UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE THIRTEEN WEEKS ENDED FEBRUARY 26, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NO. 1-12188 SODEXHO MARRIOTT SERVICES, INC. ---------------------------------------------------- (Exact name of registrant as specified in its charter) DELAWARE 52-0936594 -------------------------------- ------------------ (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 9801 WASHINGTONIAN BOULEVARD, GAITHERSBURG, MARYLAND 20878 ---------------------------------------------------- ---------- (Address of principal executive offices) (Zip Code) (301) 987-4431 ---------------------------------------------------- (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Shares outstanding CLASS AT APRIL 5, 1999 -------------------- ---------------- Common Stock $1.00 par value per share 62,180,822 SODEXHO MARRIOTT SERVICES, INC. FORM 10-Q INDEX PAGE NO. -------- Introduction Overview 1 Glossary of Terms 2 Forward-Looking Statements 3 Pro Forma Financial Information (Unaudited) 4 Part I. Financial Information (Unaudited): Condensed Consolidated Statement of Income - Thirteen and Twenty-Six Weeks Ended February 26, 1999 and Twelve and Twenty-Eight Weeks Ended March 27, 1998 8 Condensed Consolidated Balance Sheet - as of February 26, 1999 and August 28, 1998 9 Condensed Consolidated Statement of Cash Flow - Twenty-Six Weeks Ended February 26, 1999 and Twenty-Eight Weeks Ended March 27, 1998 10 Condensed Consolidated Statement of Stockholders' Deficit- as of February 26, 1999 11 Notes to Condensed Consolidated Financial Statements 12 Management's Discussion and Analysis of Results of Operations and Financial Condition 25 Quantitative and Qualitative Disclosures about Market Risk 30 Part II. Other Information and Signatures: Legal Proceedings 30 Changes in Securities 30 Defaults Upon Senior Securities 30 Submission of Matters to a Vote of Security Holders 30 Other Information 31 Exhibits and Reports on Form 8-K 31 Signatures 31 INTRODUCTION OVERVIEW Sodexho Marriott Services, Inc. (the "Company") is the leading provider in North America of outsourced food and facilities management services to businesses, health care facilities, colleges and universities, and primary and secondary schools. Food services include food and beverage procurement, preparation and menu planning, as well as the operation and maintenance of food service and catering facilities, generally on a client's premises. Facilities management services include plant maintenance, energy management, grounds keeping, housekeeping and custodial services. The Company was formerly named Marriott International, Inc. Upon the consummation of the distribution of its lodging, senior living and distribution services businesses to existing shareholders (see "Distributed Operations" below), which occurred on March 27, 1998, the Company then acquired the North American operations of Sodexho Alliance, S.A. ("Sodexho"), and the combined operations were renamed Sodexho Marriott Services, Inc. THE TRANSACTIONS As of March 27, 1998, the assets, liabilities and business operations of the Company changed substantially due to the Distribution to shareholders, the Acquisition of Sodexho North America and the Refinancing of debt (the "Transactions"). Below is an overview of the Transactions, which were followed on April 15, 1998, by a change in the Company's fiscal year-end from the Friday nearest to December 31 to the Friday nearest to August 31 of each year. DISTRIBUTED OPERATIONS. On March 27, 1998, the Company distributed to its shareholders the lodging segment and two of the three lines of business in the contract services segment - Marriott Senior Living Services ("MSLS") and Marriott Distribution Services ("MDS"). The lodging, MSLS and MDS business are collectively referred to as the Distributed Operations. The third line of business in the contract services segment, formerly known as Marriott Management Services ("MMS"), combined with Sodexho North America and became the principal business of the Company. The lodging segment distributed to shareholders is presented as Discontinued Operations in the historical financial statements of the Company. ACQUISITION. Immediately after the Distribution, on March 27, 1998, Sodexho transferred to the Company the operations of Sodexho North America having a fair market value of approximately $278 million, combined with a cash payment of $304 million in exchange for 29.9 million shares of the Company's common stock, after giving effect to the one-for-four reverse stock split (see Note 1 and Note 3). The purchase price included approximately $3 million in transaction costs. As a result of the issuance of new shares of the Company's common stock to Sodexho in connection with the Acquisition, the shareholders that owned 100% of the Company immediately prior to the Transactions owned approximately 51% immediately thereafter. THE REFINANCING. On March 27, 1998, the Company borrowed $615 million and $620 million under the Secured SMS Facility and Guaranteed SMS Facility, respectively (see Note 5). The proceeds were used to repurchase $713 million of the Company's $720 million publicly held debt and to repay its $950 million outstanding obligations under the Company's existing $1.5 billion credit facility, which was cancelled immediately after such repayment. Also, the Company repaid debt of $73 million assumed in the Acquisition. The $304 million received from Sodexho was used in conjunction with the debt proceeds to fund the debt repayments. The Company also received letters of credit for $13 million under the Secured SMS Facility on March 27, 1998. The Company's borrowing agreements contain various covenants, which, among other things, require the Company to meet certain financial ratios and tests. -1- Due to the extensive changes in the Company's business that resulted from the Transactions, the Company is providing the following glossary of significant terms used in this report for informational purposes. In certain places in this document, where deemed meaningful for the reader's understanding, these definitions may be repeated. GLOSSARY OF TERMS THE ACQUISITION. On March 27, 1998, the Company acquired Sodexho North America, and Sodexho paid the Company $304 million, in exchange for approximately 48% of the shares of the Company's common stock that were issued and outstanding immediately after the Transactions. ADJUSTED NET TANGIBLE ASSETS. The amount by which stockholders' equity exceeds intangible assets with certain adjustments. THE COMPANY. Sodexho Marriott Services, Inc. (together with its consolidated subsidiaries), formerly Marriott International, Inc. DISCONTINUED OPERATIONS. The Company's lodging business segment. DISTRIBUTED OPERATIONS. The lodging, senior living services, and distribution services businesses taken collectively. THE DISTRIBUTION. On March 27, 1998, the Company distributed the stock of New Marriott MI, Inc., which contained all of the assets and liabilities of the Company's lodging, senior living services, and distribution services businesses, to its shareholders in a tax-free transaction. ICC. International Catering Corporation and subsidiaries. I&R COSTS. Integration and Restructuring costs related to the Transactions. MI. New Marriott MI, Inc. (together with its subsidiaries), renamed Marriott International, Inc. MDS. Marriott Distribution Services, the Company's distribution services business. MMS. The former Marriott Management Services Corp. and the former Marriott Corporation of Canada, Ltd., collectively. MMS- UK OPERATIONS. Marriott Management Services' United Kingdom operations sold in October 1997 to a subsidiary of Sodexho Alliance, S.A. in anticipation of the Transactions. MSLS. Marriott Senior Living Services, the Company's senior living services business. NEW MARRIOTT MI, INC. Subsequently renamed Marriott International, Inc. ("MI"), conducts business in the lodging segment, MDS and MSLS, and is also referred to herein as "New Marriott." OTHER CONTRACT SERVICES. MDS and MSLS, which for the first quarter of the 1998 Transition Period and prior fiscal years were part of the Company's continuing operations. PRO FORMA SECOND QUARTER FISCAL 1999. The 13-week period ended February 26, 1999. PRO FORMA SECOND QUARTER FISCAL 1998. The 13-week period ended February 27, 1998. PRO FORMA FIRST HALF FISCAL 1999. The 26-week period ended February 26, 1999. PRO FORMA FIRST HALF FISCAL 1998. The 26-week period ended February 27, 1998. THE REFINANCING. On March 27, 1998, the Company and its indirect subsidiary, RHG Finance Corporation, tendered for a total of $720 million principal amount of their respective outstanding publicly held debt. In addition, the Company refinanced its commercial paper and indebtedness outstanding under its revolving credit facility, which totaled $950 million on March 27, 1998. -2- GLOSSARY OF TERMS, CONTINUED RETAINED BUSINESS. All operations not distributed. REVERSE STOCK SPLIT. On March 27, 1998, the Company's common stock underwent a one-for-four reverse stock split. SODEXHO. Sodexho Alliance, S.A., a worldwide food and management services organization headquartered in France and an approximate 48% shareholder of the Company. SODEXHO NORTH AMERICA. Sodexho Financiere du Canada and subsidiaries, and International Catering Corporation and subsidiaries (also known as Sodexho USA) taken collectively. THE TRANSACTIONS. The Distribution, Acquisition, and Refinancing taken collectively. TRANSITION PERIOD. On April 15, 1998, the Board of Directors of the Company approved the change of the fiscal year end of the Company to the Friday nearest to August 31 of each year. Prior to this change in fiscal year, the Company's fiscal year ended on the Friday nearest to December 31 of each year. Thus, the 1998 fiscal year, which began on January 3, 1998, and ended on August 28, 1998, was considered the Transition Period. The 1999 fiscal year, which began on August 29, 1998, will end on September 3, 1999, and will include 53 weeks. TRANSITION REPORT. The Company's Transition Report on Form 10-K for the 34-week period ended August 28, 1998. FORWARD-LOOKING STATEMENTS This report by the Company contains forward-looking statements within the meaning of the federal securities laws. These statements are based on the Company's current expectations and relate to anticipated future events that are not historical facts, such as the Company's business strategies and their intended results. The forward-looking statements included in this report are subject to numerous risks and uncertainties that could cause the Company's future activities and results of operations to differ materially from those expressed or implied in the forward-looking statements. These risks and uncertainties, which are further discussed in Management's Discussion and Analysis of Results of Operations and Financial Condition and other parts of this report, include: (i) the ability of the Company to adapt to changes in its corporate structure related to the Transactions, (ii) the potential adverse impact of the Company's substantial indebtedness, (iii) competition in the food services and facilities management industries, (iv) the effects of general economic conditions, (v) the ability of the Company to retain existing clients and obtain new clients on satisfactory terms in light of the Transactions, (vi) the ability of the Company to remedy any computer-related issues resulting from the advent of the Year 2000, and other factors described from time to time in the Company's filings with the Securities and Exchange Commission including those set forth in Exhibit 99 filed herein and the Company's Transition Report on Form 10-K filed with the Securities and Exchange Commission on November 23, 1998. As a result of these risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements included in this report or elsewhere from time to time by or on behalf of the Company. The Company assumes no obligation to update any forward-looking statements. -3- PRO FORMA FINANCIAL INFORMATION (UNAUDITED) As of March 27, 1998, the assets, liabilities and business operations of the Company changed substantially due to the Transactions described fully in Notes 1, 2 and 3 to the Condensed Consolidated Financial Statements. As a result of these changes, there are substantial differences in the comparability of the Company's historical operating results presented in Part I of this document and the Company's ongoing operations. To assist readers in understanding the present operations of the Company, management believes it is meaningful and relevant to set forth in this report not only the actual results of operations for the 13 and 26 weeks ended February 26, 1999 compared with the historical 12 and 28 weeks ended March 27, 1998 (presented in Part I of this report), but also the Pro Forma Second Quarter and First Half Fiscal 1999 and 1998 presented in this section. The pro forma operating results were prepared as if the Transactions occurred at the beginning of the periods presented. Therefore, the pro forma operating results only include the Company's Retained Business and the acquired operations of Sodexho North America. Pro forma sales and operating profit presented include the combined actual sales of the food and facilities management services business of MMS and Sodexho North America. Pro forma corporate expenses include the combined corporate overhead of both businesses. No synergies were assumed for either the Pro Forma Second Quarter Fiscal 1998 nor the Pro Forma First Half Fiscal 1998, and losses from the sale of the MMS-UK operations in October 1997 and related operating results prior to the sale were also excluded from these periods. Integration and restructuring charges of $5.4 million and $13.0 million pretax were excluded from Pro Forma Second Quarter and First Half Fiscal 1999, respectively. Estimated expenses of $1.6 million and $3.2 million were included in Pro Forma Second Quarter and First Half Fiscal 1998, respectively, representing incremental costs to operate the Company as a separate public entity. Pro forma net income reflects approximately $4.0 million and $8.0 million of amortization expense for the intangible assets related to the Acquisition for both Pro Forma Second Quarter and First Half Fiscal 1999 and 1998, respectively. Pro forma interest expense, net, represents the estimated costs as if the Refinancing and the interest rate agreements had been in place on the first day of all periods presented. Effective income tax rates of 44% and 48% were used for Pro Forma First Half Fiscal 1999 and 1998, respectively. Pro forma results do not include any extraordinary charges related to the Refinancing. Pro forma basic earnings per share were calculated on a base of 62.1 million and 61.9 million shares for Pro Forma Second Quarter Fiscal 1999 and 1998, respectively, which was the average number of shares outstanding during the 13 weeks ended February 26, 1999 and the number of shares outstanding on August 28, 1998. Pro forma diluted earnings per share were calculated on a base of 64.0 million and 62.5 million for Pro Forma Second Quarter Fiscal 1999 and 1998, respectively. The dilutive shares were the result of the Company's convertible debt, stock option plans and deferred stock incentive plans outstanding. Pro forma basic earnings per share were calculated on a base of 62.0 million and 61.9 million shares for Pro Forma First Half Fiscal 1999 and 1998, respectively, which was the average number of shares outstanding during the 26 weeks ended February 26, 1999 and the number of shares outstanding on August 28, 1998. Pro forma diluted earnings per share were calculated on a base of 64.1 million and 62.5 million for Pro Forma First Half Fiscal 1999 and 1998, respectively. The dilutive shares were the result of the Company's convertible debt, stock option plans and deferred stock incentive plans outstanding. -4- PRO FORMA UNAUDITED CONDENSED STATEMENT OF INCOME BY SEGMENT FOR THIRTEEN AND TWENTY-SIX WEEKS ENDED FEBRUARY 26, 1999 AND FEBRUARY 27, 1998 ($ IN MILLIONS, EXCEPT PER SHARE AMOUNTS) THIRTEEN WEEKS ENDED TWENTY-SIX WEEKS ENDED ------------------------------------- ------------------------------------- FEBRUARY 26, FEBRUARY 27, FEBRUARY 26, FEBRUARY 27, 1999 1998 1999 1998 ----------------- ----------------- ----------------- ----------------- SALES Corporate Services $ 324 $ 319 $ 659 $ 646 Health Care 324 316 639 634 Education 294 283 690 659 Schools 96 93 204 196 Canada 35 36 72 77 Laundries/Other 17 16 35 32 ----------------- ----------------- ----------------- ----------------- TOTAL SALES 1,090 1,063 2,299 2,244 OPERATING COSTS AND EXPENSES Corporate Services 303 299 616 607 Health Care 297 290 585 583 Education 278 269 630 606 Schools 89 88 190 185 Canada 33 35 68 74 Laundries/Other 16 15 34 30 ----------------- ----------------- ----------------- ----------------- TOTAL OPERATING COSTS AND EXPENSES 1,016 996 2,123 2,085 ----------------- ----------------- ----------------- ----------------- OPERATING PROFIT BEFORE CORPORATE ITEMS Corporate Services 21 20 43 39 Health Care 27 26 54 51 Education 16 14 60 53 Schools 7 5 14 11 Canada 2 1 4 3 Laundries/Other 1 1 1 2 ----------------- ----------------- ----------------- ----------------- TOTAL OPERATING PROFIT 74 67 176 159 CORPORATE ITEMS: Amortization of Intangible Assets (10) (10) (19) (19) Corporate Expenses (18) (21) (37) (42) Interest Expense, Net (21) (22) (44) (44) Gain on Sale of Investment -- -- 8 -- ----------------- ----------------- ----------------- ----------------- INCOME BEFORE INCOME TAXES 25 14 84 54 Provision for Income Taxes (11) (7) (37) (26) ----------------- ----------------- ----------------- ----------------- PRO FORMA NET INCOME $ 14 $ 7 $ 47 $ 28 ================= ================= ================= ================= PRO FORMA BASIC EARNINGS PER SHARE $ 0.23 $ 0.12 $ 0.76 $ 0.46 ================= ================= ================= ================= PRO FORMA DILUTED EARNINGS PER SHARE $ 0.22 $ 0.12 $ 0.74 $ 0.45 ================= ================= ================= ================= -5- DISCUSSION OF PRO FORMA SECOND QUARTER FISCAL 1999 AND 1998 RESULTS OF OPERATIONS Total sales for Pro Forma Second Quarter Fiscal 1999 were $1.09 billion, an increase of $27 million, or 2.5%, over $1.06 billion for Pro Forma Second Quarter Fiscal 1998. This growth was mostly attributable to the performance of the Education and Schools (K-12) divisions. Sales growth in Corporate Services was hampered by the absence of sales to clients lost during and after Pro Forma Second Quarter Fiscal 1998 that largely offset the favorable impact of the Crossroads Cuisines retail strategy. New sales in the Health Care division were offset by the absence of sales to clients lost during and after Pro Forma Second Quarter Fiscal 1998. The absence of sales to clients lost last year was greater than historical experience, principally due to the disruption of the Transactions. Management believes that the retention of clients during Fiscal 1999 will return to the more favorable historical levels. The Canada division's sales would have been flat compared with last year's quarter without the fluctuations in the Canadian dollar. Operating profit before corporate items (corporate expenses, interest expense, amortization of intangible assets and gain on sale of investment) totaled $74 million for the Pro Forma Second Quarter Fiscal 1999, an increase of $7 million, or 10%, over the $67 million in operating profit for the Pro Forma Second Quarter Fiscal 1998. Pro Forma Second Quarter Fiscal 1998 included a $3.5 million charge for potential sales and use tax exposure. Excluding this charge, operating profit grew 4%, reflecting increases across all divisions, particularly in Education. Corporate expenses and amortization of intangible assets in the Pro Forma Second Quarter Fiscal 1999 totaled $28 million, a 10% reduction from the $31 million for the Pro Forma Second Quarter Fiscal 1998, reflecting the elimination of certain positions after the Transactions along with other administrative synergies. The Pro Forma Second Quarter Fiscal 1999 included the favorable impact from the sale of the Company's remaining interest in the Bright Horizons Family Solutions ("BFAM") investment. The sale of the remaining investment in BFAM resulted in a pretax gain of $0.5 million, or $0.3 million after-tax (no impact to diluted earnings per share) during the Second Quarter Fiscal 1999. Total operating costs, corporate expenses and amortization of intangible assets represented, in the aggregate, 95.8% of total sales for the Pro Forma Second Quarter Fiscal 1999 compared with Fiscal 1998's comparable period ratio of 96.6%. The Company anticipates this margin will continue to improve in the periods ahead, as the Company continues its integration of the MMS and Sodexho North America operations resulting in savings realized from purchasing and administrative actions. These savings are anticipated to reach $60 million annually by fiscal year 2001. The growth in operating profit combined with reduced corporate expenses contributed to an increase in pretax income of $11 million, or 79%, to $25 million for the Pro Forma Second Quarter Fiscal 1999. The effective tax rate for the current pro forma period was 44%, a decrease from 48% for 1998, due to the implementation of effective tax planning strategies and the lower proportion of nondeductible intangible amortization expense in relation to total operating profit between the years. Net income doubled to $14 million, or $0.22 per diluted share, compared with $7 million, or $0.12 per diluted share for Pro Forma Second Quarter Fiscal 1998. -6- DISCUSSION OF PRO FORMA FIRST HALF FISCAL 1999 AND 1998 RESULTS OF OPERATIONS Total sales for Pro Forma First Half Fiscal 1999 were $2.30 billion, an increase of $55 million, or 2.5%, over $2.24 billion for Pro Forma First Half Fiscal 1998. This growth was mostly attributable to the performance of the Education, Schools (K-12) and Laundry divisions. Sales growth in Corporate Services was hampered by the absence of sales to clients lost during and after Pro Forma First Half Fiscal 1998 that largely offset the favorable impact of the Crossroads Cuisines retail strategy. New sales in the Health Care division in Pro Forma First Half Fiscal 1999 were offset by the absence of sales to clients lost during and after Pro Forma First Half Fiscal 1998 and by the impact of several large clients switching their contract types from profit and loss to certain types of management fee contracts, which reduced the amount of revenue recognized. The absence of sales to clients lost last year was greater than historical experience, principally due to the disruption of the Transactions. Management believes that the retention of clients during Fiscal 1999 will return to the more favorable historical levels. The Canada division's sales would have been flat compared with last year without the fluctuations in the Canadian dollar. Operating profit before corporate items (corporate expenses, interest expense, amortization of intangible assets and gain on sale of investment) totaled $176 million for the Pro Forma First Half Fiscal 1999, an increase of $17 million, or 11%, over the $159 million in operating profit for the Pro Forma First Half Fiscal 1998. Pro Forma First Half Fiscal 1998 included charges totaling $5 million for potential sales and use tax exposure. Excluding these charges, operating profit grew by 7%, driven by growth in profits at existing clients in the Education and Schools divisions, combined with the favorable impact of administrative synergies realized in the current period. Corporate expenses and amortization of intangible assets in the Pro Forma First Half Fiscal 1999 totaled $56 million, an 8% reduction from the $61 million for the Pro Forma First Half Fiscal 1998, reflecting the elimination of certain positions after the Transactions along with other administrative synergies. The Pro Forma First Half Fiscal 1999 included the favorable impact from the sale of the Company's Bright Horizons Family Solutions ("BFAM") investment. The Company made the investment in and formed a marketing affiliation with Corporate Child Care Inc., a predecessor of BFAM, in 1989. The Company sold the majority of its interest in this investment in the Pro Forma First Quarter Fiscal 1999 for a pretax gain of $7.8 million, or $4.3 million after-tax ($0.07 per diluted common share). The Company sold the remainder of its investment in the Pro Forma Second Quarter Fiscal 1999, resulting in a cumulative pretax gain of $8.3 million, or $4.6 million after-tax ($0.07 per diluted common share) recognized in the Pro Forma First Half Fiscal 1999. Total operating costs, corporate expenses and amortization of intangible assets represented, in the aggregate, 94.8% of total sales for the Pro Forma First Half Fiscal 1999 compared with Fiscal 1998's comparable period ratio of 95.6%. The Company anticipates this margin will continue to improve in the periods ahead, as the Company continues its integration of the MMS and Sodexho North America operations resulting in savings realized from purchasing and administrative actions. These savings are anticipated to reach $60 million annually by fiscal year 2001. The growth in operating profit combined with the gain on sale of investment and reduced corporate expenses contributed to an increase in pretax income of $30 million, or 56%, to $84 million for the Pro Forma First Half Fiscal 1999. The effective tax rate for the current pro forma period was 44%, a decrease from 48% for 1998, due to the implementation of effective tax planning strategies and the lower proportion of nondeductible intangible amortization expense in relation to total operating profit between the years. Net income increased 68% to $47 million, or $0.74 per diluted share, compared with $28 million, or $0.45 per diluted share for Pro Forma First Half Fiscal 1998. -7- PART I FINANCIAL INFORMATION (UNAUDITED) ITEM 1. FINANCIAL STATEMENTS SODEXHO MARRIOTT SERVICES, INC. CONDENSED CONSOLIDATED STATEMENT OF INCOME ($ in millions, except per share amounts) (Unaudited) THIRTEEN TWELVE TWENTY-SIX TWENTY-EIGHT WEEKS WEEKS WEEKS WEEKS ENDED ENDED ENDED ENDED FEBRUARY 26, MARCH 27, FEBRUARY 26, MARCH 27, 1999 1998 1999 1998 ---------------- ----------------- ---------------- ----------------- SALES $1,090 $1,111 $2,299 $2,747 Operating Costs and Expenses 1,016 1,072 2,124 2,632 Loss on Sale of MMS-UK Operations -- -- -- 22 ---------------- ----------------- ---------------- ----------------- 1,016 1,072 2,124 2,654 ---------------- ----------------- ---------------- ----------------- OPERATING PROFIT BEFORE CORPORATE ITEMS 74 39 175 93 CORPORATE ITEMS: Corporate expenses, including amortization of intangible assets (33) (43) (67) (73) Interest expense, net (21) (16) (44) (36) Gain on sale on investment -- -- 8 -- ---------------- ----------------- ---------------- ----------------- Income (Loss) From Continuing Operations, Before Income Taxes and Extraordinary Item 20 (20) 72 (16) (Provision) benefit for income taxes (9) 9 (32) 5 ---------------- ----------------- ---------------- ----------------- INCOME (LOSS) FROM CONTINUING OPERATIONS, BEFORE DISCONTINUED OPERATIONS AND EXTRAORDINARY ITEM 11 (11) 40 (11) Discontinued operations, net of income taxes -- 77 -- 185 ---------------- ----------------- ---------------- ----------------- Income Before Extraordinary Item 11 66 40 174 Loss from extraordinary item, net of income taxes -- (43) -- (43) ---------------- ----------------- ---------------- ----------------- NET INCOME $ 11 $ 23 $ 40 $ 131 ================ ================= ================ ================= BASIC EARNINGS PER SHARE: Continuing Operations $ 0.18 $(0.34) $ 0.64 $(0.34) Discontinued Operations -- 2.43 -- 5.72 ---------------- ----------------- ---------------- ----------------- 0.18 2.09 0.64 5.38 Extraordinary Item -- (1.36) -- (1.36) ---------------- ----------------- ---------------- ----------------- BASIC EARNINGS PER SHARE $ 0.18 $ 0.73 $ 0.64 $ 4.02 ================ ================= ================ ================= DILUTED EARNINGS PER SHARE: Continuing Operations $ 0.18 $(0.34) $ 0.63 $(0.34) Discontinued Operations -- 2.43 -- 5.72 ---------------- ----------------- ---------------- ----------------- 0.18 2.09 0.63 5.38 Extraordinary Item -- (1.36) -- (1.36) ---------------- ----------------- ---------------- ----------------- DILUTED EARNINGS PER SHARE $ 0.18 $ 0.73 $ 0.63 $ 4.02 ================ ================= ================ ================= See notes to condensed consolidated financial statements. -8- SODEXHO MARRIOTT SERVICES, INC. CONDENSED CONSOLIDATED BALANCE SHEET ($ in millions) FEBRUARY 26, AUGUST 28, 1999 1998 (UNAUDITED) ------------------ ------------------- ASSETS Current Assets Cash and equivalents $ 66 $ 79 Accounts and notes receivable, net 513 374 Other 152 152 ------------------ ------------------- Total current assets 731 605 Property and equipment, net 78 82 Intangible assets, net 558 573 Other assets 79 81 ------------------ ------------------- $ 1,446 $ 1,341 ================== =================== LIABILITIES AND STOCKHOLDERS' DEFICIT Current Liabilities Current portion of long-term debt $ 121 $ 96 Accounts payable 272 222 Other current liabilities 386 328 Payable to affiliates for excess net tangible assets 15 49 ------------------ ------------------- Total current liabilities 794 695 Long-term debt 1,021 1,062 Other long-term liabilities 108 110 Convertible subordinated debt 29 29 Stockholders' Deficit Preferred stock, no par value, 1 million shares authorized; no shares issued - - Common stock, $1 par value, 300 million shares authorized; 62 million shares issued and outstanding 62 62 Additional paid-in capital 1,325 1,322 Accumulated deficit (1,895) (1,946) Accumulated other comprehensive income 2 7 ------------------ ------------------- Total stockholders' deficit (506) (555) ------------------ ------------------- Total liabilities and stockholders' deficit $ 1,446 $ 1,341 ================== =================== See notes to condensed consolidated financial statements. -9- SODEXHO MARRIOTT SERVICES, INC. CONDENSED CONSOLIDATED STATEMENT OF CASH FLOW ($ in millions) (Unaudited) TWENTY-SIX TWENTY-EIGHT WEEKS ENDED WEEKS ENDED FEBRUARY 26, 1999 MARCH 27, 1998 --------------------- --------------------- CASH PROVIDED BY OPERATING ACTIVITIES Net Income $ 40 $ 131 Adjustments to reconcile to cash provided by continuing operations: Income from discontinued operations -- (185) Loss on retirement of debt, net of tax -- 43 Depreciation and amortization expense 42 52 Gain on sale of investment (8) -- Deferred income taxes -- 5 Changes in working capital (39) (9) Changes in discontinued operations -- 144 Other 3 -- --------------------- --------------------- NET CASH PROVIDED BY CONTINUING OPERATING ACTIVITIES 38 181 CASH FLOW FROM INVESTING ACTIVITIES Capital expenditures (33) (175) Net cash - Acquisitions -- 24 Dispositions 22 130 Payments for excess net tangible assets (22) -- Cash - distributed operations -- (305) Net investment in discontinued operations -- (217) Other (5) (30) --------------------- --------------------- NET CASH USED IN INVESTING ACTIVITIES (38) (573) CASH FLOW FROM FINANCING ACTIVITIES Proceeds from issuances of long-term debt -- 1,923 Proceeds from borrowings from short-term credit facility 20 -- Repayments of long-term debt (35) (1,816) Proceeds received from Sodexho -- 304 Issuance of common stock 2 84 Purchases of treasury stock -- (159) Dividends paid - common stock -- (22) --------------------- --------------------- NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES (13) 314 --------------------- --------------------- NET DECREASE IN CASH AND CASH EQUIVALENTS (13) (78) CASH AND CASH EQUIVALENTS BEGINNING OF PERIOD 79 160 --------------------- --------------------- CASH AND CASH EQUIVALENTS END OF PERIOD $ 66 $ 82 ===================== ===================== See notes to condensed consolidated financial statements. -10- SODEXHO MARRIOTT SERVICES, INC. CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' DEFICIT (amounts in millions) (Unaudited) ACCUMULATED OTHER NUMBER ADDITIONAL COMPREHENSIVE OF COMMON PAID-IN ACCUMULATED INCOME SHARES STOCK CAPITAL DEFICIT (EXPENSE) TOTAL - ------------ ------------------------------- --------------- -------------- --------------- ----------------- --------------- 61.9 Balance, August 28, 1998 $62 $1,322 $(1,946) $7 $(555) -- Net income -- -- 40 -- 40 Reclassification of gain realized in net income, -- net of taxes -- -- -- (5) (5) -- Foreign exchange translation -- -- -- 1 1 -- Other -- -- -- (1) (1) - ------------ ------------------------------- --------------- -------------- --------------- ----------------- --------------- -- TOTAL COMPREHENSIVE INCOME -- -- 40 (5) 35 Adjustment of distribution -- to shareholders -- -- 11 -- 11 Employee stock plan 0.3 issuance and other -- 3 -- -- 3 - ------------ ------------------------------- --------------- -------------- --------------- ----------------- --------------- 62.2 Balance, February 26, 1999 $62 $1,325 $(1,895) $2 $(506) ============ =============================== =============== ============== =============== ================= =============== See notes to condensed consolidated financial statements. -11- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION Sodexho Marriott Services, Inc. (together with its consolidated subsidiaries, the "Company") is the leading provider in North America of outsourced food and facilities management services to businesses, health care facilities, colleges and universities, and primary and secondary schools. Food services include food and beverage procurement, preparation and menu planning, as well as the operation and maintenance of food service and catering facilities, generally on a client's premises. Facilities management services include plant maintenance, energy management, grounds keeping, housekeeping and custodial services. The Company was formerly named Marriott International, Inc. ("MI"). Upon consummation of the Distribution, Acquisition and Refinancing (collectively, the "Transactions"), which occurred on March 27, 1998, the last day of the first quarter of 1998, Marriott International, Inc. was renamed Sodexho Marriott Services, Inc. As of March 27, 1998, the principal business of the Company changed from lodging and contract services to food and facilities management services. In connection with the Distribution and Acquisition, the Company restructured and refinanced its debt. The Transactions are explained in detail below and in Notes 2 and 3. The accompanying Condensed Consolidated Financial Statements of the Company have been prepared without audit. Certain information and footnote disclosures normally included in financial statements presented in accordance with generally accepted accounting principles have been condensed or omitted. The Company believes the disclosures made are adequate to make the information presented not misleading. However, the Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company's Transition Report on Form 10-K for the period ended August 28, 1998. In the opinion of the Company, the accompanying Condensed Consolidated Financial Statements reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position of the Company as of February 26, 1999 and August 28, 1998, and the results of operations for the 13 weeks and 26 weeks ended February 26, 1999 and the 12 weeks and 28 weeks ended March 27, 1998. Interim results are not necessarily indicative of fiscal year performance. All material intercompany transactions and balances between Sodexho Marriott Services, Inc., and its consolidated subsidiaries have been eliminated. Certain amounts previously presented have been reclassified to conform to the current presentation. Additionally, related to the Distribution on March 27, 1998, the Company has combined the results of operations and cash flow items of the lodging segment as "Discontinued Operations" for all periods presented prior to the Distribution (see "Distribution" below and Note 2). DISTRIBUTION On March 27, 1998, the Company completed the Distribution to its shareholders, on a pro rata basis, of all outstanding shares of New Marriott MI, Inc. ("New Marriott"), a wholly owned subsidiary of the Company, in a tax-free distribution (the "Distribution"). New Marriott conducts the lodging (including timeshare resort development and operation), senior living services and distribution service businesses previously conducted by the Company and changed its name to Marriott International, Inc. The food service and facilities management business continues to be conducted by the Company. Immediately after the Distribution, the Company acquired the North American food service and facilities management operations of Sodexho Alliance, S.A. ("Sodexho") in exchange for stock of the Company, with the Company operating the combined food service and facilities management businesses under the name - Sodexho Marriott Services, Inc. As a result of the issuance of new shares of the Company's common stock to Sodexho in connection with the Acquisition, the shareholders that owned 100% of the Company immediately prior to the Distribution owned approximately 51% of the Company thereafter. At the same time, the Company obtained financing arranged by Sodexho, to refinance certain existing indebtedness of the Company. -12- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED DISTRIBUTION, CONTINUED For the purposes of governing certain of the ongoing relationships between MI and the Company after the Distribution and to provide for an orderly transition, MI and the Company entered into various agreements including the Employee Benefits and Other Employment Matters Allocation Agreement, Liquid Yield Option Notes (LYONs) Allocation Agreement, Tax Sharing Agreement, Trademark and Trade Name License Agreement, Noncompetition Agreement, Employee Benefit Services Agreement, Procurement Services Agreement, Distribution Services Agreement and other transitional services agreements. Effective March 27, 1998, these agreements provided, among other things, that MI assumed administration of certain of the Company's employee benefit plans and insurance programs as well as succeed to the Company's liability to LYONs holders under the LYONs Indenture, a portion of which was assumed by the Company. In connection with the Distribution, on October 31, 1997, the Company sold the MMS- UK operations to Sodexho for $50 million in cash. The sale resulted in a pretax loss of $22 million ($14 million after-tax, or $0.40 per share). As part of the Transactions, the Company entered into separate agreements with MI and Sodexho that established reasonable amounts of adjusted net tangible assets (as defined in the agreements) for the respective operations that were not part of the Distribution immediately prior to the consummation of the Transactions. These agreements provided that the Company would pay MI and Sodexho an amount by which the adjusted net tangible assets total is greater or less than certain predetermined amounts, which resulted in an estimated $29 million and $20 million, payable to MI and Sodexho, respectively, as of August 28, 1998. Subsequent to the close of the current quarter, the Company completed arbitration with MI and Sodexho resulting in payments totaling $36 million, of which $22 million was paid prior to February 26, 1999 and the remaining $14 million was paid thereafter. The $10 million reduction in the payable to MI was mostly due to adjustments related to deferred taxes, with an offsetting adjustment to stockholders' deficit related to the Transaction's distribution to shareholders. REVERSE STOCK SPLIT The Company combined every four shares of its common stock into one share of the Company's common stock pursuant to a reverse stock split on March 27, 1998. All share and per share data has been adjusted to reflect a one-for-four reverse stock split effective March 27, 1998. FISCAL YEAR On April 15, 1998, the Company's Board of Directors approved a change in the Company's fiscal year end from the Friday closest to the end of December to the Friday closest to the end of August, effective immediately. This change resulted in a 34-week transition period (the "Transition Period") from the end of fiscal 1997 to the end of the new fiscal year on August 28, 1998. The new fiscal 1999 year will have 53 weeks, ending on September 3, 1999. REVENUE RECOGNITION AND ACCOUNTS AND NOTES RECEIVABLE Revenues are recognized at the time services are rendered or products are delivered. Revenues include reimbursements for food and payroll costs incurred on behalf of customers under contracts in which the Company manages food service programs for a fee. Losses, if any, are provided for at the time management determines the cost will ultimately exceed contract revenue for the duration of the contract. The allowance for doubtful accounts for continuing operations was $18 million and $17 million at February 26, 1999 and August 28, 1998, respectively. Concentration of credit risk within accounts receivable is limited because a large number of customers make up the Company's customer base, thus spreading risk associated with trade credit. In addition, the Company closely monitors its accounts receivable. The Company generally does not require collateral and maintains reserves for potential uncollectible amounts, which, in the aggregate, have not exceeded management's expectations. -13- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED IMPAIRMENT OF LONG-LIVED ASSETS Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the sum of undiscounted expected future cash flow is less than the carrying amount of long-lived assets, the Company recognizes an impairment loss based on the amount by which the carrying amount of the asset exceeds the fair value of the asset. INTEREST-RATE AGREEMENTS The Company's policies prohibit the use of derivative instruments for trading purposes and procedures are in place to monitor and control their use. The use of derivative instruments is limited to interest-rate agreements for the purpose of reducing the variability of the Company's debt costs. These agreements are entered into in conjunction with the issuance of the debt they are intended to modify. The notional balances of these agreements represent a balance used to calculate the exchange of cash flows and are not assets or liabilities of the Company, and do not represent an exposure to credit loss. The notional amount and interest payments of these agreements match the cash flows of the related debt. Accordingly, any market risk or opportunity associated with these agreements is offset by the opposite market impact on the related debt. The Company's credit risk related to interest-rate agreements is considered low because they are entered into only with strong creditworthy counterparties and are generally settled on a net basis. The difference paid or received on interest-rate agreements is recognized as an adjustment to interest expense. INCOME TAXES The Company recognizes deferred tax assets and liabilities based upon the expected future tax consequences of existing differences between the financial reporting and tax reporting bases of assets and liabilities and operating loss and tax credit carryforwards. EARNINGS PER SHARE The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share," in fiscal 1997. Under SFAS No. 128, basic earnings per share is computed by dividing net income by the weighted-average number of outstanding common shares. Diluted earnings per share is computed by dividing net income, adjusted for interest expense related to convertible securities (after-tax), by the diluted weighted-average number of outstanding common shares, including the "if-converted" shares relating to convertible securities. On March 27, 1998, the Company's common stock underwent a one-for-four reverse stock split. Earnings per share computations have been restated to reflect this reverse stock split. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less at date of purchase to be cash equivalents. The Company uses drafts in its cash management system. At February 26, 1999 and August 28, 1998, the Company had $77 million and $34 million of outstanding drafts included in accounts payable, respectively. INVENTORIES Inventories consist of food items and supplies, which are stated at the lower of average cost or market, generally using the first-in, first-out method. -14- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED PROPERTY AND EQUIPMENT Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally ranging from 3 to 40 years. Replacements and improvements are capitalized. Leasehold improvements, net of estimated residual value, are amortized over the shorter of the useful life of the asset or the lease term. INTANGIBLE ASSETS Intangible assets primarily consist of goodwill and customer relationships. Intangible assets are amortized on a straight-line basis over periods generally ranging from 30 to 40 years for goodwill and 10 to 20 years for customer relationships. Amortization expense for continuing operations totaled $10 million and $19 million for the 13 weeks and 26 weeks ended February 26, 1999, respectively, compared with $5 million and $12 million for the 12 weeks and 28 weeks ended March 27, 1998, respectively. Amortization expense for discontinued operations totaled $10 million and $24 million for the 12 weeks and 28 weeks ended March 27, 1998. OTHER ASSETS Included in other assets are client investments, which represent amounts provided by the Company to clients at contract inception for the purchase of property and equipment pertaining to the contract. These amounts are amortized over the life of the related contract. When a contract terminates prior to its scheduled termination date, the client generally must repay any unamortized client investment balance to the Company. ACCUMULATED OTHER COMPREHENSIVE INCOME In June 1997, SFAS No. 130--"Reporting Comprehensive Income" was issued, requiring that certain financial activity typically disclosed in stockholders' equity be reported in the financial statements as an adjustment to net income in determining comprehensive income. Items applicable to the Company include activity in foreign exchange translation adjustments and securities available for sale under SFAS No. 115. Items identified as comprehensive income are reported, under separate captions, in the Condensed Consolidated Balance Sheet and the Condensed Consolidated Statement of Stockholders' Deficit. Results for the Canada division are translated to U.S. dollars using the average exchange rates during the period. Assets and liabilities are translated using the exchange rate in effect at the applicable balance sheet date, and the resulting translation adjustments are reflected in stockholders' deficit as accumulated other comprehensive income. Total accumulated other comprehensive income included $2.6 million of gross foreign exchange translations gains, net of taxes totaling $1.1 million, at February 26, 1999. Total accumulated other comprehensive income included $10.1 million of gross unrealized securities gain adjustments under SFAS No. 115, net of taxes totaling $4.0 million and gross foreign exchange translation gains totaling $1.1 million, net of taxes totaling $0.4 million at August 28, 1998. During the first half of fiscal 1999, Total Comprehensive Income was comprised of $40 million in net income, partially offset by the reclassification of the realized gain on the sale of investment totaling $8.3 million pretax, net of taxes totaling $3.7 million, for a cumulative $4.6 million net realized gain on sale of investment recorded to the year-to-date Condensed Consolidated Statement of Income. -15- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED SEGMENT REPORTING In June 1997, SFAS No. 131--"Disclosures about Segments of an Enterprise and Related Information" was issued requiring the reporting of selected segmented information in quarterly and annual reports. Information from operating segments is derived from methods used by the Company's management to allocate resources and measure performance. For fiscal year reporting, the Company disclosed profit/loss, revenues and assets for each segment identified, including reconciliations of these items to consolidated totals. For interim reporting periods, the Company disclosed profit/loss and revenues for each segment. The Company also disclosed the basis for identifying the segments and the types of products and services within each segment. SFAS No. 131 was effective for the Company for the Transition Period ended August 28, 1998 and quarterly beginning in fiscal 1999 (see Note 8), including the restatement of prior periods reported consistent with this pronouncement, if practicable. NEW ACCOUNTING STANDARDS SFAS No. 133-- "Accounting for Derivative Instruments and Hedging Activities," was issued in June 1998 and will require the Company to record derivative instruments, such as interest-rate agreements on the Consolidated Balance Sheet as assets or liabilities, measured at fair value. Currently, the Company treats such instruments as off-balance-sheet items. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the specific use of each derivative instrument and whether it qualifies for hedge accounting treatment as stated in the standard. SFAS No. 133 will be effective for the Company on September 4, 1999, the beginning of fiscal year 2000. The impact to the Company's financial position of implementing SFAS No. 133 is not anticipated to be material. (2) THE DISTRIBUTION AND DISCONTINUED OPERATIONS THE DISTRIBUTION On March 27, 1998, the Company distributed to its shareholders, on a pro rata basis, all outstanding shares of New Marriott MI, Inc., a wholly owned subsidiary of the Company, in a tax-free distribution (the "Distribution"). New Marriott MI, Inc., subsequently renamed Marriott International, Inc. (together with subsidiaries, "MI") conducts business in the lodging segment and two of the three lines of business in the contract services segment - Marriott Senior Living Services ("MSLS") and Marriott Distribution Services ("MDS"). The lodging, MSLS and MDS businesses are collectively referred to as Distributed Operations. The third line of business in the contract services segment, Marriott Management Services ("MMS"), has become the principal business of the Company. DISCONTINUED OPERATIONS As a result of the Distribution, the Condensed Consolidated Financial Statements and Notes thereto have been restated to present the lodging segment distributed to shareholders as Discontinued Operations. The MDS, MSLS and MMS business make up the Contract Services segment in the historical financial statements of the Company. Thus, the distributed operations of MSLS and MDS are presented as continuing operations prior to the date of distribution, March 27, 1998. -16- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (2) THE DISTRIBUTION AND DISCONTINUED OPERATIONS, CONTINUED Discontinued Operations, Net of Income Taxes, is comprised of the following: 28 WEEKS ENDED MARCH 27, 1998 -------------------- ($ in millions, except per share amounts) Sales $4,014 Income Before Income Taxes $ 332 Income Taxes (130) -------------------- Discontinued Operations, Net of Income Taxes 202 Cost Associated with Effecting the Distribution (28) Income Taxes 11 -------------------- Net Costs Associated with Effecting the Distribution (17) -------------------- Discontinued Operations, Net of Income Taxes $ 185 ==================== Basic Earnings Per Share $ 5.72 ==================== Diluted Earnings Per Share $ 5.72 ==================== No identifiable assets or liabilities of the Lodging segment were included in the Condensed Consolidated Balance Sheet as of March 27, 1998. (3) ACQUISITION On March 27, 1998, Sodexho transferred to the Company the operations of Sodexho North America having a fair market value of $278 million, combined with a cash payment of $304 million, in exchange for 29.9 million shares of the Company's common stock, after giving effect to the one-for-four reverse stock split (see Note 1 and Note 6). The purchase price included approximately $3 million in transaction costs. As a result of the issuance of new shares to the Company's common stock to Sodexho in connection with the Acquisition, the shareholders who owned 100% of the Company immediately prior to the Distribution owned approximately 51% immediately thereafter. Certain adjustments have been made to the preliminary allocation of the purchase price to the fair market value of assets acquired, as shown in the table below: ($ in millions) ----------------- Current assets $ 142 Other assets 54 Customer relationships 120 Current liabilities (137) Payable to Sodexho for excess net tangible assets (18) Other liabilities (46) Debt (73) Deferred taxes, net (6) Goodwill 242 ----------------- Subtotal 278 Cash contributed to the Company 304 ----------------- Total purchase price $ 582 ================= -17- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (4) INTEGRATION AND RESTRUCTURING Integration and restructuring actions taken in the 26 weeks ended February 26, 1999, reflect the undertaking by the Company to integrate and realign resources for more effective and efficient execution of operating strategies. Integration costs totaled $13 million during the first half of fiscal 1999. The integration costs include, among other items, training and relocating of former MMS employees, incremental overhead during the integration phase, systems modifications, and other one-time costs. Restructuring costs represent employee termination benefits, office closure expenditures, and other costs related to a restructuring plan initiated from the Transactions. The acquisition reserve, which totaled $11 million at February 26, 1999, generally represents the estimated cost of termination benefits for approximately 350 former Sodexho North America employees as well as the estimated cost for the closure of certain Sodexho North America offices. Acquisition reserve activity, reflecting certain adjustments made to the preliminary allocation of the purchase price to the fair market value of assets acquired (see Note 3), is detailed below: BALANCE AS OF BALANCE AS OF AUGUST 28, 1998 ADJUSTMENTS PAYMENTS FEBRUARY 26, 1999 -------------------- ----------------- ------------- ---------------------- ($ in millions) Employee Terminations $10.0 $(0.2) $(4.6) $ 5.2 Relocation of Sodexho Facilities 2.6 -- (0.9) 1.7 Closures 3.1 1.2 (1.1) 3.2 Other Restructuring 1.6 1.3 (1.8) 1.1 -------------------- ----------------- ------------- ---------------------- Total $17.3 $ 2.3 $(8.4) $11.2 ==================== ================= ============= ====================== In addition, integration expenses recorded in the Condensed Consolidated Statement of Income during the second quarter and first half of fiscal 1999 are detailed below. No restructuring expenses were recorded in the Condensed Consolidated Statement of Income during the first half of fiscal 1999. THIRTEEN WEEKS TWENTY-SIX WEEKS ENDED ENDED FEBRUARY 26, 1999 FEBRUARY 26, 1999 ---------------------- --------------------- ($ in millions) Integration: Duplicate Overhead $2.8 $ 6.5 MMS Relocation -- 0.1 Training Systems 0.4 0.9 Other 2.2 5.5 ---------------------- --------------------- Total $5.4 $13.0 ====================== ===================== -18- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (5) DEBT FEBRUARY 26, AUGUST 28, 1999 1998 ----------------- ----------------- ($ in millions) SHORT-TERM DEBT: Current Portion of Long-Term Debt $ 75 $ 70 Senior Secured Revolving Credit Facility 45 25 Other 1 1 ----------------- ----------------- Total $ 121 $ 96 ================= ================= LONG-TERM DEBT: Senior Secured Credit Facility, maturing 2004 averaging 7.20% in fiscal 1999 $ 465 $ 500 Senior Guaranteed Credit Facility, due 2005 averaging 6.92% in fiscal 1999 620 620 Unsecured debt: Senior Debt, maturing through 2009 averaging 7.07% in fiscal 1999 6 6 Other 1 2 Capital Lease Obligations 4 4 ----------------- ----------------- Total $1,096 $1,132 Amount Reclassified to Short-Term Debt (75) (70) ----------------- ----------------- $1,021 $1,062 ================= ================= Senior Secured Credit Facility-- the senior secured credit facility consists of $235 million of revolving credit and an additional $500 million, six-year term loan facility. Interest is based on a bank prime rate, an amount over the Federal funds rate, or an amount over the London interbank offered rate for Eurodollar deposits ("LIBOR"), payable in arrears quarterly. At February 26, 1999, the Company is paying a rate of 6.96% on the term loan facility, adjusted for fee amortization and hedging costs. The senior secured credit facility is secured predominately by inventory, accounts receivable and the stock of certain subsidiaries of the Company. Up to $100 million of the $235 million revolving credit may be used to collateralize letters of credit, which totaled $26 million at February 26, 1999. At February 26, 1999, $164 million of this facility was not used and was available to the Company. Senior Guaranteed Credit Facility-- the senior guaranteed credit facility consists of a $620 million seven-year term loan. Interest is based on a bank prime rate, an amount over the Federal funds rate, or an amount over LIBOR, payable in arrears quarterly. At February 26, 1999, the Company is paying a rate of 6.82% on this facility, adjusted for fee amortization and hedging costs. This facility is guaranteed by Sodexho, for which the Company pays Sodexho an annual fee of 0.5% of the outstanding balance of the Senior Guaranteed Credit Facility, or $3 million pretax. The Company's debt agreements require the maintenance of certain financial ratios and stockholders' equity balances, and also include, among other things, limitations on additional indebtedness, certain acquisitions, dividend payments, pledging of assets, and other restrictions on operations related to cash flow. The Company met the financial covenants of the debt agreements as of February 26, 1999 and for the 26-weeks then ended. Prior to the Distribution, the Company entered into a $1.5 billion bank credit facility in March 1997. This facility had a term of five years at an interest rate of LIBOR plus a spread, 21.5 basis points, based on the Company's senior debt rating as of January 2, 1998. -19- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (5) DEBT, CONTINUED CONVERTIBLE SUBORDINATED DEBT On March 25, 1996, the Company issued $540 million (principal amount at maturity) of zero coupon convertible subordinated debt in the form of Liquid Yield Option Notes ("LYONs") due 2011. Each $1,000 LYON is convertible at any time, at the option of the holder, into 8.76 shares of the Company's Common Stock prior to the Transactions and the Distribution (see below). The LYONs were issued at a discount representing a yield to maturity of 4.25%. The Company recorded the LYONs at the discounted amount at issuance. Accretion is recorded as interest expense and an increase to the carrying value. Gross proceeds from the LYONs issuance were $288 million. Upon consummation of the Distribution, each LYON was convertible into 2.19 shares of the Company's common stock (after giving effect for the one-for-four reverse stock split), as well as a certain amount of shares of MI's Common Stock. The LYONs were assumed by MI, and the Company assumed responsibility for a portion of the LYONs equal to its pro rata share of the relative equity values of the Company and MI as determined in good faith by the Company prior to the Distribution, although MI remains liable to the holders of the LYONs for any payments that the Company fails to make on its allocable portion. The Company's allocated portion of the LYONS totaled $29 million at February 26, 1999. INTEREST-RATE AGREEMENTS At February 26, 1999, the majority of the Company's debt was payable at variable rates of interest. As part of the Refinancing of the Company's debt, the Company entered into several interest-rate agreements on May 29, 1998 totaling $900 million in notional principal balances to hedge a portion of its variable rate debt. These agreements guarantee a fixed rate of interest over the life of the agreements. The Company is paying a fixed rate ranging between 5.71% and 5.90%, plus a residual margin that is not hedged relating to the underlying variable-rate debt. The weighted-average rate for the total debt portfolio, including the affect of the interest-rate agreements, was 6.91% at February 26, 1999. These agreements expire between August 2001 and February 2005. Details of these interest rate agreements as of February 26, 1999 are as follows: YEAR-TO-DATE NOTIONAL WEIGHTED-AVERAGE NET IMPACT PRINCIPAL FAIR INTEREST RATE TO EARNINGS-- TERMS BALANCE VALUE* PAID RECEIVED 26 WEEKS - --------------------------------------------------------------------------------------------------------- ($ in millions) Received Variable Pay Fixed $400 $(1) 5.71% 5.25% $(0.7) Received Variable Pay Fixed 300 (4) 5.84 5.25 (0.4) Received Variable Pay Fixed 200 (2) 5.90 5.25 (0.4) - --------------------------------------------------------------------------------------------------------- $900 $(7) 5.80% 5.25% $(1.5) ========================================================================================================= <FN> *-- based on the termination cost for these agreements obtained by third party market quotes. </FN> At February 26, 1999, the Company did not have any accrued interest receivable or payable to its counterparties and did not have any unamortized fees or premiums under these agreements. All of the Company's interest-rate agreements are for purposes other than trading. -20- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (5) DEBT, CONTINUED Subsequent to February 26, 1999, the Company entered two new interest-rate agreements to guarantee a fixed rate of interest payments for a portion of its floating interest rate debt. These agreements were entered into on March 30, 1999 and April 1, 1999, with notional principal amounts of $80 million and $70 million, respectively, and will pay a fixed rate of 5.02% and 5.05% while receiving interest based on three-month LIBOR. Both agreements mature in September 1999 and will reduce the Company's exposure to the uncertainty of changes in interest rates during their term. (6) STOCKHOLDERS' DEFICIT STOCKHOLDERS' DEFICIT The Company is authorized to issue three hundred million shares of the Company's common stock, with a par value of $1 per share. One million shares of preferred stock, without par value, are authorized, with none issued. At the Distribution, each shareholder received two shares of New Marriott MI, Inc. stock (renamed Marriott International, Inc.) for each share of the Company's stock. In addition, the Company's stock underwent a one-for-four reverse stock split on March 27, 1998. Prior to the Distribution, the Company's charter authorized the issuance of seventy-five million shares of the Company's common stock, with a par value of $1 per share, with one million shares of preferred stock, without par value, authorized, with none issued. In addition, on March 27, 1998, the Company issued to Sodexho Alliance, S.A., approximately 48% of its shares of common stock, representing 29.9 million shares (after the effect of the reverse stock split), in exchange for $304 million in cash and the operations of Sodexho North America. At February 26, 1999, the Company had 62,169,270 shares outstanding. -21- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (6) STOCKHOLDERS' DEFICIT, CONTINUED EARNINGS PER SHARE The following table details earnings and number of shares used in the basic and diluted earnings per share calculations. THIRTEEN TWELVE TWENTY-SIX TWENTY-EIGHT WEEKS WEEKS WEEKS WEEKS ENDED ENDED ENDED ENDED FEBRUARY 26, MARCH 27, FEBRUARY 26, MARCH 27, 1999 1998 1999 1998 ----------------- ----------------- ---------------- ---------------- (in millions, except per share amounts) (in millions, except per share amounts) COMPUTATION OF BASIC EARNINGS PER SHARE: Net Income (Loss) from Continuing Operations $ 11 $ (11) $ 40 $ (11) Net Income from Discontinued Operations -- 77 -- 185 Net Loss from Extraordinary Item -- (43) -- (43) ----------------- ----------------- ---------------- ---------------- Net Income $ 11 $ 23 $ 40 $ 131 ================= ================= ================ ================ Weighted Average Shares Outstanding 62.1 31.7 62.0 32.3 ================= ================= ================ ================ Basic Earnings (Loss) Per Share: Continuing Operations $0.18 $(0.34) $0.64 $(0.34) Discontinued Operations -- 2.43 -- 5.72 Extraordinary Item -- (1.36) -- (1.36) ----------------- ----------------- ---------------- ---------------- BASIC EARNINGS PER SHARE $0.18 $ 0.73 $0.64 $ 4.02 ================= ================= ================ ================ COMPUTATION OF DILUTED EARNINGS PER SHARE: Diluted Net Income (Loss) from Continuing Operations $ 11 $ (11) $ 40 $ (11) Diluted Net Income from Discontinued Operations -- 77 -- 185 Diluted Net Loss from Extraordinary Item -- (43) -- (43) ----------------- ----------------- ---------------- ---------------- Diluted Net Income $ 11 $ 23 $ 40 $ 131 ================= ================= ================ ================ Weighted Average Shares Outstanding 62.1 31.7 62.0 32.3 Effect of Dilutive Securities: Employee Stock Option Plan 0.6 * 0.8 * Deferred Stock Incentive Plan 0.1 * 0.1 * Convertible Subordinated Debt 1.2 * 1.2 * ----------------- ----------------- ---------------- ---------------- Diluted Weighted Average Shares Outstanding 64.0 31.7 64.1 32.3 ================= ================= ================ ================ Diluted Earnings Per Share: Continuing Operations $0.18 $(0.34) $0.63 $(0.34) Discontinued Operations -- 2.43 -- 5.72 Extraordinary Item -- (1.36) -- (1.36) ----------------- ----------------- ---------------- ---------------- DILUTED EARNINGS PER SHARE $0.18 $ 0.73 $0.63 $ 4.02 ================= ================= ================ ================ <FN> *--The effect of dilutive securities is computed using the treasury stock method and average market prices during the periods. The if-converted method is used for convertible subordinated debt ("debt securities"). For the 12 weeks and 28 weeks ended March 27, 1998, dilutive securities under the employee stock option plan (of 3.5 million and 2.1 million, respectively), the deferred stock incentive plan (of 0.9 million and 0.8 million, respectively), and the debt securities (1.2 million for both periods) were excluded due to the loss from continuing operations. </FN> -22- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (7) EMPLOYEE BENEFIT AND INCENTIVE PLANS DEFERRED COMPENSATION PLANS Employees meeting certain eligibility requirements can participate in the Company's deferred compensation and savings plans. As part of the Distribution, the Company elected to continue the deferred compensation plan and has established a new savings plan for the Company separate from the MI profit sharing plan. The Company assumed the obligations and liabilities of the undistributed portion of the deferred compensation plan in relationship to the employees retained by the Company after the Distribution. The Company currently contributes generally 50% of the participants' contributions to these plans, limited to 6% of compensation, with certain exceptions. For the 13-week and 26-week periods ended February 26, 1999, expenses that related to these plans totaled $3.2 million and $6.8 million, respectively. STOCK OPTION PLANS Prior to the Distribution, the Company amended and restated the 1993 Stock Plan and the 1996 Stock Plan, presently known as the Sodexho Marriott Services, Inc. 1993 and 1998 Comprehensive Stock Incentive Plans, respectively (the "1993 Plan" or the "1998 Plan"). The purpose of these plans is to promote and enhance the long-term growth of the Company by aligning the interests of the employees with the interests of the Company's shareholders. The 1993 Plan will administer the converted stock options prior to the Distribution, with no new awards made under this plan. The 1998 Plan will govern the issuance and administration of conversion awards under the previous 1996 stock plan and will also be available for the issuance of new awards. These stock plans are administered by the Compensation Policy Committee as authorized by the Board of Directors. As part of the Distribution and the amendment of these plans, and in relationship to the changes in the capital structure of the Company after the Distribution, the Board of Directors had approved up to 10 million shares of common stock to be available under the 1998 Plan for converted options as well as new awards. Employee stock options may be granted to officers and key employees at exercise prices not less than the market price of the Company's stock on the date of grant. Most options under the stock option plans are exercisable in cumulative installments of one-fourth at the end of each of the first four years following the date of grant. During the first 26 weeks of fiscal 1999, the Company issued 112,575 new stock option awards. A summary of the Company's stock option activity during the 26 weeks ended February 26, 1999, is presented below: TWENTY-SIX WEEKS ENDED FEBRUARY 26, 1999 -------------------------------------- WEIGHTED NUMBER OF AVERAGE OPTIONS EXERCISE (IN MILLIONS) PRICE ----------------- ----------------- Outstanding at August 28, 1998 5.0 $20 Granted during the twenty-six weeks 0.1 26 Exercised during the twenty-six weeks (0.3) 7 Forfeited during the twenty-six weeks (0.1) 9 ----------------- ----------------- Outstanding at February 26, 1999 4.7 $21 ================= ================= Options exercisable at February 26, 1999 1.4 $14 ================= ================= -23- SODEXHO MARRIOTT SERVICES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (8) BUSINESS SEGMENTS The Company is the leading provider in North America of outsourced food and facilities management services to businesses, health care facilities, colleges and universities, primary and secondary schools and other clients. The Company has six business segments within these markets: Corporate Services, Health Care, Education, Schools, Canada, and Laundries/Other. Prior to the Distribution, the Company was a diversified hospitality company with operations in two business segments: Lodging, which includes development, ownership, operation and franchising of lodging properties under 10 brand names and development and operation of vacation timesharing resorts; and Contract Services, consisting of the Company's principal business operations after the Distribution, in addition to the senior living communities business and the wholesale food distribution business ("Other Contract Services"). SALES AND OPERATING PROFIT BY BUSINESS SEGMENT: 13 WEEKS 12 WEEKS 26 WEEKS 28 WEEKS ENDED ENDED ENDED ENDED FEBRUARY 26, MARCH 27, FEBRUARY 26, MARCH 27, 1999 1998 1999 1998 ---------------- ---------------- ---------------- ---------------- ($ in millions) ($ in millions) GROSS SALES Corporate Services $ 324 $ 222 $ 659 $ 512 Health Care 324 238 639 563 Education 294 204 690 522 Schools 96 87 204 203 Canada 35 24 72 60 Laundries/Other 17 15 35 72 Other Contract Services -- 321 -- 815 ---------------- ---------------- ---------------- ---------------- Contract Services 1,090 1,111 2,299 2,747 Discontinued Operations -- 1,774 -- 4,014 ---------------- ---------------- ---------------- ---------------- Total Gross Sales $1,090 $2,885 $2,299 $6,761 ================ ================ ================ ================ GROSS OPERATING PROFIT Corporate Services $ 21 $ 11 $ 43 $ 23 Health Care 27 12 54 36 Education 16 6 60 33 Schools 7 5 13 10 Canada 2 -- 4 2 Laundries/Other 1 -- 1 -- Other Contract Services -- 5 -- 11 Loss on Sale of MMS-UK Operations -- -- -- (22) ---------------- ---------------- ---------------- ---------------- Contract Services 74 39 175 93 Discontinued Operations -- 158 -- 332 ---------------- ---------------- ---------------- ---------------- Total Gross Operating Profit $ 74 $ 197 $ 175 $ 425 ================ ================ ================ ================ Total Net Operating Profit from Continuing Operations (Contract Services) $ 74 $ 39 $ 175 $ 93 Corporate Items (54) (59) (103) (109) ---------------- ---------------- ---------------- ---------------- Income From Continuing Operations, Before Taxes $ 20 $ (20) $ 72 $ (16) ================ ================ ================ ================ (9) COMMITMENTS AND CONTINGENCIES The nature of the business of the Company causes it to be involved in routine legal proceedings from time to time. Management of the Company believes that there are no pending or threatened legal proceedings that upon resolution would have a material adverse impact to the Company. -24- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS The following discussion presents an analysis of results of operations of the Company for the unaudited 13-week period ended February 26, 1999 ("Second Quarter Fiscal 1999") as compared with the historical unaudited 12-week period ended March 27, 1998. Also included is an analysis for the unaudited 26-week period ended February 26, 1999 ("First Half Fiscal 1999") as compared with the historical unaudited 28-week period ended March 27,1998. While the comparison of the Second Quarter Fiscal 1999 to the previously reported 12-week period in 1998 differs by one week, and the First Half Fiscal 1999 to the previously reported 28-week period differs by two weeks, management believes that these comparisons are reasonable. DUE TO THE SUBSTANTIAL DIFFERENCES IN THE COMPARABILITY OF THE COMPANY'S HISTORICAL OPERATING RESULTS FOR THE FIRST QUARTER AND FIRST HALF FISCAL 1999 VERSUS THE PRIOR FISCAL YEAR'S PERIODS, MANAGEMENT BELIEVES THAT IT IS MOST MEANINGFUL AND RELEVANT, IN UNDERSTANDING THE PRESENT AND ONGOING OPERATIONS OF THE COMPANY, TO REVIEW THE COMPANY'S PRO FORMA OPERATING RESULTS PRESENTED IN THE "INTRODUCTION" SECTION OF THIS REPORT. THIRTEEN WEEKS ENDED FEBRUARY 26, 1999 VS. TWELVE WEEKS ENDED MARCH 27, 1998. Total sales for Second Quarter Fiscal 1999 were $1.09 billion, a decrease of $21 million, or 2%, when compared with $1.11 billion for the 12 weeks ended March 27, 1998. The decline in sales between the periods was mostly attributable to the distribution of the Marriott Distribution Services ("MDS") and Marriott Senior Living Services ("MSLS") divisions to shareholders on March 27, 1998. The results of these divisions were included in total sales in the 12-week period ended March 27, 1998, but were not included in the Second Quarter Fiscal 1999. Excluding the MDS and MSLS divisions, total sales increased $300 million, or 38%. This growth was a result of the Acquisition, which had a significant impact on the current period's sales, with Corporate Services' sales increasing $102 million, or 46%, Health Care's increasing $86 million, or 36%, and Education's increasing $90 million, or 44%. Operating profit before corporate items totaled $74 million for the Second Quarter Fiscal 1999 period, an increase of $35 million, or 90%, over the $39 million in operating profit for the 12-week period ended March 27, 1998. This increase was the result of the significant sales growth in the Corporate Services, Health Care and Education divisions as detailed above. In addition to increased sales, operating margins improved as the result of the Acquisition, with Corporate Services' operating profit increasing $10 million, or 91%, Health Care's increasing $15 million, or 125%, and Education's increasing $10 million, or 167%. Corporate expenses, after excluding $5 million in integration charges, totaled $28 million in the Second Quarter Fiscal 1999 period, down $15 million, or 35% from the 12-week prior period. The Company anticipates increased efficiencies in its operating costs and corporate expenses in the periods ahead, from the integration of the MMS and Sodexho North America operations. These savings are anticipated to reach $60 million annually by fiscal year 2001. Increases in interest expense of $5 million were the result of the Refinancing on March 27, 1998. Income from continuing operations before income taxes increased to $20 million, the result of growth in operating profit between the periods. Discontinued operations, net of income taxes, totaled $77 million for the 12-week period ended March 27, 1998, reflecting net income from the distributed lodging segment. The extraordinary charge for costs associated with the early extinguishment of debt, which was part of the Refinancing on March 27, 1998, was $43 million, net of $28 million in taxes, or $1.36 per basic and diluted share. The Company's effective income tax rate was 44% for the Second Quarter Fiscal 1999, compared with 41% for continuing and discontinued operations in the prior year's period. This increase was due to the higher proportion of nondeductible intangible amortization expense largely from the Acquisition, partially offset by the implementation of effective tax planning strategies. Net income for the Second Quarter Fiscal 1999 was $11 million, or $0.18 per diluted share, compared with a net loss from continuing operations of $11 million, or $0.34 net loss per diluted share, in the prior year's period. Discontinued Operations, net of income taxes, totaled $77 million, or $2.43 per diluted share, reflecting the performance of the Distributed lodging segment in the prior year's period before the Distribution to shareholders on March 27, 1998. -25- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, CONTINUED TWENTY-SIX WEEKS ENDED FEBRUARY 26, 1999 VS. TWENTY-EIGHT WEEKS ENDED MARCH 27, 1998. Total sales for First Half Fiscal 1999 were $2.30 billion, a decrease of $448 million, or 16%, when compared with $2.75 billion for the 28 weeks ended March 27, 1998. The decline in sales between the periods was mostly attributable to the distribution of the Marriott Distribution Services ("MDS") and Marriott Senior Living Services ("MSLS") divisions to shareholders on March 27, 1998. The results of these divisions were included in total sales in the 28-week period ended March 27, 1998, but were not included in the First Half Fiscal 1999. Excluding the MDS and MSLS divisions, total sales increased $367 million, or 19%. This growth was a result of the Acquisition, which had a significant impact on the current period's sales, with Corporate Services' sales increasing $147 million, or 29%, Health Care's increasing $76 million, or 13%, and Education's increasing $168 million, or 32%. Excluding the loss on the sale of MMS-UK operations, operating profit before corporate items totaled $175 million for the First Half Fiscal 1999 period, an increase of $60 million, or 52%, over the adjusted $115 million in operating profit for the 28-week period ended March 27, 1998. This increase was the result of the strong sales growth in the Corporate Services, Health Care and Education divisions as detailed above. In addition to increased sales, operating margins improved as the result of the Acquisition, with Corporate Services' operating profit increasing $20 million, or 87%, Health Care's increasing $18 million, or 50%, and Education's increasing $27 million, or 82%. Corporate expenses, after excluding $13 million in integration charges, totaled $54 million in the First Half Fiscal 1999 period, down $19 million, or 26% from the 28-week prior period. The Company anticipates increased efficiencies in its operating costs and corporate expenses in the periods ahead, from the integration of the MMS and Sodexho North America operations. These savings are anticipated to reach $60 million annually by fiscal year 2001. Increases in interest expense of $8 million were the result of the Refinancing on March 27, 1998. Also, the Company recognized an $8 million gain on the sale of the Company's investment in Bright Horizons Family Solutions ("BFAM"). The Company decided to sell the majority of this investment in BFAM in the First Quarter Fiscal 1999, and the remainder in the Second Quarter Fiscal 1999, for an aggregate pretax gain of $8.3 million, or $4.6 million after-tax ($0.07 per diluted common share). Excluding the $22 million pretax loss from the sale of MMS-UK to Sodexho Alliance in the prior period, income from continuing operations before income taxes increased significantly to $40 million, the result of strong increases in operating profit between the periods. Discontinued operations, net of income taxes, totaled $185 million for the 28-week period ended March 27, 1998, reflecting net income from the distributed lodging segment. The extraordinary charge for costs associated with the early extinguishment of debt, which was part of the Refinancing at March 27, 1998, was $43 million, net of $28 million in taxes, or $1.36 per basic and diluted share. The Company's effective income tax rate was 44% for the First Half Fiscal 1999, compared with 40% for continuing and discontinued operations in the prior year's period. This increase was due to the higher proportion of nondeductible intangible amortization expense largely from the Acquisition, partially offset by the implementation of effective tax planning strategies. Net income for the First Half Fiscal 1999 was $40 million, or $0.63 per diluted share, compared with a net loss from continuing operations of $11 million, or $0.34 loss per diluted share, for the prior year's period. Discontinued Operations, net of income taxes, totaled $185 million, or $5.72 per diluted share, reflecting the performance of the Distributed lodging segment in the prior year's period before the Distribution to shareholders on March 27, 1998. -26- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, CONTINUED LIQUIDITY AND CAPITAL RESOURCES After the Distribution, the Company has been focused on the integration of the former MMS and Sodexho North America operations, capitalizing on its combined market presence as well as focusing on attracting new accounts and enhancing services to sustain growth. The Company is substantially more leveraged on a relative basis than the Company was prior to the Distribution. The Company anticipates that it would have long-term unsecured debt ratings, if obtained, below investment grade based on its pro forma financial statements. The debt resulting from the Refinancing contains restrictive covenants and requires grants of security and guarantees by subsidiaries of the Company, which limit the Company's ability to incur additional debt and engage in certain other activities. Additionally, these debt covenants limit the Company's ability to pay dividends. The Company funds its capital requirements with a combination of existing cash balances and operating cash flow. As of February 26, 1999, the Company had a $235 million revolving credit facility available at an interest rate of 7.47% to provide funds for liquidity, seasonal borrowing needs and other general corporate purposes. At February 26, 1999, $45 million of this facility was outstanding, and an additional $26 million of the revolving credit facility had been utilized by letters of credit outstanding, principally related to insurance programs. The Company believes that cash flow generated from operations and current cash balances will be adequate to finance ongoing capital needs, as well as meet debt service requirements. The Company's debt agreements do not restrict the Company's ability to fund its planned growth initiatives from operating cash flow and existing credit facilities. Prior to the Transactions, the Company paid regular quarterly dividends, including declared dividends of 28 cents per share in each quarter of 1995, 32 cents per share in each quarter of 1996 and the first quarter of 1997, and 36 cents per share in each of the last three quarters of 1997 and the first quarter of 1998. The Company expects to reinvest most of its earnings in its businesses. The Company may pay dividends in future periods, subject to the judgment of its Board of Directors and restrictive covenants in its debt agreements limiting the payment of dividends. In general, the restrictive covenants do not permit the Company to pay dividends to shareholders in an amount greater than 40% of the Company's net income, or 45% when the ratio of the Company's consolidated debt to Earnings Before Interest, Taxes, Depreciation and Amortization ratio ("EBITDA", as defined in the documentation for the credit facility agreements) is less than 4 but not less than 3. This restriction will no longer apply when such ratio is less than 3. The payment and amount of cash dividends on the Company's common stock will be subject to the sole discretion of the Company's Board, which will review the Company's dividend policy at such times as may be deemed appropriate. The Board will closely monitor the results of the Company's operations, capital requirements, and other considerations to determine the dividend to be declared in future periods. The Company is required to make quarterly cash interest payments on its term facilities, as well as scheduled principal repayments on its Senior Secured Credit Facility (as detailed in Note 5 to Condensed Consolidated Financial Statements). Annual interest expense is estimated to be approximately $90 million based on current debt balances, with scheduled principal repayments amounting to approximately: $70 million in 1999; $80 million in 2000; $80 million in 2001; $90 million in 2002; $115 million in 2003 and $65 million in 2004. During the First Half Fiscal 1999, the Company experienced its normal seasonal impact on working capital as accounts receivable and accounts payable decreased from the end of the First Quarter Fiscal 1999. This is consistent with the reduction in overall demand for services in the Education and Schools divisions as the holiday season occurred during the current quarter. However, accounts receivable and accounts payable increased from August 28, 1998, as the Company experienced its normal seasonal decreases in working capital as the overall demand for services in these segments decreases during the summer season. Also, subsequent to the close of the current quarter, the Company completed arbitration with MI and Sodexho related to Adjusted Net Tangible Assets in accordance with the respective Distribution and Acquisition agreements, resulting in payments totaling $36 million (see Note 1-- Distribution), of which $22 million was paid prior to February 26, 1999 and the remaining $14 million was paid thereafter. -27- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, CONTINUED NEW ACCOUNTING STANDARDS SFAS No. 133-- "Accounting for Derivative Instruments and Hedging Activities," was issued in June 1998 and will require the Company to record derivative instruments, such as interest-rate agreements, on the Consolidated Balance Sheet as assets or liabilities, measured at fair value. Currently, the Company treats such instruments as off-balance-sheet items. Gains or losses resulting from changes in the values of those derivatives would be accounted for depending on the specific use of each derivative instrument and whether it qualifies for hedge accounting treatment as stated in the standard. SFAS No. 133 will be effective for the Company on September 4, 1999, the beginning of fiscal year 2000. The impact to the Company's financial position of implementing SFAS No. 133 is not anticipated to be material. YEAR 2000 GENERAL. The Company is actively addressing potential issues associated with the computer programming practice historically used to signify dates by using two digits rather than four digits (e.g. "00" instead of "2000"). Accordingly, the Company's owned and operated computer-based technology may incorrectly process dates and may not distinguish properly between 1900 and 2000, which could result in computer systems failures or miscalculations. These potential issues are collectively referred to as the Year 2000 issue. The Year 2000 issue could arise at any point in the Company's purchasing, supply, processing, distribution and financial chains. Incomplete or untimely resolution of the Year 2000 issue by the Company, its key suppliers, clients and other parties could have a material adverse effect on the Company's business, results of operations, financial condition and cash flow. The Company has established a Year 2000 project (the "Project") to address the Year 2000 issue. The Project's Steering Committee consists of members of the Company's senior management, including representatives from each of the Company's divisions and most corporate functions. This Steering Committee oversees and regularly reviews the status of the Company's efforts on the seven phases of the Project: (1) awareness, (2) inventory, (3) assessment, (4) remediation, (5) testing and validation, (6) implementation and (7) contingency planning. The Steering Committee is also tasked with estimating and controlling the associated costs of the Project. Additionally, the Company has established a Year 2000 Project team, led by an experienced project manager, that is responsible for the day-to-day oversight and coordination of the Company's Year 2000 efforts. YEAR 2000 READINESS DISCLOSURE. The Company began the process of understanding the Year 2000 issue in 1996. The Company's Board of Directors and senior management are committed to minimizing the impact of the Year 2000 issue on the Company's operations. Senior management has grouped the Company's exposure in five general categories: o Internally developed software o Third party software o Infrastructure (mainframe, personal computers, etc.) o Facilities systems o Other external systems (supply chain and other outside relationships) Internally developed software, third party software and infrastructure hardware are all information technology ("IT") systems. Facilities and other external systems are non-IT systems. The inventory and assessment phases both began in 1996. An inventory of internally developed software and the assessment of the necessary remediation are complete. Similarly, an inventory of third party software and mainframe systems is complete. The Company has substantially completed the inventory and assessment of personal computers, which are used at most of the Company's operating locations to support unit level financial and operating systems. The Company is also surveying and assessing facilities systems, which include food service refrigeration and food preparation systems that the Company manages for its clients. The Company also manages elevators, heating, ventilation and air conditioning systems, and other equipment for its clients pursuant to plant operations and maintenance agreements. Because these facilities systems reside at client sites, they are generally not under the Company's control, and responsibility for these systems generally rests with the client. -28- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, CONTINUED YEAR 2000, CONTINUED The assessment of these systems has involved close cooperation between the Company and its clients. With respect to plant operations and maintenance clients, the Company is providing certain services to assist its clients in achieving their Year 2000 objectives relative to their facilities systems. Finally, the Company is in the process of obtaining compliance information regarding its vendors and suppliers and is monitoring the compliance status of other external systems that support the different facets of its business, such as utilities, government entities and other service providers. These systems are not under the Company's control. The remediation phase is complete for internally developed software and mainframe systems. With respect to third party software and personal computers, the Company has formulated a plan establishing the priorities for remediation or contingency planning. Both internal and external resources are involved in executing the plan, which is substantially complete as of March 31, 1999. Systems considered most critical to ongoing operations and those that could have a material adverse effect on the Company's business results of operations, financial condition and cash flow are being given the highest priority. Remediation of facilities systems at its clients' facilities and other external systems is not under the Company's control. However, as stated above, the Company is providing certain services in support of its clients' remediation efforts and is monitoring the progress of external entities. The testing phase is complete for the Company's internally developed software and mainframe systems. The third party validation that these systems are Year 2000 compliant is substantially complete. Third party software and personal computer specifications are being validated where they are considered critical to the Company's business operations. The Company is working with clients and other external entities to validate the compliance status of their systems. The implementation and rollout of compliant systems have been or are expected to be substantially complete by June 30, 1999. Given the large number and geographic diversity of the Company's operating locations, the installation of compliant systems and removal of non-compliant systems, as necessary, at these locations may pose certain difficulties, primarily related to the coordination of efforts and resources in relationship to the geographic constraints. To manage potential points of failure, the Company is developing contingency plans to mitigate the potential disruptions that may result from the Year 2000 issue. Contingency plans and associated cost estimates are expected to be completed by June 30, 1999, and will be continually refined as additional information becomes available. RISKS. There are many risks associated with the Year 2000 issue. Because the Company's Year 2000 compliance depends upon numerous third parties also being Year 2000 compliant on a timely basis, there can be no guarantee that the Company's efforts will prevent a material adverse impact on its business, results of operations, financial condition and cash flow. The possible consequences to the Company of its business partners or the general infrastructure (including transportation, government, utilities, and communications) not being fully Year 2000 compliant include temporary facilities closings, delays in the delivery of products, delays in the receipt of key food products, equipment and packaging supplies, invoice and collection delays and errors, and inventory and supply shortages. These consequences could have a material adverse impact on the Company's business, results of operations, financial condition and cash flow if the Company is unable to conduct its business in the ordinary course. The Company believes that its readiness plan should significantly reduce the adverse effects any such disruptions may have. COSTS. The Company has estimated that the pretax costs to be borne by it to address the Year 2000 issue will be approximately $5-8 million, principally for modification, testing, validation, project management and contingency planning. These are expected to be expensed as incurred and funded from operating cash flow. Through February 26, 1999, approximately $1.8 million had been incurred and expensed. The Company does not separately identify internal costs incurred for the Project, and such costs are mostly related to the Company's IT personnel costs. The actual costs to be incurred by the Company will depend on a number of factors which cannot be accurately predicted, including the extent and difficulty of the remediation and other work to be done, the clients' expectations of the Company's responsibility to help remediate the clients' facilities systems, the availability and cost of consultants, the extent of testing required to demonstrate Year 2000 compliance, the portion of such costs that may be borne by the Company's clients pursuant to existing contractual agreements and the Company's ability to timely collect all payments due to it under existing contracts. -29- ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's earnings are not materially affected by changes in interest rates, due to the relatively low balances of borrowings at floating interest rates as well as notes receivable which earn a variable rate of interest. However, changes in interest rates also impact the fair value of the Company's debt, totaling $1.1 billion at February 26, 1999. If interest rates increased by 100 basis points, the fair value of the Company's debt would have decreased by approximately $24 million, while a 100 basis point decrease in rates would have increased the fair value of the Company's debt by approximately $25 million, based on balances at February 26, 1999. PART II OTHER INFORMATION AND SIGNATURES ITEM 1. LEGAL PROCEEDINGS - -------------------------- There are no material legal proceedings pending against the Company. ITEM 2. CHANGES IN SECURITIES - ------------------------------ None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES - ---------------------------------------- None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ The Annual Meeting of the shareholders of the Company was held on January 13, 1999, in Chantilly, Virginia. Chairman of the Board William J. Shaw presided and 56,321,936 of the 62,110,491 shares outstanding as of the record date of November 25, 1998, were represented at the meeting in person or by proxy. 1-Elections of Directors Nominees for membership on the Board of Directors of the Corporation, listed below, were elected by the shareholders. The following schedule lists the number of shares cast for each nominee: Total Total Votes For Votes Withheld ------------------ ------------------ Pierre Bellon 55,616,066 705,870 Bernard Carton 55,616,066 705,870 Edouard de Royere 55,615,722 706,214 William J. Shaw 55,615,884 706,052 Charles D. O'Dell 55,616,066 705,870 John W. Marriott III 55,615,648 706,288 Doctor R. Crants 55,615,958 705,978 Daniel J. Altobello 55,615,884 706,052 2-Ratification of the appointment of PricewaterhouseCoopers, LLP as independent auditors of the Company for fiscal year 1999: By a vote of 56,261,365 For, to 22,356 Against, with 38,215 Abstaining, the Company's shareholders approved the appointment of PricewaterhouseCoopers, LLP as independent auditors of the Company for fiscal year 1999. -30- ITEM 5. OTHER INFORMATION - -------------------------- None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K - ----------------------------------------- (a) Exhibits Exhibit NO. DESCRIPTIONS ---- ------------ 27 Financial Data Schedule of the Registrant 99 Forward-Looking Statements (b) Reports on Form 8-K None. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SODEXHO MARRIOTT SERVICES, INC. April 9, 1999 /s/ LAWRENCE E. HYATT ----------------------------------------------- Lawrence E. Hyatt Senior Vice President and Chief Financial Officer /s/ LOTA S. ZOTH ----------------------------------------------- Lota S. Zoth Vice President, Corporate Controller and Chief Accounting Officer -31-