundry facilities management assets of a regional operator in Southern New England. On January 10, 2005, the Company acquired the laundry facilities management assets of Web Service Company, Inc., or “Web”, in several western and southern states. These acquisitions have been reflected in the accompanying condensed consolidated financial statements from the date of the acquisition, and have been accounted for as purchase business combinations in accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations”, (“FAS 141”). The total purchase price for each of these acquisitions has been allocated to the acquired assets and liabilities based on estimates of their related fair value. For the Web assets acquired, a twenty-year amortization period has been assigned to the acquired contract rights and a five-year depreciation period has been assigned to the acquired used laundry equipment. The amount allocated to the Web trade name will not be amortized, as the Company believes it will use the name indefinitely. For the 2006 acquisitions, a twenty-year amortization period has been assigned to the acquired contract rights and the acquired used laundry equipment has been assigned a life ranging from two to five years.
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The total purchase price for each of these acquisitions, including assumed liabilities of $7,500 related to the January 10, 2005 acquisition, which consisted of accrued facilities management rent, accrued notes payable and deferred tax liabilities, was allocated as follows:
| | January 10, 2005 | | January 20, 2006 | | May 23, 2006 | | July 7, 2006 | |
Contract Rights | | $ | 71,858 | | $ | 10,730 | | $ | 2,344 | | $ | 2,939 | |
Goodwill | | — | | — | | — | | 513 | |
Equipment | | 25,099 | | 885 | | 673 | | 497 | |
Trade Name | | 12,650 | | — | | — | | — | |
Accounts Receivable | | — | | — | | 8 | | — | |
Inventory | | 999 | | 86 | | — | | 39 | |
Accrued Uncollected Cash | | 3,900 | | — | | — | | — | |
Furniture & Fixtures | | 1,452 | | — | | — | | 66 | |
| | | | | | | | | |
Total Purchase Price | | $ | 115,958 | | $ | 11,701 | | $ | 3,025 | | $ | 4,054 | |
The allocation of the purchase price for each of the 2006 acquisitions is subject to the finalization of the asset valuations.
3. Sale of Corporate Headquarters
On June 30, 2005, we completed the sale of our corporate headquarters in Cambridge, Massachusetts for $11,800 in cash. We used the net proceeds from the sale to repay the $3,800 balance of the mortgage loan on the property and repay $2,000 under the 2005 senior credit facilities. Concurrently with the closing of the sale, we leased the property back from the purchaser until March 31, 2006 while we relocated our corporate, warehouse and branch operations to new facilities. In connection with this sale, in the second quarter of 2005 we recorded a gain of approximately $6,100, net of taxes.
4. Long Term Debt
Concurrent with the January 10, 2005 acquisition, the Company entered into new Senior Secured Credit Facilities (“2005 Credit Facilities”). This transaction retired both the June 2003 Revolving Line of Credit and the June 2003 Senior Secured Term Loan Facility, which had been amended in January 2004 (the “January 2004 amendment”). The 2005 Credit Facilities provided for borrowings up to $200,000, consisting of a $120,000 Revolving Line of Credit (“2005 Revolver”) and an $80,000 Senior Secured Term Loan Facility (“2005 Term Loan”).
On August 16, 2005, the Company restructured its long-term debt by issuing senior unsecured notes in the amount of $150,000. These notes bear interest at 7.625% payable semi-annually each February and August. The maturity date of the notes is August 15, 2015. The 2005 Credit Facilities were amended to permit the offering of the notes and modify certain of the covenants applicable to the 2005 Credit Facilities. The proceeds from the senior notes, less financing costs, were used to retire the 2005 Term Loan and pay down the 2005 Revolver.
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On and after August 15, 2010, the Company will be entitled, at its option, to redeem all or a portion of these notes at the redemption prices (expressed in percentages of principal amount on the redemption date), plus accrued interest to the redemption date, if redeemed, during the 12-month period commencing on August 15 of the years set forth below:
Period | | Redemption
Price | |
2010 | | 103.813 | % |
2011 | | 102.542 | % |
2012 | | 101.271 | % |
2013 and thereafter | | 100.000 | % |
Subject to certain conditions, the Company will be entitled, at its option, on one or more occasions prior to August 15, 2008 to redeem notes in an aggregate principal amount not to exceed 35% of the aggregate principal amount of the notes originally issued at a redemption price (expressed as a percentage of principal amount on the redemption date) of 107.625%, plus accrued and unpaid interest to the redemption date, with the net cash proceeds from one or more equity offerings.
The terms of the senior notes include customary covenants, including, but not limited to, restrictions pertaining to: (i) incurrence of additional indebtedness and issuance of preferred stock; (ii) payment of dividends on or making of distributions in respect of capital stock or making certain other restricted payments or investments; (iii) entering into agreements that restrict distributions from restricted subsidiaries; (iv) sale or other disposition of assets, including capital stock of restricted subsidiaries; (v) transactions with affiliates; (vi) incurrence of liens; (vii) sale/leaseback transactions and (viii) merger, consolidation or sale of substantially all of our assets, in each case subject to numerous baskets, exceptions and thresholds. The Company was in compliance with these and all other financial covenants at September 30, 2006.
The terms of the senior notes provide for customary events of default, including, but not limited to: (i) failure to pay any principal or interest when due, (ii) failure to comply with covenants and limitations, (iii) certain insolvency or receivership events affecting us or any of our subsidiaries and (iv) unsatisfied material judgments, claims or liabilities against us. There were no events of default under the senior notes at September 30, 2006.
The 2005 Revolver matures on January 10, 2010 and is collateralized by a blanket lien on the assets of the Company and its two main subsidiaries, Mac-Gray Services, Inc. and Intirion Corporation, as well as a pledge by the Company of all the capital stock of these two subsidiaries.
Borrowings outstanding under the 2005 Revolver bear interest at a fluctuating rate equal to (i) in the case of Eurodollar rate loans, the LIBOR rate (adjusted for statutory reserves) plus an applicable percentage, ranging from 1.75% to 2.50% (as of September 30, 2006, 2.25%) determined quarterly by reference to the funded debt ratio, or (ii) in the case of alternate base rate loans and swing line loans, the higher of (a) the federal funds rate plus 0.5% or (b) the annual rate of interest announced by JPMorgan Chase Bank, N.A. as its “prime rate,” in each case, plus an applicable percentage, ranging from 0.75% to 1.50% (as of September 30, 2006, 1.25%), determined quarterly by reference to the funded debt ratio. We pay a commitment fee equal to a percentage, either 0.375% or 0.50%, determined and payable quarterly by reference to the funded debt ratio, of the average daily unused portion of the 2005 Senior Credit Facilities. This commitment fee percentage is currently 0.375%.
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As of September 30, 2006, there was $33,000 outstanding under the revolving line of credit and $760 in outstanding letters of credit. The available balance under the revolving line of credit was $86,240 at September 30, 2006. The actual amount that may be borrowed against the line of credit is governed by the funded debt ratio covenant. At September 30, 2006, the total additional amount that could be borrowed was $44,000.
The 2005 Revolver includes customary covenants, including, but not limited to, restrictions pertaining to: (i) the incurrence of additional indebtedness, (ii) limitations on liens, (iii) making distributions, dividends and other payments, (iv) the making of certain investments and loans, (v) mergers, consolidations and acquisitions, (vi) dispositions of assets, (vii) the maintenance of minimum consolidated net worth, maximum funded debt ratios, minimum consolidated cash flow coverage ratios, and maximum senior secured leverage ratios, (viii) transactions with affiliates, (ix) sale and leaseback transactions, (x) entering into swap agreements and (xi) changes to governing documents, in each case subject to numerous baskets, exceptions and thresholds. The funded debt ratio, consolidated cash flow coverage ratio and senior secured leverage ratio that the Company was required to meet as of September 30, 2006 were 4.25 to 1.00, 1.10 to 1.00, and 2.00 to 1.00, respectively. The Company was in compliance with these and all other financial covenants at September 30, 2006.
The 2005 Revolver provides for customary events of default, including, but not limited to: (i) failure to pay any principal or interest when due, (ii) failure to comply with covenants, (iii) any material representation or warranty made by the Company proving to be incorrect in any material respect, (iv) defaults relating to or acceleration of other material indebtedness, (v) certain insolvency or receivership events affecting the Company or any of its subsidiaries, (vi) a change in control, (vii) material judgments, claims or liabilities against the Company or (viii) a material defect in the lenders’ lien against the collateral securing the obligations under the Credit Agreement. There were no events of default under the 2005 Revolver at September 30, 2006.
The Company used a portion of the proceeds from our $150,000 senior note offering to repay the term loan portion of the 2005 senior credit facility. Unamortized financing costs of $461 related to the term loan were expensed during the three months ended September 30, 2005. In connection with the 2005 senior credit facilities, the Company repaid in full and terminated our 2003 senior credit facilities. Unamortized financing costs of $207 associated with our 2003 senior credit facilities as amended in January 2004 were expensed during the first quarter of 2005.
The weighted average interest rates of the Company’s borrowings under the 2005 Credit Facilities at December 31, 2005 and September 30, 2006 were 5.43% and 6.65%, respectively.
Long-term debt also includes capital lease obligations on the company’s vehicles totaling $2,678 and $2,644 at December 31, 2005 and September 30, 2006, respectively.
Required payments under the Company’s long-term debt and capital lease obligations are as follows:
| | Amount | |
2006 (three months) | | $ | 319 | |
2007 | | 1,051 | |
2008 | | 703 | |
2009 | | 423 | |
2010 | | 33,148 | |
Thereafter | | 150,000 | |
| | $ | 185,644 | |
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5. Derivative Instruments
The Company entered into standard International Swaps and Derivatives Association (“ISDA”) interest rate swap agreements (the “Swap Agreements”) to manage the interest rate risk associated with its debt. Concurrent with the reduction of the amounts due under the 2005 credit facilities, eight swap agreements previously designated as cash flow hedges ceased to qualify as such, of which four were terminated by the Company. The change in the fair value of the remaining four swap agreements that do not qualify for hedge accounting is recognized in the income statement in the period in which the change occurs. The change in the fair value of these four contracts resulted in a loss of $965 and $40 for the three and nine months ended September 30, 2006, respectively. One swap agreement continues to be designated as a cash flow hedge.
The table below outlines the details of each remaining swap agreement:
| | | | | | Notional | | | | | |
| | Original | | | | Amount | | | | | |
Date of | | Notional | | Fixed/ | | September 30, | | Expiration | | Fixed | |
Origin | | Amount | | Amortizing | | 2006 | | Date | | Rate | |
| | | | | | | | | | | |
June 24, 2003 | | $ | 20,000 | | Amortizing | | $ | 10,714 | | Jun 30, 2008 | | 2.34 | % |
June 24, 2003 | | $ | 20,000 | | Fixed | | $ | 20,000 | | Jun 30, 2008 | | 2.69 | % |
May 2, 2005 | | $ | 17,000 | | Fixed (2) | | $ | — | | Dec 31, 2011 | | 4.69 | % |
May 2, 2005 | | $ | 12,000 | | Fixed (1) | | $ | — | | Sep 30, 2009 | | 4.66 | % |
May 2, 2005 | | $ | 10,000 | | Fixed (2) | | $ | — | | Dec 31, 2011 | | 4.77 | % |
(1) Effective Date is March 31, 2007
(2) Effective Date is June 30, 2008
In accordance with the Swap Agreements and on a quarterly basis, interest expense is calculated based on the floating 90-day LIBOR and the fixed rate. If interest expense as calculated is greater based on the 90-day LIBOR, the financial institution pays the difference to the Company; if interest expense as calculated is greater based on the fixed rate, the Company pays the difference to the financial institution. Depending on fluctuations in the LIBOR, the Company’s interest rate exposure and its related impact on interest expense and net cash flow may increase or decrease. The counter party to the swap agreements expose the Company to credit loss in the event of non-performance; however, nonperformance is not anticipated.
The fair value of a Swap Agreement is the estimated amount that the Company would receive or pay to terminate the agreement at the reporting date, taking into account current interest rates and the credit worthiness of the counter party. At December 31, 2005 and September 30, 2006, the fair value of the Swap Agreements was $1,647 and $1,450, respectively. These amounts have been included in other assets on the condensed consolidated balance sheets.
The changes in accumulated other comprehensive income relate entirely to the Company’s interest rate swap agreement which is accounted for as a cash flow hedge. If the Company were to change its hedging strategy, it would recognize a gain of approximately $396 based on the fair value of this Swap Agreement at September 30, 2006.
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The components of other comprehensive income are as follows:
| | For the three months ended | | For the nine months ended | |
| | September 30, | | September 30, | | September 30, | | September 30, | |
| | 2005 | | 2006 | | 2005 | | 2006 | |
| | | | | | | | | |
Unrealized gain (loss) on derivative instruments | | $ | 1,426 | | $ | (147 | ) | $ | 630 | | $ | (156 | ) |
Reclassification adjustment | | (1,659 | ) | — | | (1,463 | ) | — | |
Total other comprehensive income before income taxes | | (233 | ) | (147 | ) | (833 | ) | (156 | ) |
Income tax expense | | 93 | | 63 | | 333 | | 69 | |
Total other comprehensive loss | | $ | (140 | ) | $ | (84 | ) | $ | (500 | ) | $ | (87 | ) |
6. Goodwill and Other Intangible Assets
Goodwill and Trade Name, which are not subject to amortization, and intangible assets to be amortized, consist of the following:
| | As of December 31, 2005 | |
| | Cost | | Accumulated
Amortization | | Net Book Value | |
Goodwill: | | | | | | | |
Facilities Management | | $ | 37,718 | | | | $ | 37,718 | |
Product Sales | | 223 | | | | 223 | |
| | $ | 37,941 | | | | $ | 37,941 | |
Intangible assets: | | | | | | | |
Facilities Management: | | | | | | | |
Trade Name | | $ | 12,650 | | $ | — | | $ | 12,650 | |
Non-compete agreements | | 4,580 | | 4,095 | | 485 | |
Contract rights | | 109,755 | | 12,344 | | 97,411 | |
Product Sales: | | | | | | | |
Customer lists | | 1,451 | | 734 | | 717 | |
Deferred financing costs | | 5,923 | | 393 | | 5,530 | |
| | $ | 134,359 | | $ | 17,566 | | $ | 116,793 | |
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| | As of September 30, 2006 | |
| | Cost | | Accumulated
Amortization | | Net Book Value | |
Goodwill: | | | | | | | |
Facilities Management | | $ | 38,231 | | | | $ | 38,231 | |
Product Sales | | 223 | | | | 223 | |
| | $ | 38,454 | | | | $ | 38,454 | |
Intangible assets: | | | | | | | |
Facilities Management: | | | | | | | |
Trade Name | | $ | 12,650 | | $ | — | | $ | 12,650 | |
Non-compete agreements | | 4,580 | | 4,152 | | 428 | |
Contract rights | | 126,053 | | 17,121 | | 108,932 | |
Product Sales: | | | | | | | |
Customer lists | | 1,451 | | 806 | | 645 | |
Deferred financing costs | | 5,923 | | 922 | | 5,001 | |
| | $ | 150,657 | | $ | 23,001 | | $ | 127,656 | |
Estimated future amortization expense of intangible assets consists of the following:
2006 (three months) | | $ | 1,847 | |
2007 | | 7,217 | |
2008 | | 7,212 | |
2009 | | 7,206 | |
2010 | | 6,969 | |
Thereafter | | 81,801 | |
| | $ | 112,252 | |
Amortization expense of intangible assets for the nine months ended September 30, 2005 and 2006 was $4,521 and $5,275, respectively.
7. Commitments and Contingencies
The Company is involved in various litigation proceedings arising in the normal course of business. In the opinion of management, the Company’s ultimate liability, if any, under pending litigation would not materially affect its financial condition or the results of its operations.
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8. Earnings Per Share
A reconciliation of the weighted average number of common shares outstanding is as follows:
| | For the Three Months Ended September 30, 2005 | |
| | Income | | Shares | | | |
| | (Numerator) | | (Denominator) | | Per Share Amount | |
| | | | | | | |
Net income available to common stockholders - basic | | $ | 1,436 | | 12,879 | | $ | 0.11 | |
Effect of dilutive securities: | | | | | | | |
Stock options | | — | | 472 | | | |
Net income available to common stockholders - diluted | | $ | 1,436 | | 13,351 | | $ | 0.11 | |
| | For the Three Months Ended September 30, 2006 | |
| | Income | | Shares | | | |
| | (Numerator) | | (Denominator) | | Per Share Amount | |
| | | | | | | |
Net income available to common stockholders - basic | | $ | (267 | ) | 13,034 | | $ | (0.02 | ) |
Effect of dilutive securities: | | | | | | | |
Stock options | | | | | | — | |
Net income available to common stockholders - diluted | | $ | (267 | ) | 13,034 | | $ | (0.02 | ) |
| | For the Nine Months Ended September 30, 2005 | |
| | Income | | Shares | | | |
| | (Numerator) | | (Denominator) | | Per Share Amount | |
| | | | | | | |
Net income available to common stockholders - basic | | $ | 10,438 | | 12,845 | | $ | 0.81 | |
Effect of dilutive securities: | | | | | | | |
Stock options | | — | | 395 | | (0.02 | ) |
Net income available to common stockholders - diluted | | $ | 10,438 | | 13,240 | | $ | 0.79 | |
| | For the Nine Months Ended September 30, 2006 | |
| | Income | | Shares | | | |
| | (Numerator) | | (Denominator) | | Per Share Amount | |
| | | | | | | |
Net income available to common stockholders - basic | | $ | 1,896 | | 12,988 | | $ | 0.15 | |
Effect of dilutive securities: | | | | | | | |
Stock options | | | | 426 | | (0.01 | ) |
Net income available to common stockholders - diluted | | $ | 1,896 | | 13,414 | | $ | 0.14 | |
There were 6 and 216 shares under option plans that were excluded from the computation of diluted earnings per share at September 30, 2005 and 2006, respectively, due to their anti-dilutive effects.
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9. Segment Information
The Company operates four business units which are based on the Company’s different product and service categories: Laundry Facilities Management, Laundry Equipment Sales, MicroFridge® and Reprographics. These four business units have been aggregated into two reportable segments (“Facilities Management” and “Product Sales”). The Facilities Management segment includes two business units: Laundry Facilities Management and Reprographics. The Laundry Facilities Management business unit provides coin and debit card-operated laundry equipment to multi-unit housing facilities such as apartment buildings, colleges and universities and public housing complexes. The Reprographics business unit provides coin and debit-card-operated copiers to academic and public libraries. The Product Sales segment includes two business units: MicroFridge® and Laundry Equipment Sales. The MicroFridge® business unit revenue includes sales of its own patented and proprietary line of refrigerator/freezer/microwave oven combinations to a customer base which includes hospitality and assisted living facilities, military housing and colleges and universities. The MicroFridge business unit also sells a full range of kitchen appliances. The Laundry Equipment Sales business unit operates as a distributor of, and provides service to, commercial laundry equipment in public laundromats, as well as for institutional purchasers, including hospitals, hotels and the United States military for use in their own on-premise laundry facilities.
There are no intersegment revenues.
The tables below present information about the operations of the reportable segments of Mac-Gray for the three and nine months ended September 30, 2005 and 2006. The information presented represents the key financial metrics that are utilized by the Company’s senior management in assessing the performance of each of the Company’s reportable segments.
| | For the three months ended | | For the nine months ended | |
| | September 30, | | September 30, | |
| | 2005 | | 2006 | | 2005 | | 2006 | |
| | | | | | | | | |
Revenue: | | | | | | | | | |
Facilities management | | $ | 51,457 | | $ | 55,770 | | $ | 157,890 | | $ | 171,241 | |
Product sales | | 14,116 | | 14,233 | | 33,439 | | 35,479 | |
Total | | 65,573 | | 70,003 | | 191,329 | | 206,720 | |
Gross margin: | | | | | | | | | |
Facilities management | | 8,800 | | 9,081 | | 29,716 | | 31,656 | |
Product sales | | 2,843 | | 2,865 | | 7,080 | | 7,346 | |
Total | | 11,643 | | 11,946 | | 36,796 | | 39,002 | |
Selling, general, administration, depreciation and amortization expenses | | 7,417 | | 8,197 | | 22,771 | | 25,863 | |
Loss on early extinguishment of debt | | 461 | | — | | 668 | | — | |
(Gain) loss on sale of assets | | (52 | ) | (92 | ) | (10,939 | ) | 23 | |
(Gain) loss related to derivative instruments | | (1,659 | ) | 965 | | (1,659 | ) | 40 | |
Interest and other expenses, net | | 2,899 | | 3,666 | | 7,724 | | 10,247 | |
Income (loss) before provision (benefit) for income taxes | | $ | 2,577 | | $ | (790 | ) | $ | 18,231 | | $ | 2,829 | |
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Certain operating expenses in 2005 which were previously included in Facilities Management cost of sales have been reclassed to Product Sales cost of sales to conform with 2006 presentation. The revised classification of $273 and $837 for the three and nine months ended September 30, 2005 consists of salaries, warehousing and other operating expenses that support the Laundry Equipment Sales business unit within the Product Sales segment.
The revised classification is as follows:
| | Three months ended | | Nine months ended | |
| | September 30, 2005 | | September 30, 2005 | |
| | As Reported | | Reclassified | | As Reported | | Reclassified | |
| | | | | | | | | |
Revenue: | | | | | | | | | |
Facilities management | | $ | 51,457 | | $ | 51,457 | | $ | 157,890 | | $ | 157,890 | |
Product sales | | 14,116 | | 14,116 | | 33,439 | | 33,439 | |
Total | | 65,573 | | 65,573 | | 191,329 | | 191,329 | |
Gross margin: | | | | | | | | | |
Facilities management | | 8,527 | | 8,800 | | 28,879 | | 29,716 | |
Product sales | | 3,116 | | 2,843 | | 7,917 | | 7,080 | |
Total | | $ | 11,643 | | $ | 11,643 | | $ | 36,796 | | $ | 36,796 | |
| | December 31,
2005 | | September 30,
2006 | |
Assets: | | | | | |
Facilities management | | $ | 281,864 | | $ | 301,631 | |
Product sales | | 23,757 | | 26,833 | |
Total for reportable segments | | 305,621 | | 328,464 | |
Corporate (1) | | 17,553 | | 16,106 | |
Deferred income taxes | | 909 | | 1,111 | |
Total | | $ | 324,083 | | $ | 345,681 | |
(1) Principally cash and cash equivalents, prepaid expenses and property, plant & equipment not included elsewhere.
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10. Stock Compensation
On April 7, 1997, the Company’s stockholders approved the 1997 Stock Option and Incentive Plan for the Company (the “1997 Stock Plan”). On May 26, 2005, the Company’s stockholders approved the 2005 Stock Option and Incentive Plan for the Company (the “2005 Stock Plan”; together the “Stock Plans”). The Stock Plans are designed and intended as a performance incentive for officers, employees, consultants and directors to promote the financial success and progress of the Company. All officers, employees and independent directors are eligible to participate in the Stock Plans. Awards, when made, may be in the form of stock options, restricted stock, unrestricted stock options, and dividend equivalent rights. The Stock Plans require the maximum term of options to be ten years.
Employee options generally vest such that thirty-three percent (33%) of the options will become exercisable on each of the first through third anniversaries of the date of grant of the options; however, the Administrator of the Stock Plans may determine, at its discretion, the vesting schedule for any option award. In the event of termination of the optionees’ relationship with the Company, vested options not yet exercised terminate within 90 days. The non-qualified options granted to independent directors are exercisable immediately and terminate ten years from the date of the grant. The exercise prices are the fair market value of the shares underlying the options on the respective dates of the grants. The Company issues shares upon exercise of options from its treasury shares, if available.
The Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments”, (“FAS123(R)”) as of January 1, 2006. FAS123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. FAS123(R) requires the Company to measure the cost of employee services received in exchange for an award of equity instruments (usually stock options) based on the grant-date fair value of the award. That cost is recognized on a straight-line basis over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period).
The grant-date fair value of employee share options and similar instruments is estimated using the Black-Scholes option-pricing model. During the nine months ended September 30, 2006, three grants of options for 196,520 shares were issued. The fair values of the stock options granted were estimated using the following components:
| | Employees | | Directors | |
Fair value of options at grant date | | $4.64 - $5.41 | | $ | 4.61 | |
Risk free interest rate | | 4.86% - 4.88% | | 5.05 | % |
Estimated forfeiture rate | | 0% - 1.65% | | 0 | % |
Estimated option term | | 7.0 - 9.0 years | | 6.0 years | |
Expected volatility | | 25.1 | % | 24.5 | % |
| | | | | | |
The expected volatility of the Company’s stock price was based on historical performance over the prior four years.
During the nine-month period ended September 30, 2006, the Company granted 59,674 shares of restricted stock with an average fair market value of $11.86 per share. The stock vests evenly over three years upon the achievement of certain performance objectives to be determined by the Board of Directors at the beginning of each fiscal year. Because the performance objectives for 2006 had not been achieved as of September 30, 2006, the restricted stock subject to vesting based upon the performance objectives for 2006 was not included in the computation of diluted earnings per share.
For the three months ended September 30, 2006, income before taxes was reduced by a stock compensation expense of $294 due to the adoption of FAS123(R). Additionally, the impact on net income was a reduction
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of $174 and a reduction in basic and diluted earnings per share of $0.01. For the nine months ended September 30, 2006, income before taxes was reduced by a stock compensation expense of $888 due to the adoption of FAS123(R). Additionally, the impact on net income was a reduction of $533 and a reduction in basic and diluted earnings per share of $0.04. For the nine months ended September 30, 2006, cash flows from financing activities were increased (and cash flows from operations were correspondingly decreased) by $319 due to additions to the windfall tax pool as a result of the adoption of FAS123(R).
The allocation of stock compensation expense is consistent with the allocation of the participants’ salary and other compensation expenses.
The Company is using the modified prospective application (“MPA”) transition method without restatement of prior interim periods in the year of adoption. Prior to the adoption of FAS123(R) in fiscal 2006, the Company’s stock option plans were accounted for in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). The Company used the disclosure requirements of Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“FAS123”). Under APB No. 25, the Company did not recognize compensation expense on stock options granted to employees, because the exercise price of each option was equal to the market price of the underlying stock on the date of the grant. Had compensation cost for the Company’s stock option awards and the stock purchase plan been determined based on the fair value at the grant dates for the awards under those plans, consistent with the provisions of FAS123, the Company’s net income and net income per share for the three and nine months ended September 30, 2005 would have decreased to the pro forma amounts indicated below:
| | | | Three | | Nine | |
| | | | months ended | | months ended | |
| | | | September 30, | | September 30, | |
| | | | 2005 | | 2005 | |
Net income: | | As reported | | $ | 1,436 | | $ | 10,438 | |
| | Pro forma | | $ | 1,328 | | $ | 10,182 | |
| | | | | | | |
Basic net income per share: | | As reported | | $ | 0.11 | | $ | 0.81 | |
| | Pro forma | | $ | 0.10 | | $ | 0.79 | |
| | | | | | | |
Diluted net income per share: | | As reported | | $ | 0.11 | | $ | 0.79 | |
| | Pro forma | | $ | 0.10 | | $ | 0.77 | |
At September 30, 2006, the stock plans provide for the issuance of up to 2,605,055 shares of common stock. At September 30, 2006, options for approximately 1,890,220 shares of common stock were granted under the stock plans, of which options for 1,189,170 shares were outstanding, 404,883 shares were issued pursuant to the exercise of options and 296,167 were forfeited and remained available for issuance.
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The following is a summary of stock option plan activity for the nine months ended September 30, 2006:
| | Nine months ended | |
| | September 30, 2006 | |
| | | | Weighted | |
| | | | Average | |
| | | | Exercise | |
| | Shares | | Price | |
Outstanding, beginning of period | | 1,123,284 | | $ | 5.60 | |
Granted | | 196,520 | | $ | 12.10 | |
Exercised | | (104,367 | ) | $ | 4.31 | |
Forfeited | | (26,267 | ) | $ | 8.27 | |
Outstanding, end of period | | 1,189,170 | | $ | 6.73 | |
Exercisable, end of period | | 814,390 | | $ | 5.37 | |
| | Options Outstanding | | Options Exercisable | |
| | Number
Outstanding at
9/30/06 | | Weighted
Average
Remaining
Contractual
Life | | Weighted
Average
Exercise
Price | | Number
Exercisable at
9/30/06 | | Weighted
Average
Exercise
Price | | Weighted
Average
Remaining
Contractual
Life | | Intrinsic
Value | |
$3.00 - $4.54 | | 523,320 | | 5.04 | | $ | 3.55 | | 523,320 | | $ | 3.55 | | 5.04 | | $ | 4,291 | |
$4.55 - $7.56 | | 105,830 | | 7.27 | | 5.52 | | 71,030 | | 5.65 | | 7.15 | | 433 | |
$7.57 - $15.13 | | 560,020 | | 8.35 | | 9.93 | | 220,040 | | 9.62 | | 5.82 | | 469 | |
| | 1,189,170 | | 6.80 | | $ | 6.73 | | 814,390 | | $ | 5.37 | | 7.33 | | $ | 5,193 | |
For the three and nine months ended September 30, 2006, 27,800 options and 104,367 options with intrinsic values of $208 and $809 were exercised. The fair values of the options vested during the three and nine months ended September 30, 2006 were $29 and $606, respectively.
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At September 30, 2006, options for 374,780 shares have been granted but have not yet vested. Compensation expense related to unvested options will be recognized in the following years:
2006 (three months) | | $ | 144 | |
2007 | | 541 | |
2008 | | 317 | |
2009 | | 64 | |
| | $ | 1,066 | |
11. Product Warranties
The Company offers limited-duration warranties on MicroFridge® products and, at the time of sale, provides reserves for all estimated warranty costs based upon historical warranty costs. Actual costs have not exceeded the Company’s estimates.
The activity for the nine months ended September 30, 2006 is as follows:
| | Accrued | |
| | Warranty | |
| | | |
Balance, December 31, 2005 | | $ | 290 | |
Accruals for warranties issued | | 187 | |
Settlements made (in cash or in kind) | | (261 | ) |
Balance, September 30, 2006 | | $ | 216 | |
12. Property, Plant and Equipment
During the three months ended September 30, 2006, the Company completed an analysis of laundry equipment disposals and as a result recorded a loss on the disposal of equipment of $512 which was recorded as depreciation expense within cost of revenue. A portion of this expense pertained to prior periods of 2006 but was deemed immaterial to the results of operations for those periods.
13. New Accounting Pronouncements
In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes, which is an interpretation of SFAS No. 109. FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. Under FIN 48, the financial statements will reflect expected future tax consequences of such positions presuming the taxing authorities’ full knowledge of the position and all relevant facts, but without considering time values. FIN 48 substantially changes the applicable accounting model and is likely to cause greater volatility in income statements as more items are recognized discretely within income tax expense. FIN 48 also revises disclosure requirements and introduces a prescriptive, annual, tabular roll-forward of the unrecognized tax benefits. The new accounting model for uncertain tax positions is effective for annual periods beginning after December 15, 2006. Companies need to assess all material open positions in all tax jurisdictions as of the adoption date and determine the appropriate amount of tax benefits that are recognizable under FIN 48. Any difference between the amounts previously recognized and the benefit determined under the new guidance, including changes in accrued interest and penalties, has to be recorded on the date of adoption. For certain types of income tax uncertainties, existing generally accepted accounting principles provide specific guidance on the accounting for modifications of the recognized benefit. Any differences in recognized tax benefits on the date of adoption that are not subject to specific guidance would be an adjustment to retained earnings as of the beginning of the adoption period. The Company is currently evaluating the impact the adoption of FIN 48 will have on its financial statements.
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In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS 157 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted. The Company is in the process of evaluating SFAS No. 157.
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (“SFAS No. 158”). SFAS No. 158 requires an employer that sponsors one or more single-employer defined benefit plans to (a) recognize the overfunded or underfunded status of a benefit plan in its statement of financial position, (b) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost pursuant to SFAS No. 87, “Employers’ Accounting for Pensions”, or SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions”, (c) measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end, and (d) disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. SFAS No. 158 is effective for fiscal years ending after December 15, 2006, with early adoption encouraged. The Company does not believe SFAS No. 158 will have any impact on its financial statements.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for fiscal years ending after November 15, 2006, with early adoption encouraged. The Company does not believe SAB 108 will have any impact on its financial statements.
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Item 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This report contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. These forward-looking statements reflect our current views about future events and financial performance. Investors should not rely on forward-looking statements because they are subject to a variety of factors that could cause actual results to differ materially from our expectations. Factors that could cause or contribute to such differences include, but are not limited to, the following:
· debt service requirements under our existing and future indebtedness;
· availability of cash flow to finance capital expenditures;
· our ability to renew laundry leases with our customers;
· competition in the laundry facilities management industry;
· our ability to maintain relationships with our suppliers, including Whirlpool Corporation;
· our ability to consummate acquisitions and successfully integrate the businesses we acquire;
· increases in multi-unit housing sector vacancy rates;
· our susceptibility to product liability claims;
· our ability to protect our intellectual property and proprietary rights and create new technology;
· our ability to retain our key personnel and attract and retain other highly skilled employees;
· decreases in the value of our intangible assets;
· our ability to comply with current and future environmental regulations;
· actions of our controlling stockholders; and
· those factors discussed under Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Risk Factors” in our Annual Report on Form 10-K/A for the year ended December 31, 2005 and our other filings with the Securities and Exchange Commission (“SEC”).
Our actual results, performance or achievements could differ materially from those expressed in, or implied by, these forward-looking statements, and accordingly, we can give no assurances that any of the events anticipated by the forward-looking statements will occur or, if any of them do, what impact they will have on our results of operations or financial condition. In view of these uncertainties, investors are cautioned not to place undue reliance on these forward-looking statements. We assume no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
In this Quarterly Report on Form 10-Q, unless the context suggest otherwise, references to the “Company,” “Mac-Gray,” “we,” “us,” “our” and similar terms refer to Mac-Gray Corporation and its subsidiaries. We have registered, applied to register or are using the following trademarks: MicroFridge®, MaytagDirectÔ, LaundryViewÔ, PrecisionWashÔ, LaundryLinxÔ, TechLinxÔ and Safe PlugÔ. The following are trademarks of parties other than us: Maytag®, Amana®, Whirlpool® and Magic Chef®.
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Overview
Since its founding in 1927, Mac-Gray Corporation has grown to become the second largest laundry facilities management business in the United States. Through our portfolio of card and coin-operated laundry equipment located in laundry facilities across the country, we provide laundry convenience to residents of multi-unit housing, such as apartment buildings, condominiums, colleges and universities, and hotels and motels. Based on our ongoing survey of colleges and universities, we believe we are the largest provider of such services to the college and university market in the United States. Mac-Gray Corporation was incorporated in Delaware in 1997. We report our business in two segments, facilities management and product sales. Facilities management consists of our laundry facilities management and reprographics business units. Product sales consist of our laundry equipment sales and MicroFridge® business units.
Our business model is built on a stable demand for laundry services, combined with long-term leases, strong customer relationships, a broad customer base and predictable capital needs. For the three and nine months ended September 30, 2006, our total revenue was $70.0 million and $206.7 million, respectively. Approximately 79.7% and 82.8% of our total revenue for these same three and nine month periods were generated by our facilities management segment. We generate facilities management revenue primarily by entering into long-term leases with property owners or property management companies for the exclusive right to install and maintain laundry equipment in common area laundry rooms within their properties in exchange for a negotiated portion of the revenue we collect. As of September 30, 2006, approximately 90% of our installed machine base was located in laundry facilities subject to long-term leases, which have a weighted average remaining term of approximately five years. Our capital costs are typically incurred in connection with new or renewed leases, and include investments in laundry equipment and card and coin-operated systems, incentive payments to property owners or property management companies and expenses to refurbish laundry facilities. Our capital costs consist of a large number of relatively small amounts, which are associated with our entry into or renewal of leases. Accordingly, our capital needs are predictable and largely within our control. For the three and nine months ended September 30, 2006, we incurred approximately $8.8 million and $20.3 million, respectively, of capital expenditures. In addition, we paid approximately $1.2 million and $3.5 million, respectively, of incentive payments in the three and nine months ended September 30, 2006 to property owners and property management companies in connection with securing our lease arrangements.
In addition, through our product sales segment, we generate revenue by selling commercial laundry equipment, our line of combination refrigerator/freezer/microwave oven units under the MicroFridge® brand and the full lines of Maytag®, Whirlpool®, Amana® and Magic Chef® domestic laundry and kitchen appliances under our MaytagDirectTM program. For the three months ended September 30, 2006, our product sales segment generated approximately 20.3% of our total revenue and 24.0% of our gross margin. For the nine months ended September 30, 2006, our product sales segment contributed 17.2% of our total revenue and 18.8% of our gross margin.
Our financial objective is to maintain and enhance profitability by retaining existing customers, adding customers in areas in which we currently operate and selectively expanding our geographic footprint and density through acquisitions. One of the key challenges we face is maintaining and expanding our customer base in a competitive industry. Within any given geographic area, Mac-Gray may compete with local independent operators, regional operators and multi-region operators, and one national operator as well as property owners and property management companies who self operate their laundry facilities. We devote substantial resources to our sales efforts and are focused on continued innovation in order to distinguish us from our competitors. Approximately 10% to 15% of our laundry room leases are up for renewal each year. Over the past five calendar years, we have been able to retain, on average, approximately 97% of our total installed equipment base each year, while adding an average of approximately 4% per year to our revenue base through organic growth.
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Results of Operations (Dollars in thousands)
Three and nine months ended September 30, 2006 compared to three and nine months ended September 30, 2005.
The information presented below for the three and nine months ended September 30, 2005 and 2006 is derived from our unaudited condensed consolidated financial statements and related notes included elsewhere in this report:
| | For the three months ended September 30, | | For the nine months ended September 30, | |
| | | | | | Increase | | % | | | | | | Increase | | % | |
| | 2005 | | 2006 | | Decrease | | Change | | 2005 | | 2006 | | Decrease | | Change | |
Laundry facilities management | | $ | 50,895 | | $ | 55,281 | | $ | 4,386 | | 9 | % | $ | 155,729 | | $ | 169,391 | | $ | 13,662 | | 9 | % |
Reprographics revenue | | 562 | | 489 | | (73 | ) | -13 | % | 2,161 | | 1,850 | | (311 | ) | -14 | % |
Total facilities management revenue | | 51,457 | | 55,770 | | 4,313 | | 8 | % | 157,890 | | 171,241 | | 13,351 | | 8 | % |
MicroFridge® revenue | | 10,205 | | 9,575 | | (630 | ) | -6 | % | 22,293 | | 22,973 | | 680 | | 3 | % |
Laundry equipment sales revenue | | 3,911 | | 4,658 | | 747 | | 19 | % | 11,146 | | 12,506 | | 1,360 | | 12 | % |
Total product sales revenue | | 14,116 | | 14,233 | | 117 | | 1 | % | 33,439 | | 35,479 | | 2,040 | | 6 | % |
Total revenue | | $ | 65,573 | | $ | 70,003 | | $ | 4,430 | | 7 | % | $ | 191,329 | | $ | 206,720 | | $ | 15,391 | | 8 | % |
Revenue
Total revenue increased by $4,430, or 7%, to $70,003 for the three months ended September 30, 2006 compared to $65,573 for the three months ended September 30, 2005. Total revenue increased by $15,391, or 8%, to $206,720 for the nine months ended September 30, 2006 compared to $191,329 for the nine months ended September 30, 2005.
Facilities management revenue. Total facilities management revenue increased by $4,313, or 8%, to $55,770 for the three months ended September 30, 2006 compared to $51,457 for the three months ended September 30, 2005. Total facilities management revenue increased by $13,351, or 8%, to $171,241 for the nine months ended September 30, 2006 compared to $157,890 for the nine months ended September 30, 2005. This increase is attributable to increases in revenue in the laundry facilities management business unit partially offset by a decrease in revenue in the reprographics business unit.
Within the facilities management segment, revenue in the laundry facilities management business unit increased by $4,386, or 9%, to $55,281 for the three months ended September 30, 2006 compared to $50,895 for the three months ended September 30, 2005. Revenue in the laundry facilities management business unit increased by $13,662, or 9%, to $169,391 for the nine months ended September 30, 2006 compared to $155,729 for the nine months ended September 30, 2005. Our 2006 acquisitions accounted for approximately 62% and 45% of our growth in the three and nine months ended September 30, 2006. The remaining increases for the three and nine months ended September 30, 2006 are attributable primarily to selected vend-price increases, a net increase in the usage of installed equipment and an increase in revenue associated with the conversion of coin-operated systems to card-operated systems. Due to the convenience of card-operated systems, usage, and therefore revenue, typically increases upon the conversion from a coin-operated system to a card-operated system.
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Revenue in the reprographics business unit decreased by $73, or 13%, to $489 for the three months ended September 30, 2006 compared to $562 for the three months ended September 30, 2005. Revenue in the reprographics business unit decreased by $311, or 14%, to $1,850 for the nine months ended September 30, 2006 compared to $2,161 for the nine months ended September 30, 2005. These decreases are primarily attributable to the continued decline in the use of copiers in libraries and similar facilities and a reduction in the number of locations we operate. We expect the decreases in revenue from our reprographics business unit to continue, as the usage of vended copiers declines and we continue our strategy of not renewing contracts which we predict will have a negative impact on income.
Product sales revenue. Revenue from our product sales segment increased by $117 or 1% for the three months ended September 30, 2006 to $14,233 compared to $14,116 for the three months ended September 30, 2005. Product sales revenue increased by $2,040 or 6% for the nine months ended September 30, 2006 to $35,479 compared to $33,439 for the nine months ended September 30, 2005. The increase in revenue for the three months ended September 30, 2006 as compared to the same period in 2005 is primarily attributable to an increase in the laundry equipment sales business unit partially offset by a decrease in the MicroFridge® business unit. The increase in revenue for the nine months ended September 30, 2006 as compared to the same period in 2005 is attributable to an increase in both the laundry and MicroFridge® business units.
Revenue in the laundry equipment sales business unit increased by $747, or 19%, to $4,658 for the three months ended September 30, 2006 compared to $3,911 for the three months ended September 30, 2005. Revenue in the laundry equipment sales business unit increased by $1,360, or 12%, to $12,506 for the nine months ended September 30, 2006 compared to $11,146 for the nine months ended September 30, 2005. Sales in the laundry equipment sales business unit are sensitive to the strength of the economy, local economic factors, local permitting and the availability of financing to small businesses, and therefore tend to fluctuate significantly from quarter to quarter.
Revenue in the MicroFridge® business unit decreased by $630, or 6%, to $9,575 for the three months ended September 30, 2006 compared to $10,205 for the three months ended September 30, 2005. Revenue in the MicroFridge® business unit increased by $680, or 3%, to $22,973 for the nine months ended September 30, 2006 compared to $22,293 for the nine months ended September 30, 2005. The decrease in revenue for the three months ended September 30, 2006 compared to the same period in 2005 is primarily attributable to a decrease in sales to the academic and government markets which were only partially offset by increased sales in the hospitality and property management markets. The increase in revenue for the nine months ended September 30, 2006 compared to the same period in 2005 is primarily attributable to an increase in sales to the hospitality and property management markets which were offset in part by decreases in the academic and government markets. Sales to the academic market are affected, among other things, by the rate of new campus housing construction and the availability of funding to state institutions. We believe that our sales to the government will continue to be affected by overall military spending being directed away from housing improvements and toward the current military efforts in the Middle East. Sales to the hospitality industry have increased in the first nine months of 2006 as compared to 2005 as a result of increased spending on new construction and renovations. Sales of appliances to the property management market through our “Maytag Direct” product line have continued to increase in the first nine months of 2006 compared to the same period in 2005.
Cost of revenue
Cost of facilities management revenue. Cost of facilities management revenue includes rent paid to customers as well as those costs associated with installing and servicing machines and costs of collecting, counting, and depositing facilities management revenue. Cost of facilities management revenue increased by $2,623, or 8%, to $37,539 for the three months ended September 30, 2006 as compared to $34,916 for the three months ended September 30, 2005 and by $8,867, or 8%, to $113,925 for the nine months ended September 30, 2006 as compared to $105,058 for the nine months ended September 30, 2005. As a percentage of facilities management revenue, cost of facilities management revenue decreased slightly year over year to 67.3% as compared to 67.9% for the three months ended September 30, 2006 and 2005, respectively and remained consistent at 66.5% for the nine months ended September 30, 2006 and 2005. Facilities management rent as a percentage of facilities management revenue increased slightly for the three months ended September 30, 2006
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as compared to the three months ended September 30, 2005 and remained relatively consistent for the nine months ended September 30, 2006 compared to the nine months ended September 30, 2005. Facilities management rent can be affected by new and renewed laundry leases, lease portfolios acquired and by other factors such as the amount of incentive payments and laundry room betterments invested in new or renewed laundry leases. As we vary the amount invested in a facility, the facilities management rent as a function of facilities management revenue can vary. Incentive payments and betterments are amortized over the life of the laundry lease. The percentage of facilities management rent to facilities management revenue is also impacted by the facilities management rent rate structure in the reprographics business unit. Because this business unit has a much lower facilities management rent rate structure than the laundry facilities management business unit, the reduction in the size of the reprographics business unit through the non-renewal of leases could result in an increase in the overall facilities management rent as a percentage of revenue.
Depreciation and amortization related to operations. Depreciation and amortization related to operations increased by $1,409, or 18%, to $9,189 for the three months ended September 30, 2006 as compared to $7,780 for the three months ended September 30, 2005. Depreciation and amortization increased by $2,546, or 11%, to $25,906 for the nine months ended September 30, 2006 as compared to $23,360 for the nine months ended September 30, 2005. The increase in depreciation and amortization for the three and nine months ended September 30, 2006 as compared to the same periods in 2005 is primarily attributable to the contract rights and equipment we acquired as part of our 2006 acquisitions. In addition, due to the decreased demand for remanufactured equipment that is not energy efficient, during the three months ended September 30, 2006 we disposed of certain laundry equipment that had a remaining net book value of $512. This cost is included in depreciation expense. Also contributing to the increased depreciation expense was new equipment placed in laundry facilities at new locations and replacement of older equipment as contracts were renegotiated.
Cost of product sales. Cost of product sales consists primarily of the cost of laundry equipment, MicroFridge® equipment and parts sold, as well as salaries and related warehousing expenses as part of the product sales segment. Costs of $273 and $837 for the three and nine months ended September 30, 2005, respectively, consisting of salaries and other operating expenses, which were included in the cost of facilities management revenue, have been reclassified to the product sales segment. The following references to 2005 give effect to the reclassification. Cost of product sales increased by $95, or 1%, to $11,329 for the three months ended September 30, 2006 as compared to $11,234 for the three months ended September 30, 2005 and by $1,772, or 7%, to $27,887 for the nine months ended September 30, 2006 as compared to $26,115 for the nine months ended September 30, 2005. As a percentage of sales, cost of product sales was consistent at 79.6% for the three months ended September 30, 2006 and 2005. Cost of product sales as a percent of sales increased by less than 1% for the nine months ended September 30, 2006 to 78.6% as compared to 78.1% for the nine months ended September 30, 2005. The gross margin on product sales includes the gross margins from the laundry equipment sales and MicroFridge® business units. The gross margin in the laundry equipment sales business unit decreased to 18% for the three month period ended September 30, 2006 as compared to 28% for the same period in 2005 and decreased to 20% from 27% for the nine months ended September 30, 2006 compared to the same period in 2005. The decrease in the margin is primarily attributable to selling Whirlpool equipment into a different distribution channel at a lower margin. The gross margin in the MicroFridge® business unit increased to 21% for the three month period ended September 30, 2006 as compared to 17% for the same period in 2005 and to 21% for the nine months ended September 30, 2006 compared to 18% in the corresponding period in 2005. The decrease in gross margin within the laundry equipment sales business unit is largely attributable to product mix. Also affecting gross margin are cost increases by some of our major suppliers as well as increased distribution costs, which we have not been able to fully recover with price increases.
Operating expenses
General, administration, sales and marketing, and related depreciation and amortization expense. General, administration, sales and marketing, and related depreciation and amortization expense increased by $780, or 11%, to $8,197 for the three months ended September 30, 2006 as compared to $7,417 for the three months ended September 30, 2005. General, administration, sales and marketing, and related depreciation and
26
amortization expense increased by $3,092, or 14%, to $25,863 for the nine months ended September 30, 2006 as compared to $22,771 for the nine months ended September 30, 2005. As a percentage of total revenue, general, administration, sales and marketing and related depreciation expenses were 11.7% and 11.3% for the three months ended September 30, 2006 and 2005, respectively and 12.5% and 11.9% for the nine months ended September 30, 2006 and 2005, respectively. The increase in expenses in the third quarter of 2006 compared to the same period in 2005 is attributable primarily to the costs of our new corporate headquarters, compensation expense related to the adoption of FAS 123(R), and compliance costs in conjunction with the first-year implementation of Sarbanes-Oxley Section 404. In addition to the items discussed above, the increase in expenses in the first nine months of 2006 compared to the same period in 2005 is also attributable to the costs of a one time cash bonus paid to certain members of senior management in recognition of their success in furthering the Company’s financial and strategic objectives, and outside legal fees incurred while the Company recruited new in-house corporate counsel. The move to new leased corporate office space coincided with the sale of the Company’s Cambridge, Massachusetts facility. The increase in rent expense going forward will be partially offset by the decrease in interest expense, since the proceeds of the sale ($6.1 million, net of tax) reduced the Company’s outstanding loan balance.
Loss on Early Extinguishment of Debt. We used a portion of the proceeds from our $150,000 senior note offering to repay the term loan portion of the 2005 senior credit facility. Unamortized financing costs of $461 related to the term loan were expensed during the three months ended September 30, 2005. In connection with the 2005 senior credit facilities, we repaid in full and terminated our 2003 senior credit facilities. Unamortized financing costs of $207 associated with our 2003 senior credit facilities as amended in January 2004 were expensed during the first quarter of 2005.
Income from operations
Income from operations increased by $24, or 1%, to $3,841 for the three months ended September 30, 2006 compared to $3,817 for the three months ended September 30, 2005 and decreased by $11,180 or 46% to $13,116 for the nine months ended September 30 2006 compared to $24,296 for the same period in 2005. To supplement the consolidated financial statements presented according to generally accepted accounting principles (GAAP), we have used a non-GAAP financial measure of adjusted income from operations. Management believes presentation of this measure is useful to investors to enhance an overall understanding of our historical financial performance and future prospects. Adjusted income from operations, which is adjusted to exclude certain gains and losses from the comparable GAAP income from operations, is an indication of our baseline performance before gains, losses or other charges that are considered by management to be outside of our core operating results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for income from operations or other measures prepared in accordance with GAAP. Excluding the expense related to stock compensation in 2006 which was not included in 2005, the gain on the sale of real estate and the loss on early extinguishment of debt, adjusted income from operations would have been $4,135 and $14,004, respectively, for the three and nine months ended September 30, 2006, compared to $4,278 and $14,197, respectively, for the three and nine months ended September 30, 2005. These decreases are due primarily to the reasons discussed above. A reconciliation of income from operations in accordance with GAAP to adjusted income from operations is provided below:
| | For the three months ended | | For the nine months ended | |
| | September 30, | | September 30, | |
| | 2005 | | 2006 | | 2005 | | 2006 | |
Income from operations | | $ | 3,817 | | $ | 3,841 | | $ | 24,296 | | $ | 13,116 | |
Stock compensation expense (1) | | — | | 294 | | — | | 888 | |
Gain on non-recurring sale of assets (2) | | — | | — | | (10,767 | ) | — | |
Loss on early extinguishment of debt (3) | | 461 | | — | | 668 | | — | |
Adjusted income from operations | | $ | 4,278 | | $ | 4,135 | | $ | 14,197 | | $ | 14,004 | |
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(1) On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments”, (“FAS123(R)”). These amounts represent expenses relating to issuances of equity awards during the periods presented.
(2) Represents a pre-tax gain recognized in connection with the sale of the Company’s office and warehouse facility in Cambridge, Massachusetts on June 30, 2005.
(3) Represents unamortized costs related to terminated credit facilities.
Non-GAAP financial measures are not in accordance with, or an alternative for, generally accepted accounting principles in the United States. The Company’s non-GAAP financial measures are not meant to be considered in isolation or as a substitute for comparable GAAP financial measures, and should be read only in conjunction with the Company’s consolidated financial statements prepared in accordance with GAAP.
Interest expense, net
Interest expense, net of interest income, increased by $767, or 26%, to $3,666 for the three months ended September 30, 2006, as compared to $2,899 for the three months ended September 30, 2005. For the nine months ended September 30, 2006 interest expense, net of interest income, increased by $2,523 or 33% to $10,247 from $7,724 in the corresponding period in 2005. The increase is primarily attributable to an increase in the average borrowing rate to 7.3% and 7.2%, respectively, for the three and nine months ended September 30, 2006 as compared to 6.3% and 5.7%, respectively, for the same periods in 2005. The increase in average borrowing rate is due, in large part, to our issuance of $150,000 of senior notes on August 16, 2005 which bear interest at the rate of 7.625% per annum. There was no non-cash interest expense associated with the accounting treatment of our interest rate swap agreements for the nine months ended September 30, 2006, as compared to $196 for the nine months ended September 30, 2005.
Loss related to derivative instruments
The Company had entered into interest rate swap agreements that it had accounted for as cash flow hedges. The fair value of these swaps had been included in other comprehensive income in the equity section of the balance sheet. As a result of the reduction in the amount outstanding under our 2005 senior credit facility, certain swap agreements no longer qualified for cash flow hedge accounting treatment. The revised accounting treatment resulted in the recording of losses of $965 and $40 in the income statement in the three and nine months ended September 30, 2006, respectively as compared to a gain of $1,659 for the corresponding periods in 2005.
Provision for income taxes
The provision for income taxes decreased by $1,664 or 146% to a benefit of $523 for the three months ended September 30, 2006 as compared to a provision of $1,141 for the three months ended September 30, 2005 and by $6,860 or 88% to $933 from $7,793 for the nine months ended September 30, 2006. The decrease is the combination of a decrease in taxable income, a decrease in the effective tax rate and a reduction in the reserve for uncertain tax positions. The effective tax rate, without considering the impact of the reduction in the reserve, decreased 1.9% to 40.9% from 42.8% and 2.8% from 42.8% to 40% respectively, for the three and nine months ended September 30, 2006 compared to the same periods in 2005. This decrease in the effective tax rate is due primarily to the affect of the gain on the sale of our corporate headquarters on the 2005 tax rate as well as a decrease in the blended state tax rate for 2006 as compared to 2005. The reduction in the reserve for uncertain tax positions further reduced the effective tax rate to 33% for the nine months ended September 30, 2006. The Company had estimated potential state income tax nexus exposure by its subsidiary for the years 2001 and 2002. As of September 15, 2006 the statute of limitations had expired and the reserve was no longer required.
Net income
As a result of the foregoing, net income decreased by 119% to a net loss of $267 for the three months ended September 30, 2006 as compared to net income of $1,436 for the same period ending September 30, 2005. Net
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income decreased by 82% to $1,896 for the nine months ended September 30, 2006 as compared to $10,438 for the same period ending September 30, 2005.
Seasonality
We experience moderate seasonality as a result of our operations in the college and university market. Revenues derived from the college and university market represented approximately 17% of our total facilities management revenue in 2005. Academic facilities management and rental revenues are derived substantially during the school year in the first, second and fourth calendar quarters. Conversely, our operating and capital expenditures have historically been higher during the third calendar quarter when we install a large amount of equipment while colleges and universities are generally on summer break. Product sales, principally of MicroFridge® products, to this market are typically higher during the third calendar quarter as compared to the rest of the calendar year, somewhat offsetting the seasonality effect of the laundry facilities management business unit.
Stock Compensation
The Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004) Share-Based Payments (“FAS123(R)”) effective January 1, 2006. FAS123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. FAS123(R) requires the Company to measure the cost of employee services received in exchange for an award of equity instruments (usually stock options) based on the grant-date fair value of the award. That cost is recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (usually the vesting period). The Company is using the modified prospective application (“MPA”) transition method, without restatement of prior interim periods. Prior to the adoption of FAS123(R), the Company’s stock option plans were accounted for in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). The Company used the disclosure requirements of Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). Under APB No. 25, the Company did not recognize compensation expense on stock options granted to employees, because the exercise price of each option was equal to the market price of the underlying stock on the date of the grant.
For the three months ended September 30, 2006, income before income taxes was reduced by a stock compensation expense of $294 due to the adoption of FAS123(R). Additionally, the impact on net income was a reduction of $174 and a reduction in basic and diluted earnings per share of $0.01. For the three months ended September 30, 2006, cash flows from financing activities were increased (and cash flow from operations were correspondingly decreased) by $126 due to additions to the windfall tax pool as a result of the adoption of FAS123(R).
For the nine months ended September 30, 2006, income before income taxes was reduced by a stock compensation expense of $888 due to the adoption of FAS123(R). Additionally, the impact on net income was a reduction of $533 and a reduction in basic and diluted earnings per share of $0.04. For the nine months ended September 30, 2006, cash flows from financing activities were increased (and cash flows from operations were correspondingly decreased) by $319 due to additions to the windfall tax pool as a result of the adoption of FAS123(R).
The allocation of stock compensation expense is consistent with the allocation of the participants’ salary and other compensation expenses.
Had compensation cost for the Company’s stock option awards and the stock purchase plan been determined based on the fair value at the grant dates for the awards under those plans, consistent with the provisions of FAS 123, the Company’s net income and net income per share for the three and nine months ended September 30, 2005 would have decreased to the pro forma amounts indicated below:
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| | | | Three months ended
September 30, 2005 | | Nine months ended
September 30, 2005 | |
Net income: | | As reported | | $ | 1,436 | | $ | 10,438 | |
| | Pro forma | | $ | 1,328 | | $ | 10,182 | |
| | | | | | | |
Diluted net income per share: | | As reported | | $ | 0.11 | | $ | 0.79 | |
| | Pro forma | | $ | 0.10 | | $ | 0.77 | |
At September 30, 2006, options for 374,780 shares have been granted but have not yet vested. Compensation expense related to unvested options will be recognized in the following years:
2006 (three months) | | $ | 144 | |
2007 | | 541 | |
2008 | | 317 | |
2009 | | 64 | |
Total | | $ | 1,066 | |
Liquidity and Capital Resources (Dollars in thousands)
We believe that we can satisfy our working capital requirements and funding of capital needs with internally generated cash flow and, as necessary, borrowings from our revolving loan facility described below. Capital requirements for the year ending December 31, 2006, including contract incentive payments, are currently expected to be between $32,000 and $34,000. In the nine months ended September 30, 2006, spending on capital expenditures and contract incentives totaled $20,340 and $3,459, respectively. The capital expenditures for 2006 are primarily composed of laundry equipment installed in connection with new customer leases and the renewal of existing leases.
From time to time, we consider potential acquisitions. We believe that any future acquisitions of significant size would likely require us to obtain additional debt or equity financing. In the past, we have been able to obtain such financing for other material transactions on terms that we believed to be reasonable. However, it is possible that we may not be able to find acquisition financing on favorable terms in the future.
Our current long-term liquidity needs are principally the repayment of the outstanding principal amounts of our long-term indebtedness, including borrowings under our 2005 senior credit facility and our senior notes. We are unable to project with certainty whether our long-term cash flow from operations will be sufficient to repay our long-term debt when it comes due. If this cash flow were insufficient, then we would need to refinance such indebtedness or otherwise amend its terms to extend the maturity dates. We cannot make any assurances that such refinancings or amendments, if necessary, would be available on reasonable terms, if at all.
For the nine months ended September 30, 2006, our source of cash was from financing and operating activities. Our primary uses of cash for the nine months ended September 30, 2006 were the acquisition of several regional laundry facility management operators and the purchase of new laundry machines and MicroFridge® equipment. We anticipate that we will continue to use cash flows provided by operating activities to finance working capital needs, including interest payments on outstanding indebtedness, capital expenditures and other working capital needs.
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Operating Activities
For the nine months ended September 30, 2006 and 2005, net cash flows provided by operating activities were $20,932 and $26,559, respectively. Cash flows from operations consists primarily of facilities management revenue and product sales, offset by the cost of facilities management revenues, cost of product sales, and general, administration, sales and marketing expenses. The decrease for the nine months ended September 30, 2006 as compared to the nine months ended September 30, 2005 is attributable to the gain on the sale of the Company’s headquarters included in net income in 2005, ordinary changes in working capital, and a decrease in accounts payable, accrued facilities management rent, accrued expenses and other liabilities of $3,150 compared to an increase of $10,796 in 2005. The change in working capital is primarily due to the timing of purchases of inventory, capital equipment and services and when such expenditures are due to be paid. These decreases were partially offset by an increase in depreciation and amortization. Depreciation and amortization expense increased due primarily to the assets acquired in our 2006 acquisitions new equipment placed in service with customers and the disposal of equipment with a remaining net book value.
Investing Activities
For the nine months ended September 30, 2006 and 2005, net cash flows used in investing activities were $38,920 and $113,863, respectively. Of the 2005 total, $106,244 was used for the January 2005 acquisition, and of the 2006 total, $18,780 was used for the 2006 acquisitions. Other capital expenditures for the first nine months of 2006 and 2005, primarily laundry equipment for new and renewed lease locations, were $20,340 and $19,950, respectively.
Financing Activities
For the nine months ended September 30, 2006 and 2005, net cash flows provided by financing activities were $18,804 and $95,268, respectively. Cash flows provided by financing activities consist primarily of net proceeds from bank borrowings, which increased significantly in 2005 due to borrowings to fund the January 2005 acquisition. Also included in the period ended September 30, 2005, are the financing costs related to the 2005 senior credit facilities obtained in connection with the same acquisition. For the nine months ended September 30, 2006, bank borrowings included approximately $19.0 million used to fund several acquisitions of regional operators.
In connection with the January 2005 acquisition, we and various lenders entered into senior credit facilities that consisted of an $80,000 term loan facility and a $120,000 revolving loan facility, each of which matures on January 10, 2010 (the “2005 Senior Credit Facilities”). The Company used $80,000 of the term loan facility borrowings, which were subsequently retired in August 2005 as discussed below, and approximately $93,400 of the revolving loan facility borrowings to finance the 2005 acquisition and to pay related costs and expenses, and to repay the outstanding obligations under and terminate our prior senior credit facilities. The 2005 Senior Credit Facilities are collateralized by a blanket lien on our assets and the assets of our subsidiaries as well as a pledge by us of all the capital stock of these subsidiaries.
As of September 30, 2006, there was $33,000 outstanding under the revolving line of credit and $760 in outstanding letters of credit. The available balance under the revolving line of credit was $86,240 at September 30, 2006. The actual amount that may be borrowed against the line of credit is governed by the funded debt ratio covenant. At September 30, 2006, the total additional amount that could be borrowed was $44,000.
Borrowings outstanding under the 2005 Senior Credit Facilities bear interest at a fluctuating rate equal to (i) in the case of Eurodollar rate loans, the LIBOR rate (adjusted for statutory reserves) plus an applicable percentage, ranging from 1.75% to 2.50% (as of September 30, 2006, 2.25%) determined quarterly by reference to the funded debt ratio or (ii) in the case of alternate base rate loans and swing line loans, the higher of (a) the federal funds rate plus 0.5% or (b) the annual rate of interest announced by JPMorgan Chase Bank, N.A. as its “prime rate,” in each case, plus an applicable percentage, ranging from 0.75% to 1.50% (as of September 30, 2006, 1.25%), determined quarterly by reference to the funded debt ratio. The average interest rates of our borrowings under the 2005 Senior Credit Facilities at December 31, 2005 and September 30, 2006 were 5.43% and 6.65%, respectively. Under the 2005 Senior Credit Facilities, we pay a commitment fee equal
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to a percentage, either 0.375% or 0.50%, determined and payable quarterly by reference to the funded debt ratio, of the average daily-unused portion of the 2005 Senior Credit Facilities. This commitment fee percentage is currently 0.375%.
The credit agreement for the 2005 Senior Credit Facilities includes customary covenants, including, but not limited to, restrictions pertaining to: (i) the incurrence of additional indebtedness, (ii) limitations on liens, (iii) making distributions, dividends and other payments, (iv) the making of certain investments and loans, (v) mergers, consolidations and acquisitions, (vi) dispositions of assets, (vii) the maintenance of minimum consolidated net worth, maximum funded debt ratios, minimum consolidated cash flow coverage ratios, and maximum senior secured leverage ratios, (viii) transactions with affiliates, (ix) sale and leaseback transactions, (x) entering into swap agreements and (xi) changes to governing documents, in each case subject to numerous baskets, exceptions and thresholds. The funded debt ratio, consolidated cash flow coverage ratio and senior secured leverage ratio that we were required to meet as of September 30, 2006 were 4.25 to 1.00, 1.10 to 1.00, and 2.00 to 1.00, respectively. We were in compliance with these and all other covenants at September 30, 2006.
The credit agreement for the 2005 Senior Credit Facilities provides for customary events of default, including, but not limited to:(i) failure to pay any principal or interest when due, (ii) failure to comply with covenants, (iii) any material representation or warranty made by us proving to be incorrect in any material respect, (iv) defaults relating to or acceleration of other material indebtedness, (v) certain insolvency or receivership events affecting us or any of our subsidiaries, (vi) a change in control, (vii) material judgments, claims or liabilities against us or (viii) a material defect in the lenders’ lien against the collateral securing the obligations under the credit agreement. We were not in default under the 2005 Senior Credit Facilities at September 30, 2006.
On August 16, 2005, we issued $150,000 of senior unsecured notes maturing on August 15, 2015. Interest on the notes accrues at the rate of 7.625% per annum payable semiannually in arrears in February and August. On and after August 15, 2010, we will be entitled at our option to redeem all or a portion of these notes at the redemption prices set forth below (expressed in percentages of principal amount on the redemption date), plus accrued interest to the redemption date, if redeemed, during the 12-month period commencing on August 15 of the years set forth below:
Period | | Redemption
Price | |
2010 | | 103.813 | % |
2011 | | 102.542 | % |
2012 | | 101.271 | % |
2013 and thereafter | | 100.000 | % |
Subject to certain conditions, we will be entitled at our option on one or more occasions prior to August 15, 2008 to redeem notes in an aggregate principal amount not to exceed 35% of the aggregate principal amount of the notes originally issued at a redemption price (expressed as a percentage of principal amount on the redemption date) of 107.625%, plus accrued and unpaid interest to the redemption date, with the net cash proceeds from one or more equity offerings.
The terms of the senior notes include customary covenants, including, but not limited to, restrictions pertaining to: (i) incurrence of additional indebtedness and issuance of preferred stock; (ii) payment of dividends on or making of distributions in respect of capital stock or making certain other restricted payments or investments; (iii) entering into agreements that restrict distributions from restricted subsidiaries; (iv) sale or other disposition of assets, including capital stock of restricted subsidiaries; (v) transactions with affiliates; (vi) incurrence of liens; (vii) sale/leaseback transactions and (viii) merger, consolidation or sale of substantially all of our assets, in each case subject to numerous baskets, exceptions and thresholds. We were in compliance with these and all other covenants at September 30, 2006.
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The terms of the senior notes provide for customary events of default, including, but not limited to:(i) failure to pay any principal or interest when due, (ii) failure to comply with covenants and limitations, (iii) certain insolvency or receivership events affecting us or any of our subsidiaries and (iv) unsatisfied material judgments, claims or liabilities against us. We were not in default under the senior notes at September 30, 2006.
The net proceeds of the senior notes were used to retire the term loan and reduce the revolving loan balance outstanding under the 2005 senior credit facility.
We have entered into standard International Swaps and Derivatives Association, or ISDA, interest rate swap agreements to manage the interest rate risk associated with our 2005 senior credit facilities. For a description of our interest rate swap agreements, see “Item 3. Quantitative and Qualitative Disclosures About Market Risk.”
Contractual Obligations
A summary of our contractual obligations and commitments related to our outstanding long-term debt and future minimum lease payments related to our vehicle fleet, warehouse rent and facilities management rent as of September 30, 2006 is as follows:
Fiscal | | Long-term | | Interest on | | Facilities rent | | Capital lease | | Operating lease | | | |
Year | | debt | | senior notes | | commitments | | commitments | | commitments | | Total | |
2006 | | $ | — | | $ | 4,448 | | $ | 1,797 | | $ | 319 | | $ | 598 | | $ | 7,162 | |
2007 | | — | | 11,438 | | 6,524 | | 1,051 | | 2,217 | | 21,230 | |
2008 | | — | | 11,438 | | 5,359 | | 703 | | 2,007 | | 19,507 | |
2009 | | — | | 11,438 | | 4,179 | | 423 | | 1,854 | | 17,894 | |
2010 | | 33,000 | | 11,438 | | 3,514 | | 148 | | 1,519 | | 49,619 | |
Thereafter | | 150,000 | | 57,185 | | 5,371 | | — | | 6,879 | | 219,435 | |
Total | | $ | 183,000 | | $ | 107,385 | | $ | 26,744 | | $ | 2,644 | | $ | 15,074 | | $ | 334,847 | |
We anticipate that available funds from current operations, existing cash and other sources of liquidity will be sufficient to meet current operating requirements and anticipated capital expenditures. However, we may require external sources of financing for any significant future acquisitions. Further, the 2005 senior secured credit facility matures in January 2010. The repayment of this facility may require external financing.
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK
We are exposed to a variety of risks, including changes in interest rates on some of our borrowings. In the normal course of our business, we manage our exposure to these risks as described below. We do not engage in trading market-risk sensitive instruments for speculative purposes.
Interest rates
The table below provides information about our debt obligations that are sensitive to changes in interest rates. For debt obligations, the table presents principal cash flows and related weighted average interest rates by
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expected maturity dates. The fair market value of long-term debt approximates book value at September 30, 2006.
(in thousands) | | 2006 | | 2007 | | 2008 | | 2009 | | 2010 | | Thereafter | | Total | |
Variable rate | | $ | — | | $ | — | | $ | — | | $ | — | | $ | 33,000 | | $ | — | | $ | 33,000 | |
Average interest rate | | 0 | % | 0 | % | 0 | % | 0 | % | 6.65 | % | 0 | % | 6.65 | % |
| | | | | | | | | | | | | | | | | | | | | | |
As required by our 2005 senior credit facilities, we entered into standard International Swaps and Derivatives Association, or ISDA, interest rate swap agreements to manage the interest rate risk associated with our 2005 senior credit facilities. We designated our interest rate swap agreements as cash flow hedges. As a result of retiring our term loan and paying down the balance of our revolving loan, four of our swap agreements ceased to qualify for hedge accounting treatment. The interest rate swap agreement dated June 24, 2003, with a notional amount of $10,714 at September 30, 2006, continues to be accounted for as a cash flow hedge.
The table below outlines the details of each remaining interest rate swap agreement:
| | | | | | Notional | | | | | |
| | Original | | | | Amount | | | | | |
Date of | | Notional | | Fixed/ | | September 30, | | Expiration | | Fixed | |
Origin | | Amount | | Amortizing | | 2006 | | Date | | Rate | |
| | | | | | | | | | | |
June 24, 2003 | | $ | 20,000 | | Amortizing | | $ | 10,714 | | Jun 30, 2008 | | 2.34 | % |
June 24, 2003 | | $ | 20,000 | | Fixed | | $ | 20,000 | | Jun 30, 2008 | | 2.69 | % |
May 2, 2005 | | $ | 17,000 | | Fixed (2) | | $ | — | | Dec 31, 2011 | | 4.69 | % |
May 2, 2005 | | $ | 12,000 | | Fixed (1) | | $ | — | | Sep 30, 2009 | | 4.66 | % |
May 2, 2005 | | $ | 10,000 | | Fixed (2) | | $ | — | | Dec 31, 2011 | | 4.77 | % |
(1) Effective Date is March 31, 2007
(2) Effective Date is June 30, 2008
In accordance with the interest rate swap agreements and on a quarterly basis, interest expense is calculated based on the floating 90-day LIBOR and the fixed rate. If interest expense as calculated is greater based on the 90-day LIBOR, the financial institution pays the difference to us; if interest expense as calculated is greater based on the fixed rate, we pay the difference to the financial institution. Depending on fluctuations in the LIBOR, our interest rate exposure and its related impact on interest expense and net cash flow may increase or decrease. The counter party to the interest rate swap agreement exposes us to credit loss in the event of non-performance; however, nonperformance is not anticipated.
The fair value of the interest rate swap agreements is the estimated amount that we would receive or pay to terminate the agreement at the reporting date, taking into account current interest rates and the credit worthiness of the counter party. At September 30, 2006, the fair values of the interest rate swap agreements were $1,450. This amount has been included in other assets on the condensed consolidated balance sheets.
As of September 30, 2006, there was $33,000 outstanding under the revolving line of credit and $760 in outstanding letters of credit. The unused balance under the revolving loan facility was $86,240 at September 30, 2006. The actual amount that may be borrowed against the line of credit is governed by the funded debt ratio covenant. At September 30, 2006 the total additional amount that could be borrowed was $44,000. The average interest rate was approximately 6.65% at September 30, 2006.
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Item 4.
CONTROLS AND PROCEDURES
As of the end of the period covered by this report, and pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, the Company carried out an evaluation under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, due to the deficiency described above, the Company’s disclosure controls and procedures were not effective in providing reasonable assurance that information required to be disclosed by us in the reports we submit or file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. There was no change in the Company’s internal control over financial reporting that occurred during the fiscal quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
We will be required to comply with Section 404 of the Sarbanes-Oxley Act as of December 31, 2006. See Part II, Item 1A, “Our internal controls over financial reporting may not be adequate and our independent auditors may not be able to certify as to their adequacy, which could have a significant and adverse effect on our business and reputation.”
PART II – OTHER INFORMATION
Item 1A. Risk Factors
Our internal controls over financial reporting may not be adequate and our independent auditors may not be able to certify as to their adequacy, which could have a significant and adverse effect on our business and reputation.
We are evaluating our internal controls over financial reporting in order to allow management to report on, and our independent auditors to attest to, our internal controls over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act of 2002 and rules and regulations of the SEC thereunder, which we refer to as Section 404. Section 404 requires a reporting company such as ours to, among other things, annually review and disclose its internal controls over financial reporting, and evaluate and disclose changes in its internal controls over financial reporting quarterly. We will be required to comply with Section 404 as of December 31, 2006. We are currently performing the system and process evaluation and testing required (and any necessary remediation) in an effort to comply with management certification and auditor attestation requirements of Section 404. In the course of our ongoing evaluation, we have identified areas of our internal controls requiring improvement, and plan to design enhanced processes and controls to address these and any other issues that might be identified through this review. As a result, we expect to incur additional expenses and diversion of management’s time. We cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of the same on our operations and may not be able to ensure that the process is effective or that the internal controls are or will be effective in a timely manner. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance or our independent auditors are not able to certify as to the effectiveness of our internal control over financial reporting, we may be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission. As a result, there could be an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements. In addition, we may be required to incur costs in improving our internal control system and the hiring of additional personnel. Any such action could adversely affect our results.
There have been no other material changes in the risk factors described in Item 1A (“Risk Factors”) of the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2005.
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Item 6. Exhibits
Exhibits
31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunder duly authorized.
| MAC-GRAY CORPORATION |
November 13, 2006 | /s/ Michael J. Shea | |
| Michael J. Shea |
| Executive Vice President, Chief |
| Financial Officer and Treasurer |
| (On behalf of registrant and as principal |
| financial officer) |
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