FINANCIAL HIGHLIGHTS
(In thousands, except per share data)
AS OF AND FOR THE YEARS ENDED DECEMBER 31 2004 2003 CHANGE
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OPERATING RESULTS
Operating revenue $3,758,568 $3,568,586 5%
Operating income (loss) (1) 336,556 (166,243)
Income (loss) from continuing operations (1, 2) 324,057 (221,975)
Income (loss) from discontinued operations (2) 7,170 (2,712)
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Net income (loss) (1, 2) $331,227 $(224,687)
Diluted earnings (loss) per share:
Income (loss) from continuing operations (1, 2) $1.08 $(0.75)
Income (loss) from discontinued operations (2) 0.02 (0.01)
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Diluted earnings (loss) per share $1.11 $(0.76)
Cash dividends per share $0.43 $0.42 2%
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FINANCIAL POSITION
Total assets $3,140,202 $2,956,426
Total debt 805,088 819,271
Shareholders' equity 991,535 816,517
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CASH FLOWS
Cash from operating activities $375,885 $283,538 33%
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SHARE PRICE RANGE
(TRADED ON THE NEW YORK STOCK EXCHANGE UNDER THE SYMBOL SVM)
High price for the year $13.87 $12.10
Low price for the year 10.65 8.95
Closing price as of December 31, 13.79 11.65
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(1) The Company's goodwill and intangible assets that are not amortized are
subject to at least an annual assessment for impairment by applying a
fair-value based test. During the third quarter of 2003, the Company
recorded a non-cash impairment charge associated with goodwill and
intangible assets at its American Residential Services, American Mechanical
Services and TruGreen LandCare business units of $481 million pre-tax ($383
million after-tax). The impact on diluted earnings per share of this charge
was $1.30.
(2) In January 2005, the Company announced that it had reached a comprehensive
agreement with the Internal Revenue Service regarding its examination of
the Company's federal income taxes through the year 2002. As a result of
this agreement, the Company recorded a non-cash reduction in its fourth
quarter and full year 2004 tax provision, thereby increasing net income by
approximately $159 million. Approximately $150 million related to
continuing operations ($.49 per diluted share) and $9 million related to
discontinued operations ($.03 per diluted share).
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MANAGEMENT DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
CONSOLIDATED REVIEW - 2005 OUTLOOK AND GUIDANCE
For the past several years, ServiceMaster (the "Company") has challenged itself
to perform as it transforms, adapt to new trends in the marketplace, manage its
costs, invest in process and technology improvements, and launch new marketing
programs and service offerings. Management believes that the Company has made a
lot of headway in doing this while also improving its revenue and earnings
growth.
In 2005, the Company is focusing on the following major initiatives:
1. IMPROVING PROBLEM RESOLUTION - The Company believes it can differentiate
its brands by handling problem resolution quicker than its competitors. The
Company's research shows that the number one reason people choose not to
renew with ServiceMaster brands is related to frustrations with problem
resolution.
2. IMPROVING THE SALES PROCESS - The Company is highly focused on improving
its sales process, to be more effective in closing sales by answering and
following up on all inquiries, doing business with customers the way they
prefer it, and by using channels and methods of communicating with
customers that are their preference. This is why the Company is making a
substantial investment in marketing and sales expansion in the first
quarter of 2005.
3. ENABLING AND PROTECTING THE TECHNICIANS - Great service people deliver a
great service experience when they are given the tools to succeed. The
Company is equipping its technicians with the tools necessary to better
serve customers. In 2005, the Company is conducting pilots and planning
rollouts related to improving technician productivity through the
deployment of routing and scheduling tools, increased use of handheld
technologies, and expanded use of global positioning systems.
4. RECOMMITTING TO BEING A VALUES-BASED COMPANY - The Company's commitment to
its objectives is being renewed. Over the last two years, the Company has
re-examined its values. The culmination of this process has resulted in the
addition of a new corporate objective, "To Excel With Customers". The
Company's commitment to honoring God in all we do, to developing our people
and to growing profitably is unwavering. The renewed objectives will be
reviewed with the Company's shareholders at the 2005 Annual Meeting.
As the Company enters 2005, it has brought in a few new executives and promoted
and moved other experienced leaders across businesses. These new combinations of
leaders create teams with complementary skills, bringing together discipline and
ideas, strategy and operational strengths, making sure that the balance of
getting it done in the field every day and making the right decisions for the
long term of our businesses is necessarily and appropriately balanced.
The Company is not satisfied with the financial performance of all its
businesses. While the Company enjoyed strong performances from several units in
2004, senior management believes that there are two businesses that are still
not performing up to their potential; TruGreen LandCare and ARS. In both
businesses, the Company has strengthened the leadership teams and is working on
the right strategies and processes, and management believes progress is being
made. In 2005, the Company is counting on more tangible results in both revenue
and margin improvement in these businesses.
As the Company looks toward 2005, it will stay focused on revenue growth,
pricing, improved retention, and consistently delivering a satisfied service
experience. The Company continues to make investments in its sales force and
processes and technologies to sustain growth. During the Company's off-season
first quarter, it will make incremental investments in salespeople and marketing
programs. In addition, this quarter will also include the first-time absorption
of off-season costs in the Canadian lawn care operations which were acquired in
April 2004. The Company expects these factors will impair first quarter profit
comparisons but will be offset by stronger results in the remaining three
quarters of 2005. The Company continues to expect full year revenue growth for
2005 to be in the mid- to high-single digit range and that earnings per share
will grow somewhat faster than revenues. The Company expects cash flows from
operating activities to continue to substantially exceed net income.
2004 COMPARED WITH 2003
Revenue for 2004 was $3.8 billion, a five percent increase over 2003. All of the
revenue growth was derived from internal sources as the positive impact from
acquisitions was offset by revenue that was eliminated as a result of branch
closures and consolidations at TruGreen LandCare and ARS in 2003 and early 2004.
The five percent overall internal growth rate represents a sharp rebound from
2003 and is the strongest rate of growth that the Company has experienced in the
past five years. Management believes that it is starting to see tangible results
from its initiatives to better differentiate its brands, develop new marketing
methods and channels, and improve customer satisfaction and retention.
The Company reported income from continuing operations in 2004 of $324 million
and income from discontinued operations of $7 million. The net income of $331
million in 2004 compared with a net loss of ($225) million in 2003. Diluted
earnings per share were $1.11 in 2004 and a loss of ($.76) in 2003.
Diluted earnings per share from continuing operations were $1.08 in 2004
compared with a loss of ($.75) in 2003. As more fully discussed below, the
diluted earnings per share from continuing operations for 2004 include a $.49
per share ($150 million) non-cash reduction in the tax provision and the 2003
amount includes a non-cash goodwill and intangible assets
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impairment charge of $1.30 per share ($481 million pre-tax, $383 million
after-tax). Operating income for 2004 was $337 million, compared with a loss of
($166) million in 2003. The 2003 results include the $481 million non-cash
impairment charge.
Management believes that the cost controls and focus on improved efficiencies
that were evident throughout the enterprise during the second half of 2003
remained firmly in place in 2004, and that these were instrumental in helping
the Company overcome approximately $35 million, or $.07 per diluted share, of
incremental variable compensation and fuel costs. The Company expects the growth
in incentive compensation to return to more normal levels in 2005 and in
subsequent years. The increase in operating income in 2004 reflects the impact
of the 2003 impairment charge, strong profit growth at American Home Shield and
TruGreen's ChemLawn operations, a reduced level of operating loss in TruGreen's
landscaping operations and improved profits at ServiceMaster Clean and Terminix,
as well as a $4 million gain that TruGreen ChemLawn realized in the third
quarter of 2004 from the sale of a support facility. These increases were
partially offset by a reduced level of profits at ARS.
TAX AGREEMENT
In January 2005, the Company reached a comprehensive agreement with the Internal
Revenue Service (IRS) regarding its examination of the Company's federal income
taxes through the year 2002. As previously disclosed, the Company had not been
audited by the IRS during the period in which it operated as a master limited
partnership (1987 through 1997) or in subsequent years. Consequently, the
examination covered numerous matters, including the tax consequences resulting
from the Company's reincorporation in 1997, and the sale of its large Management
Services segment in November 2001. The principal terms of the agreement were as
follows:
1. The agreement affirmed the previously identified step-up in the tax
basis of the Company's assets which occurred upon reincorporation. For
income tax reporting purposes, this step-up is generally being
amortized and deducted over the 15 year period ending December 31,
2012.
2. The agreement increased taxes and interest due on the 2001 sale of the
Company's Management Services business. This occurred primarily as a
result of changes in the timing of certain items which were previously
netted against the gain and will now be amortized as additional
deductions over the 15 year period ending December 31, 2016.
3. The agreement resolved all other matters in the years under review.
For 2004, the IRS agreement resulted in a $25 million favorable timing
difference in fourth quarter 2004 tax payments. Pursuant to the agreement, the
Company paid taxes and interest (primarily in February 2005) to the IRS and
various states in the amount of $133 million ($113 million of increased taxes
and $20 million of interest). Existing financial resources were utilized to fund
the payment and the Company does not believe that the payment significantly
impaired its financial flexibility. Also related to the agreement, the Company
will realize an approximate $45 million reduction in the 2005 estimated tax
payments that would otherwise have been paid in the second half of 2005.
Finally, the agreement resulted in incremental future tax benefits of
approximately $57 million, which will be recovered on the Company's tax returns
over the 11 year period ending in 2016.
Certain deferred tax assets which had previously not been recorded due to
uncertainties associated with the complexity of the matters under review and the
extended period of time effectively covered by the examination were recorded.
This resulted in a non-cash reduction in the Company's 2004 income tax
provision, thereby increasing 2004 consolidated net income by approximately $159
million ($150 million, or $.49 per diluted share, related to continuing
operations and $9 million, or $.03 per diluted share, related to discontinued
operations).
2003 IMPAIRMENT CHARGE
In the third quarter of 2003, the Company recorded a non-cash impairment charge
associated with the goodwill and intangible assets at its ARS, AMS and TruGreen
LandCare business units. This charge, which totaled $481 million pre-tax, $383
million after-tax, and $1.30 per share, reduced the carrying value of the assets
to their estimated fair value of $56 million. In accordance with SFAS 142,
"Goodwill and Other Intangible Assets", goodwill and intangible assets that are
not amortized are subject to assessment for impairment by applying a fair-value
based test on an annual basis or more frequently if circumstances indicate a
potential impairment. The Company's annual assessment date is October 1.
OPERATING AND NON-OPERATING EXPENSES
Cost of services rendered and products sold increased four percent compared to
the prior year and decreased as a percentage of revenue to 67.2 percent in 2004
from 68.1 percent in 2003. This decrease reflects a change in the mix of
business as TruGreen ChemLawn, Terminix, and American Home Shield increased in
size in relationship to the overall business of the Company. These businesses
generally operate at higher gross margin levels than the rest of the business,
but also incur relatively higher selling and administrative expenses. Selling
and administrative expenses increased nine percent and increased as a percentage
of revenue to 23.7 percent from 22.9 percent in 2003. The increase in selling
and administrative expenses primarily reflects the change in business mix
described above, as well as an increased level of variable incentive
compensation expense at the headquarters level and increased investments in the
sales force, particularly at Terminix and American Home Shield.
Net interest expense decreased $5 million from 2003, primarily reflecting the
favorable impact of interest rate swap agreements entered into at the end of
2003 and early 2004, and a slightly higher level of investment income from
securities in the American Home Shield investment portfolio. It is important to
note that investment gains are an integral part of the business model at
American Home Shield, and there will always be some market-based variability in
the timing and amount of investment gains realized from year to year.
The comparison of the effective tax rate is impacted by the 2004 reduction in
the tax provision related to the Company's agreement with the IRS, as well as
the impairment charge
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recorded in 2003. The effective tax rate of continuing operations reflects a
benefit of 14 percent in 2004 and a benefit of one percent in 2003. As
previously discussed, the agreement with the IRS resulted in a $150 million
non-cash reduction in the 2004 income tax provision for continuing operations.
The impairment charge recorded in 2003 included a portion of goodwill that was
not deductible for tax purposes, resulting in a tax benefit of $98 million, or
only approximately 20 percent of the pre-tax impairment charge of $481 million.
Excluding the impact of the 2004 IRS agreement and the 2003 impairment charge,
the effective tax rates for continuing operations were 38 percent in 2004 and 37
percent in 2003. The Company expects that its effective tax rate for 2005 will
approximate 39 percent.
SEGMENT REVIEW (2004 VS. 2003)
KEY PERFORMANCE INDICATORS
As of December 31,
2004 2003
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TRUGREEN CHEMLAWN -
Growth in Full Program Contracts 8% 4%
Customer Retention Rate 62.2% 59.5%
TERMINIX -
Growth in Pest Control Customers 7% 2%
Pest Control Customer Retention Rate 78.1% 77.1%
Growth in Termite Customers 0% -2%
Termite Customer Retention Rate 87.9% 88.1%
AMERICAN HOME SHIELD -
Growth in Warranty Contracts 5% 5%
Customer Retention Rate 55.2% 55.1%
TRUGREEN SEGMENT
The TruGreen segment includes lawn care services performed under the TruGreen
ChemLawn brand name and landscape maintenance services provided under the
TruGreen LandCare brand name. The TruGreen segment reported revenue of $1.4
billion in 2004, five percent above the prior year. The segment reported
operating income of $171 million in 2004 compared to an operating loss of ($34)
million in 2003. During the third quarter of 2003, the Company recorded a
non-cash impairment charge of $189 million pre-tax, relating to goodwill and
intangible assets of its TruGreen LandCare operations. For a further discussion
of the impairment charge see the "Goodwill and Intangible Assets" section in the
Notes to Consolidated Financial Statements. The increase in segment operating
income reflects the impact of the 2003 impairment charge as well as a strong
increase in profits in the lawn care operations, a $4 million gain from the sale
of a support facility, and a reduced level of operating losses in the
landscaping operations.
Revenue in the lawn care operations increased eight percent over 2003. The
growth in revenue was supported by an eight percent increase in customer counts,
with five percent of that growth from organic sources and three percent from
acquisitions. The organic customer count growth reflected continued significant
improvement in customer retention, partially offset by a modest decline in new
sales. The customer retention improvement of 270 basis points in 2004 was
geographically broad-based, resulting from programs implemented to improve
customer communications and problem resolution, initiatives to produce more
visible results, focused incentive compensation structures at all levels, and
more favorable weather conditions. Over the last three years, the retention rate
has improved by 450 basis points, reflecting management's concerted focus on
customer satisfaction.
Management is encouraged with the progress TruGreen has made in diversifying its
marketing model, with telemarketing now accounting for about 60 percent of its
new sales, down from over 90 percent just a few years ago. Overall, new sales in
2004 were down less than two percent, reflecting a decline in telemarketing
sales as a result of new restrictions, including implementation of the National
Do Not Call registry, offset by a substantial increase in sales from new
channels such as neighborhood sales efforts and direct mail. In 2005, the
Company anticipates that the proportion of non-telemarketing sales to total
sales will continue to grow. One important timing matter to note is that as the
Company continues to develop these new channels, the timing of customer sales
will trend more heavily toward the early part of the second quarter versus the
historical first quarter period where telemarketing was more heavily
concentrated.
In April 2004, TruGreen ChemLawn acquired the assets of Greenspace Services
Limited ("Greenspace"), Canada's largest professional lawn care service company.
The Greenspace acquisition continues to perform above the Company's initial
financial expectations.
Operating income in the lawn care operations grew nine percent, with
approximately three percent of the increase related to the $4 million gain
realized from the sale of a support facility in the third quarter. Operating
income margins improved slightly, reflecting the impact of the support facility
gain, partially offset by increased fuel and chemical costs as well as increased
variable incentive compensation costs.
Revenue in the landscape maintenance business was consistent with prior year
levels, reflecting stronger volume of enhancement sales (e.g., add-on services
such as seasonal flower plantings, mulching, etc.) and a comparable level of
base contract maintenance revenue, offset by the effects of branch
consolidations and closures that were completed in late 2003 and early 2004.
Excluding the impact of branch consolidations, revenue increased two percent.
The growth in enhancement revenue reflects the impact of focused sales efforts
and an improving economy. The level of operating loss in the landscaping
operations improved, reflecting the favorable grow-over effects of the 2003
impairment charge, an increased level of enhancement sales, and an improvement
in materials expense. These items were offset in part by a weather-related
reduction in high-margin snow removal revenue and higher variable incentive
compensation and fuel costs.
Although the Company believes that TruGreen LandCare has significant
opportunities for further improvement, it is encouraged by their accomplishments
in 2004 and the Company believes that the recently strengthened management team
will continue to show progress in 2005 and beyond. Key strategic priorities
include continuing to strengthen the sales organization, increasing customer
retention, and improving performance at underperforming branches by focusing on
operating consistency through better process disciplines,
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especially in the areas of labor management and in the pricing of new jobs.
Capital employed in the TruGreen segment increased one percent, reflecting
acquisitions, offset in part by improved working capital management. Capital
employed is a non-U.S. GAAP measure that is defined as the segment's total
assets less liabilities, exclusive of debt balances. The Company believes this
information is useful to investors in helping them compute return on capital
measures and therefore better understand the performance of the Company's
business segments.
TERMINIX SEGMENT
The Terminix segment, which includes termite and pest control services, reported
a five percent increase in revenue to $997 million from $945 million in 2003 and
operating income of $133 million compared to $131 million in the prior year, a
one percent increase.
Entering 2004, Terminix was making significant changes to its operating model
with the implementation of a dual service offering for termites and the
migration in pest control from monthly to quarterly service frequency. With the
improved efficacy of liquid termite treatments, the Company began providing
consumers with the choice of receiving termite services through baiting systems
or liquid treatments. As previously disclosed, with this enhanced termite
offering, the Company anticipated and did experience a shift in the mix of its
termite customer base from bait to liquid. While the estimated lifetime values
of these two types of offerings are comparable, the earnings cycles are
different with liquid customers having less first year revenues and profits but
more profitability in subsequent years. By offering consumers a choice in
treatments, Terminix was able to increase the average price realized for each of
the two treatment alternatives, thus helping to offset the adverse, short-term
revenue and profit impacts of the mix shift. The mix of new termite sales
("termite completions"), which represent about a quarter of Terminix's total
revenue, moved from approximately 80 percent bait and 20 percent non-bait at the
end of 2003 to approximately 45 percent bait and 55 percent non-bait at the end
of 2004. As a result, overall termite completion revenue increased only modestly
in 2004, even though the Company achieved solid double-digit unit growth in
sales and improved price realization for each treatment alternative viewed
discreetly.
Termite renewal revenues experienced strong growth, supported by improved
pricing. Pest control revenue increased modestly as high single-digit growth in
customer counts, attributable in part to a 100 basis point improvement in
retention, was partially offset by the unfavorable impact to revenues from the
increased number of customers receiving quarterly service visits versus monthly
service visits. The Company believes this shift has had a positive impact on
improving customer satisfaction and has already caused and should continue to
lead to improved labor efficiencies.
Operating income grew modestly as the projected termite mix shift did have a
negative effect on first year gross profit. Operating income was also adversely
impacted by higher insurance, fuel, and bad debt costs, as well as the costs
associated with a procedural change in the branches to ensure that termite
renewal reinspections occur before the actual renewal payments are due. In 2004,
the Company recorded a final adjustment to reflect positive trending in damage
claim costs associated with the Sears termite customer base acquired several
years ago. This resulted in an $8 million reduction in expense in 2004, compared
with a $13 million reduction in 2003. In the fourth quarter of 2003, Terminix
corrected its method of recognizing renewal revenue from certain customers who
have prepaid. A cumulative adjustment was recorded reducing fourth quarter 2003
revenue by $9 million and operating income by $7 million.
Capital employed in the Terminix segment increased six percent, primarily
reflecting acquisitions.
AMERICAN HOME SHIELD SEGMENT
The American Home Shield segment, which provides home warranties to consumers
that cover HVAC, plumbing and other systems and appliances, reported an eight
percent increase in revenue to $487 million from $450 million in 2003, and
operating income growth of 24 percent to $72 million compared to $58 million in
2003.
Renewal sales, which are American Home Shield's largest source of revenue,
experienced solid growth, reflecting management's specific programs to improve
satisfaction and retention. Real estate sales, which are the second-largest
channel, had slight growth with volume negatively impacted by strong declines in
home listings in high warranty usage states like California and Texas. And
consumer sales, which are the smallest but fastest-growing channel, experienced
very strong double-digit growth, reflecting an increased level of direct-mail
solicitations. American Home Shield's total new contract sales in the fourth
quarter increased three percent, a rate less than the full year growth rate due
in part to the relative timing of direct mail solicitations.
Operating income increased, reflecting the effects of revenue growth and
continued very strong controls over claim costs. Partially offsetting these
factors were continuing investments to increase market penetration and customer
retention. In 2005, American Home Shield is planning to continue its efforts to
expand sales in less established real estate markets by expanding its sales
force, improving training, and reducing the span of control of sales force
supervisors. These efforts are intended to drive a replication of the results of
high performing account executives. Management is also focusing on continuing to
improve customer satisfaction and retention through enhanced customer
communications.
In the third quarter of 2004, American Home Shield recorded a cumulative,
non-cash negative adjustment to revenue and operating income of approximately
$5.5 million related to the conversion from a historically manual deferred
revenue calculation to an automated computation. In the fourth quarter of 2003,
American Home Shield recorded a cumulative adjustment of a comparable amount
related to a correction in its method of recognizing revenue from customers who
have prepaid.
Capital employed increased 25 percent reflecting a higher level of investments
due to the growth in the business and improved
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market performance. The calculation of capital employed for the American Home
Shield segment includes approximately $258 million and $221 million of cash,
short-term and long-term securities at December 31, 2004 and 2003, respectively.
The interest and realized gains/losses on these investments are reported as
non-operating income/expense.
ARS/AMS SEGMENT
The ARS/AMS segment primarily provides HVAC and plumbing installation and repair
services under the brand names of ARS Service Express, Rescue Rooter,
(collectively "ARS Service Express") and American Mechanical Services (AMS) for
large commercial accounts. The segment reported revenue of $691 million, an
increase of three percent compared to $674 million in 2003. Excluding the
effects of branch closures in 2003, revenue increased six percent. The segment
reported operating income of $6 million compared with an operating loss of
($282) million in 2003. During the third quarter of 2003, the Company recorded a
pre-tax non-cash impairment charge of $292 million relating to goodwill and
intangible assets of this segment. For a further discussion on the impairment
charge see the "Goodwill and Intangible Assets" section in the Notes to
Consolidated Financial Statements. The increase in segment operating income
reflects the impact of the 2003 impairment charge and modest profit growth at
AMS, partially offset by decreased profitability in the ARS Service Express
operations.
Within ARS Service Express, revenue decreased three percent. These operations
reported good growth in residential construction revenue, excluding the impact
of closed branches. Plumbing revenue increased modestly as relatively strong
improvements in sewer line repairs and light commercial services were partially
offset by continued softness in core residential service revenue. Cooler
seasonal temperatures posed a significant challenge to the air-conditioning
business, which experienced a decline in service revenue. HVAC replacement sales
volume increased modestly as the Company's retail initiative and efforts to
increase the sale of higher priced and more energy efficient units helped
mitigate the adverse, weather-related impact on volume.
AMS' revenue increased 16 percent, with profits showing improved momentum in the
second half of the year. The project backlog increased substantially from prior
year-end levels. However, due to competitive industry conditions, backlog margin
percentages were below prior year and the backlog consisted of a greater mix of
longer duration contracts.
The segment's increase in operating income reflects the favorable grow-over
impact of the 2003 impairment charge, offset in part by higher sales, marketing,
insurance and fuel costs as well as the negative impact on ARS Service Express'
HVAC volume from cooler seasonal temperatures.
Capital employed in the ARS/AMS segment increased two percent.
OTHER OPERATIONS SEGMENT
The Other Operations segment includes the Company's ServiceMaster Clean and
Merry Maids operations as well as its headquarters functions. Revenue in this
segment increased eight percent to $164 million in 2004 compared with $152
million in the prior year. On a combined basis, the ServiceMaster Clean and
Merry Maids franchise operations reported revenue growth of 10 percent and a
solid increase in operating income. ServiceMaster Clean continued to experience
strong growth in disaster restoration services. At Merry Maids, a better economy
and improved sales processes have driven steady increases in internal revenue
growth in both the branch and franchise operations. The segment's operating loss
increased over the prior year, primarily reflecting a higher level of variable
incentive compensation expense at the headquarters level, partially offset by
increased profits in the franchise operations.
Total initial and recurring franchise fees represented 2.7 percent and 2.6
percent of consolidated revenue in 2004 and 2003, respectively and direct
franchise operating expenses were 1.7 percent and 1.6 percent of consolidated
operating expenses in 2004 and 2003, respectively. Total franchise fee profits
comprised 10.1 percent and 10.5 percent of consolidated operating income
(without the impairment charge in 2003) before headquarter overheads in 2004 and
2003, respectively. The portion of total franchise fee profits related to
initial fees received from the sales of franchises was not material to the
Company's consolidated financial statements for all periods.
Capital employed in the Other Operations segment increased primarily reflecting
the deferred tax assets recorded at the conclusion of the IRS review.
DISCONTINUED OPERATIONS
During the third quarter of 2003, the Company sold the assets and related
operational obligations of Trees, Inc., the utility line clearing operations of
TruGreen LandCare. In October 2001, the Company's Board of Directors approved a
series of strategic actions which were the culmination of an extensive portfolio
review process. As part of this portfolio review, the Company sold or exited
certain non-strategic or under-performing businesses in 2001 and 2002.
As discussed in the "Income Taxes" note to the consolidated financial
statements, as a result of the Company's comprehensive agreement with the IRS
regarding its examination of the Company's federal income taxes through 2002,
the Company recorded a non-cash reduction in the 2004 tax provision of
discontinued operations, thereby increasing net income of discontinued
operations by $9 million.
The components of discontinued operations income (loss), net of income taxes are
as follows:
(In thousands) 2004 2003 2002
- ------------------------------------------------------------------
Income (loss) from
discontinued
operations $7,170 $(2,107) $4,531
Net loss on
disposition - (605) (4,840)
- ------------------------------------------------------------------
Discontinued
operations $7,170 $(2,712) $(309)
==================================================================
2003 COMPARED WITH 2002
The Company faced challenging weather and economic conditions and 10 year lows
in consumer confidence in the first
6
half of 2003. Late snow and cooler temperatures early in the year in many
regions of the country delayed TruGreen's lawn care production season and
impeded the development of the termite swarm, negatively impacting the volume of
termite services in Terminix. The Company responded to these challenges by
implementing an aggressive cost reduction program which resulted in the
elimination of over 600 jobs, enacting a wage and hiring freeze, reducing
significantly or eliminating incentive compensation for senior management, and
enforcing tighter management of field labor. These actions, as well as more
normal weather conditions in the fourth quarter of 2003, contributed to improved
results in the second half of the year.
Revenue for 2003 was $3.6 billion, two percent above 2002. The Company reported
a net loss from continuing operations in 2003 of ($222) million and a loss from
discontinued operations of ($3) million. The net loss of ($225) million in 2003
compared with net income of $157 million in 2002. Diluted earnings per share
were a ($.76) loss in 2003 and $.51 in 2002.
Diluted earnings per share from continuing operations were a loss of ($.75) in
2003 compared with $.51 in 2002. The diluted earnings per share for 2003 include
the non-cash goodwill and intangible assets impairment charge that is discussed
below. This charge totaled $1.30 per diluted share, $481 million pre-tax, and
$383 million after-tax. Operating income for 2003 was a loss of ($166) million,
compared with income of $335 million in 2002. The 2003 results include the $481
million non-cash impairment charge. The net change in operating income reflects
strong growth at American Home Shield and ServiceMaster Clean and increased
profits in TruGreen's lawn care operations and Terminix, offset by the impact of
the impairment charge, reduced profitability in TruGreen's landscaping
operations as well as at AMS. There was also increased spending at the
headquarters level.
In the third quarter of 2003, the Company recorded a non-cash impairment charge
associated with the goodwill and intangible assets of its ARS, AMS and TruGreen
LandCare business units of $481 million pre-tax, $383 million net of tax, or
$1.30 per diluted share. The pre-tax charge consisted of $224 million at
American Residential Services, $68 million at American Mechanical Services and
$189 million at TruGreen LandCare. The impairment charge included a portion of
goodwill that was not deductible for tax purposes, resulting in a tax benefit of
$98 million or only approximately 20 percent of the pre-tax charge amount.
Throughout the first half of 2003, management believed that the significant
declines in the operating results of these businesses were due to temporary
conditions and that the operations, with an anticipated good summer season,
would show ongoing improvement which would support the amount of goodwill and
intangible assets on the balance sheet. The Company had discussed such events,
trends and expectations in its press releases and periodic filings with the
Securities and Exchange Commission. In the third quarter of 2003, the results
did not improve. In addition, the Company identified certain branch closures at
ARS and announced the sale of its utility line clearing operations at TruGreen
LandCare. The lack of a good 2003 summer season, combined with declining
profitability in the base businesses, led management to conclude that the
businesses were unlikely to meet the previous projections which had supported
the carrying value. A valuation was performed during the third quarter of 2003
which incorporated third quarter 2003 performance. The fair value of the
reporting units was determined primarily by utilizing a discounted cash flow
methodology. The Company used an independent valuation firm to confirm the
Company's assessment of the fair value of its reporting units. Based on the
evaluation, it was determined that the fair values of the ARS, AMS, and TruGreen
LandCare reporting units were less than their carrying values. As a result, in
the third quarter of 2003, the Company recorded a non-cash impairment charge of
$481 million pre-tax, $383 million net of tax, to reduce the carrying value of
the intangible assets to $56 million, their estimated fair value.
During the fourth quarter of 2003, the Company recorded a reduction in revenue
and operating income as a result of a correction in its historical method of
recognizing renewal revenue from certain Terminix and American Home Shield
customers who have prepaid. The effects of the adjustment were not material to
years prior to 2003. This adjustment reduced operating and pre-tax income by $12
million, or $.02 per diluted share in the fourth quarter of 2003. The Company
also recorded a favorable adjustment as a result of positive trending in termite
damage claim costs related to the portion of the customer base that had been
acquired from Sears several years ago. This resulted in a pre-tax reduction in
expense of $7 million in the fourth quarter of 2003 and a total of $13 million,
or $.03 per diluted share, for the full year 2003. Combined, these items reduced
revenue for the fourth quarter of 2003 by $14 million and reduced operating and
pre-tax income in the fourth quarter by approximately $5 million.
OPERATING AND NON-OPERATING EXPENSES
Cost of services rendered and products sold increased one percent compared to
2002 and decreased as a percentage of revenue to 68.1 percent in 2003 from 68.5
percent in 2002. This decrease reflects a change in the mix of business as
TruGreen ChemLawn, Terminix, and American Home Shield increased in size in
relationship to the overall business of the Company. These businesses generally
operate at higher gross margin levels than the rest of the business, but also
incur somewhat higher selling and administrative expenses as a percentage of
revenue. Selling and administrative expenses increased seven percent and
increased as a percentage of revenue to 22.9 percent in 2003 from 21.7 percent
in 2002. The increase in selling and administrative expenses primarily reflects
the change in business mix described above, as well as increased expenditures
for sales and marketing and higher technology and compliance costs at the
headquarters level.
Net interest expense decreased $35 million from 2002, reflecting the payment in
2002 of a $15 million premium to repurchase public bonds, lower interest expense
from reduced debt balances, as well as higher investment income from securities
gains in the American Home Shield investment portfolio.
Comparability of the effective tax rate is impacted by the impairment charge
recorded in the third quarter of 2003 and the use of prior year net operating
losses in 2002. The
7
effective tax rate of continuing operations reflects a one percent benefit in
2003 and a 35 percent provision in 2002. The impairment charge recorded in 2003
included a portion of goodwill that was not deductible for tax purposes,
resulting in a tax benefit of $98 million, or only approximately 20 percent of
the pre-tax impairment charge of $481 million. Excluding the impairment charge,
the 2003 tax rate was 37 percent. The 2002 rate included a one-time benefit from
utilizing the prior year net operating losses of the ServiceMaster Home Service
Center operations, which resulted in a reduction in the tax provision.
SEGMENT REVIEW (2003 VS. 2002)
KEY PERFORMANCE INDICATORS
As of December 31,
2003 2002
----------- -----------
TRUGREEN CHEMLAWN -
Growth in Full Program Contracts 4% 2%
Customer Retention Rate 59.5% 59.3%
TERMINIX -
Growth in Pest Control Customers 2% 2%
Pest Control Customer Retention Rate 77.1% 75.8%
Growth in Termite Customers -2% 0%
Termite Customer Retention Rate 88.1% 89.0%
AMERICAN HOME SHIELD -
Growth in Warranty Contracts 5% 15%
Customer Retention Rate 55.1% 55.0% *
* Restated to conform with the 2003 calculation
TRUGREEN SEGMENT
The TruGreen segment reported revenue of $1.3 billion in 2003, five percent
above 2002. The segment reported an operating loss of ($34) million, compared
with operating income of $165 million in 2002. During the third quarter of 2003,
the Company recorded a non-cash impairment charge of $189 million pre-tax,
relating to goodwill and intangible assets of its TruGreen LandCare operations.
For a further discussion of the impairment charge see the "Goodwill and
Intangible Assets" section in the Notes to Consolidated Financial Statements.
The decrease in segment operating income primarily reflects the impact of the
impairment charge as well as a $15 million decline in profits in the landscaping
operations, partially offset by a $5 million increase in operating income in the
lawn care operations.
Revenue in the lawn care operations increased six percent over 2002 reflecting a
four percent increase in the number of customers, which was supported by tuck-in
acquisitions, and growth in revenue from commercial accounts and ancillary
services. The Company has responded to increased state and federal restrictions
on telemarketing by broadening its marketing approach, with increased
expenditures on direct mail and other advertising. A 10 percent decline in sales
through the traditional telemarketing channel was offset by a doubling of sales
through other channels, most notably direct mail. Sales through
non-telemarketing channels comprised 20 percent of new sales in 2003.
Telemarketing is a cost effective sales channel relative to other channels.
Therefore, as a result of this shift, the Company experienced an increase in its
marketing costs.
Quality of service initiatives resulted in the customer retention rate improving
20 basis points to 59.5 percent in 2003 compared to 59.3 percent in 2002. This
improvement followed a 160 basis point increase in retention achieved in 2002.
Customer feedback indicated that cancellations due to quality issues decreased
relative to 2002, whereas those due to economic considerations increased. The
Company believed this trend is a result of its increased focus on customer
service and problem resolution.
Operating income in the lawn care operations increased three percent compared to
2002. Favorable weather in the fourth quarter of 2003 partially offset the
impact of poor weather in the first quarter of 2003. Margins declined slightly,
reflecting the higher marketing costs discussed above as well as increased
insurance costs.
Revenue in the landscape maintenance business increased two percent compared to
2002, consisting of modest growth in base contract maintenance volume and an
increase in first quarter snow removal revenue, offset by a reduced level of
enhancement sales. Enhancement sales activity was depressed due to the weak
economy and increased pricing pressure from competitors. Operating income in the
landscaping operations declined in 2003, reflecting the impact of the impairment
charge as well as a decreased level of higher margin enhancement sales,
increased insurance and labor costs, and approximately $1.5 million of costs
incurred to consolidate branch locations.
During the third quarter of 2003, the Company sold the assets and related
operational obligations of the utility line clearing operations of TruGreen
LandCare for approximately $20 million in cash. The impact of this sale was not
material to the Company's consolidated financial statements for 2003. The
results of the sold utility line clearing operations have been classified as
discontinued operations and are not included in continuing operations.
Capital employed in the TruGreen segment decreased 16 percent, primarily
reflecting the impact of the impairment charge, partially offset by tuck-in
acquisitions.
TERMINIX SEGMENT
The Terminix segment reported a two percent increase in revenue to $945 million
from $924 million in 2002 and operating income growth of three percent to $131
million compared to $127 million in 2002. The growth in revenue reflects higher
revenue in both termite renewals and pest control. Cooler temperatures earlier
in 2003 that impacted many regions of the country significantly impeded the
development of the termite swarm. This resulted in fewer sales of new termite
contracts and also had a dampening effect on renewals. Operating performance
improved in the second half of 2003 as termite revenue stabilized, customer
retention rates improved and strong cost controls were implemented. Renewal
revenue increased, resulting from favorable mix and pricing. Pest control volume
increased, driven by improved customer retention and stronger commercial sales.
Operating income margins improved slightly compared to 2002, reflecting lower
than expected damage claims in the acquired
8
Sears termite customer base, partially offset by incremental costs associated
with the unit's new branch operating system. In the fourth quarter of 2003,
Terminix corrected its method of recognizing renewal revenue from certain
customers who have prepaid. A cumulative adjustment was recorded reducing fourth
quarter 2003 revenue by $9 million and operating income by $7 million. The
Company also continued to experience positive trending in damage claim costs
associated with its acquired Sears termite customer base, resulting in a $7
million reduction in expense in the fourth quarter of 2003 and a total reduction
of $13 million for the full year 2003.
Capital employed in the Terminix segment was comparable to the level in 2002.
AMERICAN HOME SHIELD SEGMENT
The American Home Shield segment reported a six percent increase in revenue to
$450 million from $424 million in 2002, and operating income growth of 21
percent to $58 million compared to $48 million in 2002. New contract sales
increased eight percent, driven by strong growth in renewal activity, reflecting
both a larger base of renewable customers and improved customer loyalty, as well
as the impact of price increases. Retention rates improved 10 basis points
despite increased cancellations from mortgage refinancings. Sales from the
direct-to-consumer channel increased modestly, with the timing of sales coming
later in 2003 as third-party direct mail solicitations were delayed. Real estate
sales increased slightly for 2003 as a whole, but were adversely impacted later
in the year by a decline in home listings, particularly in California and Texas,
which are two of the Company's largest warranty usage states.
In the fourth quarter of 2003, American Home Shield corrected its method of
recognizing revenue from customers who have prepaid. A $5 million cumulative
adjustment was recorded, reducing fourth quarter 2003 revenue and operating
income by that amount. Operating margins improved 40 basis points due to a
reduction in the current year claims incidence rate and favorable trending of
prior year claims. American Home Shield has been successful in implementing
programs to reduce low cost claims, control the prices paid to its contractor
network, and utilize technology to improve both productivity and customer
convenience.
Capital employed increased 34 percent reflecting a higher level of investments
due to the growth in the business and improved market performance of the
investments. The calculation of capital employed for the American Home Shield
segment includes approximately $221 million and $172 million of cash, short-term
and long-term securities at December 31, 2003 and 2002, respectively. The
interest and realized gains/losses on these investments are reported as
non-operating income/expense.
ARS/AMS SEGMENT
The ARS/AMS segment reported revenue of $674 million, a decrease of six percent
compared to $719 million in 2002. The segment reported an operating loss of
($282) million compared with operating income of $17 million in 2002. During the
third quarter of 2003, the Company recorded a non-cash impairment charge of $292
million pre-tax relating to goodwill and intangible assets of its ARS/AMS
segment. For a further discussion on the impairment charge see the "Goodwill and
Intangible Assets" section in the Notes to Consolidated Financial Statements.
Within ARS Service Express, revenue in 2003 declined five percent, primarily
reflecting an industry-wide reduction in plumbing service calls and the effects
of discontinued branches. HVAC replacement sales from ongoing operations were up
slightly, despite less favorable temperatures and the weak economy. The Company
is encouraged by its progress with specific initiatives to increase replacement
sales through third-party retail channels, and to increase residential sewer
line repairs. In addition, ARS achieved a 98 percent success rate on its
two-hour arrival guarantee in its HVAC service line, which was rolled out in
October 2003 in certain markets. As part of its efforts to offset the revenue
shortfalls it has been experiencing and to improve profitability, ARS has
strengthened its management team and industry experience at all levels,
emphasized higher margin sales, tightened control over indirect costs and
overheads, and sold or closed 12 under-performing branches or service lines.
Those operations had $35 million in revenue in 2002 and $20 million prior to
their closure in 2003. Operating profits at ARS Service Express declined due to
the third-quarter impairment charge as well as a decrease of $.7 million from
operations. These results, however, include incremental shutdown costs and
operating losses prior to disposition of approximately $1.8 million.
AMS' revenue decreased nine percent in 2003, reflecting reduced levels of
project work due to depressed conditions in the commercial construction
industry. The project backlog increased substantially by the end of 2003, but
bid pricing was very competitive and there were longer lead-times for projects
to start.
Capital employed in the ARS/AMS segment declined, reflecting the impact of the
impairment charge.
OTHER OPERATIONS SEGMENT
The Other Operations segment reported a two percent increase in revenue to $152
million in 2003 compared with $149 million in 2002. The combined ServiceMaster
Clean and Merry Maids franchise operations reported revenue growth of eight
percent in 2003, driven primarily by continued excellent results in disaster
restoration services. The impact of the franchise operations revenue growth was
partially offset by $6 million of licensing fees recorded in the third quarter
of 2002 related to the Company's former Terminix United Kingdom operations.
The segment reported an operating loss of ($40) million in 2003 compared with a
loss of ($23) million in 2002. Continued strong growth in operating income of
ServiceMaster Clean was more than offset by higher costs at the headquarters
level related to insurance, marketing and compliance, and the effect of $6
million of non-recurring licensing fee income earned in 2002, as well as the
compensation expense related to a deferred compensation trust. Accounting
standards require that appreciation on investments in a deferred compensation
trust be reflected as compensation expense in computing operating income, with a
corresponding amount of investment income included in non-operating
income/expense.
9
Total initial and recurring franchise fees (excluding trade name license
agreements) represented 2.6 percent of consolidated revenue in both 2003 and
2002, respectively, and direct franchise operating expenses were 1.6 percent and
1.7 percent of consolidated operating expenses in 2003 and 2002, respectively.
Total franchise fee profits (excluding the aforementioned trade name license
agreements) comprised 10.5 percent and 9.4 percent of consolidated operating
income (without the impairment charge for 2003) before headquarter overheads in
2003 and 2002, respectively. The portion of total franchise fee profits related
to initial fees received from the sales of franchises was not material to the
Company's consolidated financial statements for all periods.
2004 FINANCIAL POSITION AND LIQUIDITY
CASH FLOWS FROM OPERATING ACTIVITIES
Net cash provided from operating activities was $376 million in 2004, $92
million more than 2003. The improvement reflects reduced working capital usage
of $45 million, a $25 million favorable timing difference in tax payments
resulting from the agreement with the IRS, and an increased level of profits.
The improvement in working capital reflects a lower rate of cash outflows in
early 2004 relating to incentive compensation earned in 2003, combined with an
increased level of non-cash accruals for 2004 incentives, reflecting a return to
more normal incentive rates. Net cash provided from operating activities has
historically exceeded net income. In 2005, the Company expects this trend to
continue. However, the rate of growth in cash flows from operating activities is
anticipated to temporarily subside due to the aforementioned tax and incentive
items.
Three factors contribute to the Company's strength in its annual cash provided
from operating activities: a solid earnings base, businesses that need
relatively little working capital to fund growth in their operations, and
significant annual deferred taxes. The Company receives a significant annual
cash tax benefit due to a large base of amortizable intangible assets which
exist for income tax reporting purposes, but not for book purposes. A
significant portion of these assets arose in connection with the 1997 conversion
from a limited partnership to a corporation. The 2004 agreement with the IRS
affirmed the previously identified step-up in the tax basis of the Company's
assets which occurred upon reincorporation. This basis will continue to be
amortized and deducted over the 15 year period ending December 31, 2012. This
amortization has resulted in $50 million of annual cash tax benefits.
The 2004 IRS agreement also increased taxes and interest due on the 2001 sale of
the Company's large Management Services segment. This occurred primarily as a
result of changes in the timing of certain items which were previously netted
against the gain and now will be amortized for tax purposes as additional
deductions over the 15 year period ending December 31, 2016. The Company will
now realize an incremental $7 million of annual cash tax benefit.
For 2004, the IRS agreement resulted in a $25 million favorable timing
difference in fourth quarter 2004 tax payments. Pursuant to the agreement, the
Company paid taxes and interest (primarily in February 2005) to the IRS and
various states in the amount of $133 million ($113 million of increased taxes
and $20 million of interest). Existing financial resources were utilized to fund
the payment and the Company does not believe that the payment significantly
impaired its financial flexibility. Also related to the agreement, the Company
will realize an approximate $45 million reduction in estimated tax payments for
2005 that would otherwise have been paid in the second half of that year.
Finally, the agreement resulted in incremental future tax benefits of
approximately $57 million, which will be recovered on the Company's tax returns
over the 11 year period ending in 2016.
In the ordinary course, the Company is subject to review by domestic and foreign
taxing authorities, including the IRS. The Company has been notified by the IRS
that it intends to commence the audits of the Company's 2003, 2004, and 2005
fiscal years in the second quarter of 2005.
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures, which include recurring capital needs and information
technology projects, were above prior year levels reflecting investments in
information and productivity enhancing operating systems. For 2005, the Company
expects capital expenditures to total approximately $50 million.
In 2004, acquisitions totaled $59 million, compared with $38 million in 2003.
The increase in acquisitions reflects TruGreen ChemLawn's purchase of Greenspace
as well as tuck-in acquisition activity at Terminix and TruGreen ChemLawn. In
2005, the Company expects to continue to expand its tuck-in acquisition program
at both Terminix and TruGreen ChemLawn, with overall acquisitions slightly
higher than the 2004 level.
CASH FLOWS FROM FINANCING ACTIVITIES
Cash dividends paid to shareholders in 2004 amounted to $.43 per share, a 2.4
percent increase over 2003. This was the 34th consecutive year of annual growth
in dividends for the Company. Cash dividends paid in 2004 totaled $125 million,
a one percent increase over 2003, reflecting the per share increase, partially
offset by the impact of share repurchases. In February 2005, the Company
announced the declaration of a cash dividend of $.11 per share to shareholders
of record on February 14, 2005. This dividend was paid on February 28, 2005. The
Company expects to continue to increase its per share dividend payment although,
as previously disclosed, at a rate lower than its corresponding growth in
profits. The timing and amount of future dividend increases are at the
discretion of the Board of Directors and will depend among other things, on the
Company's capital structure objectives and cash requirements.
In July 2000, the Board of Directors authorized $350 million for share
repurchases. In 2004, the Company repurchased $64 million of its shares at an
average price of approximately $11.70 per share. There remains approximately $81
million available for repurchases under the July 2000 authorization. The Company
anticipates continuing its share repurchase program in 2005 at a similar level
as 2004. The actual level of future share repurchases will depend on various
factors such as the
10
Company's commitment to maintain investment grade credit ratings and other
strategic investment opportunities.
LIQUIDITY
Cash and short and long-term marketable securities totaled approximately $496
million at December 31, 2004, with approximately $300 million of that amount
effectively required to support regulatory requirements at American Home Shield
and for other purposes. In February 2005, the Company utilized approximately
$125 million of its excess cash amount to fund the previously discussed tax
payments to the IRS and various states.
Total debt at December 31, 2004 was $805 million, approximately $14 million
below the amount at December 31, 2003 and the lowest level since March of 1997.
Approximately 45 percent of the Company's debt matures beyond five years and 34
percent beyond fifteen years. The Company's next public debt maturity of
approximately $138 million is in April 2005. The Company intends to fund this
debt payment with long-term financing under existing credit facilities. Based on
annual projected cash flows, the amount of the borrowing is expected to be
largely repaid by December 31, 2005.
Management believes that funds generated from operating activities and other
existing resources provide it with significant financial flexibility which will
continue to be adequate to satisfy its ongoing working capital needs, enable it
to pay or refinance the maturing debt, as well as meet its obligations under the
agreement with the IRS. During the second quarter of 2004, the Company replaced
its previous $490 million credit facility with a new five-year revolving credit
facility of $500 million expiring in May 2009. As of December 31, 2004, the
Company had issued approximately $158 million of letters of credit under this
facility and had unused commitments of approximately $342 million. The Company
also has $550 million of senior unsecured debt and equity securities available
for issuance under an effective shelf registration statement. In addition, the
Company has an arrangement enabling it to sell, on a revolving basis, certain
receivables to unrelated third party purchasers. The agreement is a 364-day
facility that is renewable at the option of the purchasers. The Company may sell
up to $65 million of its receivables to these purchasers in the future and
therefore has immediate access to cash proceeds from these sales. The amount of
the eligible receivables varies during the year based on seasonality of the
business and will at times limit the amount available to the Company. During
2004, there were no receivables sold to third parties under this agreement.
The Company is party to a number of debt agreements which require it to maintain
certain financial and other covenants, including limitations on indebtedness
(debt cannot exceed 3.25 times EBITDA, as defined) and interest coverage ratio
(EBITDA needs to exceed four times interest expense). In addition, under certain
circumstances, the agreements may limit the Company's ability to pay dividends
and repurchase shares of common stock. These limitations are not expected to be
an inhibiting factor in the Company's future dividend and share repurchase
plans. Failure by the Company to maintain these covenants could result in the
acceleration of the maturity of the debt. At December 31, 2004, and throughout
the year, the Company was in compliance with the covenants and based on its
operating outlook for 2005 expects to be able to maintain compliance in the
future. The Company does not have any debt agreements that contain put rights or
provide for acceleration of maturity as a result of a change in credit rating.
The Company maintains operating lease facilities with banks totaling $68 million
which provide for the acquisition and development of branch properties to be
leased by the Company. At December 31, 2004, there was approximately $68 million
funded under these facilities. Approximately $15 million of these leases have
been included on the balance sheet as assets with related debt as of December
31, 2004 (the comparable balances were $20 million as of December 31, 2003). The
balance of the funded amount is treated as operating leases. During the third
quarter of 2004, the Company replaced an $80 million operating lease facility
that was due to expire in October 2004 with a new five-year operating lease
facility of approximately $53 million expiring in September 2009. The Company
also maintains a $15 million operating lease facility that expires in January
2008. The Company has guaranteed the residual value of the properties under the
leases up to 82 percent of the fair market value at the commencement of the
lease. At December 31, 2004, the Company's residual value guarantee related to
the leased assets totaled $56 million for which the Company has recorded the
estimated fair value of this guarantee (approximately $1.2 million) in the
Consolidated Statements of Financial Position.
The majority of the Company's fleet and some equipment is leased through
operating leases. The lease terms are non-cancelable for the first twelve month
term, and then are month-to-month, cancelable at the Company's option. There are
residual value guarantees (ranging from 70 percent to 87 percent depending on
the agreement) on these vehicles and equipment, which historically have not
resulted in significant net payments to the lessors. At December 31, 2004, there
was approximately $260 million of residual value guarantee relating to the
Company's fleet and equipment leases. The fair value of the assets under the
leases is expected to fully mitigate the Company's obligations under the
agreements. Accordingly, no liabilities have been recorded with respect to the
guarantees.
The following table presents the Company's contractual obligations and
commitments:
(In millions) Total <1 Yr 2-3 Yrs 4-5 Yrs >5 Yrs
- -------------------------------------------------------------------------
Debt balances * $805 $161 $75 $210 $359
Non-cancelable
operating leases 300 79 121 65 35
Purchase
Obligations:
Telecommunications 49 23 26 - -
Supply agreements and
other 44 30 9 5 -
Other long-term
liabilities: *
Insurance claims 188 78 56 21 33
Discontinued operations 20 10 4 2 4
Other 32 2 6 3 21
- -------------------------------------------------------------------------
Total amount $1,438 $383 $297 $306 $452
=========================================================================
* These items are reported in the Consolidated Statements of Financial Position.
Not included in the table above are deferred income tax liabilities and the
related interest payments on the Company's
11
long-term debt. Deferred income tax liabilities totaled $88 million and are
discussed in the Notes to the Consolidated Financial Statements. The majority of
the Company's debt is fixed rate debt. Therefore, the Company has calculated the
expected interest payments to be approximately $52 million, $47 million, $45
million, $42 million, $36 million and $471 million in 2005, 2006, 2007, 2008,
2009, and 2010 and thereafter, respectively.
FINANCIAL POSITION - CONTINUING OPERATIONS
Receivables increased from prior year levels, reflecting general business
growth. Deferred customer acquisition costs were consistent with prior year
levels. The Company capitalizes sales commissions and other direct contract
acquisition costs relating to termite baiting and pest contracts, as well as
home warranty agreements. These costs vary with and are directly related to a
new sale or contract renewal. Property and equipment increased, reflecting
general business growth as well as increases related to information and
productivity enhancing operating systems. The Company does not have any material
capital commitments at this time.
Deferred revenue increased, reflecting growth in warranty contracts written at
American Home Shield. Accrued payroll and related expenses increased from prior
year levels, reflecting an increased level of accruals for 2004 variable
compensation as the Company returned to more normal levels of incentive
earnings. Payments related to the 2004 incentive compensation accruals were made
in the first quarter of 2005. Income taxes payable at December 31, 2004
primarily reflects the February 2005 federal tax payment related to the IRS
agreement.
The Company has minority investors in Terminix. This minority ownership reflects
an interest issued to the former owners of the Allied Bruce Terminix Companies
in connection with the acquisition of that entity. At any time, the former
owners may convert this equity security into eight million ServiceMaster common
shares. The ServiceMaster shares are included in the shares used for the
calculation of diluted earnings per share, when their inclusion has a dilutive
impact. Subsequent to December 31, 2005, ServiceMaster has the ability to
require conversion of the security into ServiceMaster common shares, provided
the closing share price of ServiceMaster's common stock averages at least $15
per share for 40 consecutive trading days.
Total shareholders' equity was $992 million and $817 million at December 31,
2004 and 2003, respectively. The increase reflects operating profits in the
business as well as the non-cash reduction in the 2004 tax provision relating to
the agreement with the IRS, partially offset by cash dividend payments and share
repurchases.
Under federal tax rules, dividends are considered taxable only when paid out of
current or accumulated earnings and profits as defined under federal tax laws.
As a result of its December 1997 reincorporation, the Company only began
generating corporate earnings and profits for tax purposes in 1998. Since 1998,
earnings and profits for tax purposes have been reduced by dividend payments,
amortization of intangible assets for tax reporting, deductions relating to
business closures and the timing of certain other tax-related items. Dividends
paid during 2004 on common stock will be 68 percent taxable as dividend income
for federal income tax reporting purposes. The Company currently expects that
approximately 80 percent of its 2005 dividends on common stock will be taxable
as dividend income, and that the taxable portion of its dividend will grow to be
fully taxable over the next few years.
FINANCIAL POSITION - DISCONTINUED OPERATIONS
The assets and liabilities related to discontinued businesses have been
classified in separate captions on the Consolidated Statements of Financial
Position. Assets from the discontinued operations have declined, reflecting cash
collections on receivables. The decrease in liabilities from discontinued
operations represents a non-cash reduction in tax reserves resulting from the
IRS agreement as well as certain payments. The remaining liabilities primarily
represent obligations related to long-term self-insurance claims.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The economy and its impact on discretionary consumer spending, labor wages, fuel
prices, insurance costs and medical inflation rates could be significant to
future operating earnings.
The Company does not hold or issue financial instruments for trading or
speculative purposes. The Company has entered into specific financial
arrangements, primarily fuel hedges, in the normal course of business to manage
certain market risks, with a policy of matching positions and limiting the terms
of contracts to relatively short durations. The effect of derivative financial
instrument transactions is not material to the Company's financial statements.
In December 2003 and January 2004, the Company entered into interest rate swap
agreements with a total notional amount of $165 million. Under the terms of
these agreements, the Company pays a floating rate of interest (based on a
specified spread over six-month LIBOR) on the notional amount and the Company
receives a fixed rate of interest at 7.88 percent on the notional amount. The
impact of these swap transactions was to convert $165 million of the Company's
debt from a fixed rate of 7.88 percent to a variable rate based on LIBOR.
The Company generally maintains the majority of its debt at fixed rates. After
considering the effect of the interest swap agreements, approximately 78 percent
of total recorded debt at December 31, 2004 was at a fixed rate.
The payments on the approximately $68 million of funding outstanding under the
Company's real estate operating lease facilities as well as its fleet and
equipment operating leases (approximately $260 million in residual value
guarantee) are tied to floating interest rates. The Company's exposure to
interest expense based on floating rates is partially offset by floating rate
investment income earned on cash and marketable securities. The Company believes
its overall exposure to interest rate fluctuations is not material to its
overall results of operations.
The Company has several debt and lease agreements where the interest rate or
rent payable under the agreements automatically adjusts based on changes in the
Company's credit ratings. While the Company is not currently expecting a change
in its
12
credit ratings, based on amounts outstanding at December 31, 2004, a one rating
category improvement in the Company's credit ratings would reduce annual expense
by approximately $0.8 million. A one rating category reduction in the Company's
credit ratings would increase annual expense by approximately $0.9 million.
The following table summarizes information about the Company's fixed rate debt
as of December 31, 2004, including the principal cash payments and related
weighted-average interest rates by expected maturity dates. The fair value of
the Company's fixed rate debt was approximately $673 million at December 31,
2004.
Expected Maturity Date
----------------------------------
There-
(In millions) 2005 2006 2007 2008 2009 after Total
- -----------------------------------------------------------------------
Fixed rate debt $160 $13 $62 $10 $21 $359 $625
Avg. rate 8.0% 6.4% 7.0% 5.8% 7.9% 7.5% 7.5%
=======================================================================
The Company's next public debt maturity of $138 million is in April 2005, and is
included in the 2005 payments in the above table. The Company intends to fund
this debt payment with long-term financing under existing credit facilities.
Based on annual projected cash flows, the amount of the borrowing is expected to
be largely repaid by December 31, 2005.
As previously discussed, the Company has entered into interest rate swap
agreements, the impact of which was to convert $165 million of the Company's
2009 maturity debt from a fixed rate of 7.88 percent to a variable rate based on
LIBOR. Consequently, this debt is not included in the fixed rate debt table
above.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of the financial statements requires management to make certain
estimates and assumptions required under generally accepted accounting
principles which may differ from actual results. The more significant areas
requiring the use of management estimates relate to the allowance for
receivables, accruals for self-insured retention limits related to medical,
workers' compensation, auto and general liability insurance claims, accruals for
home warranty claims, the possible outcomes of outstanding litigation, accruals
for income tax liabilities as well as deferred tax accounts, useful lives for
depreciation and amortization expense and the valuation of tangible and
intangible assets. In 2004, there have been no changes in the significant areas
that require estimates or in the methodologies which underlie these associated
estimates.
The allowance for receivables is developed based on several factors including
overall customer credit quality, historical write-off experience and specific
account analyses that project the ultimate collectibility of the outstanding
balance. As such, these factors may change over time causing the reserve level
to vary.
The Company carries insurance policies on insurable risks at levels which it
believes to be appropriate, including workers' compensation, auto and general
liability risks. The Company has self-insured retention limits and insured
layers of excess insurance coverage above those limits. Accruals for
self-insurance losses and warranty claims in the American Home Shield business
are made based on the Company's claims experience and actuarial projections.
Current activity could differ causing a change in estimates. The Company has
certain liabilities with respect to existing or potential claims, lawsuits, and
other proceedings. The Company accrues for these liabilities when it is probable
that future costs will be incurred and such costs can be reasonably estimated.
Any resulting adjustments, which could be material, are recorded in the period
identified.
The Company records deferred income tax balances based on the net tax effects of
temporary differences between the carrying value of assets and liabilities for
financial reporting purposes and income tax purposes. There are significant
amortizable intangible assets for tax reporting purposes (not for financial
reporting purposes) which arose as a result of the Company's reincorporation
from partnership to corporate form in 1997. The Company records its deferred tax
items based on the estimated value of the tax basis. As discussed in the "Income
Taxes" note to the Consolidated Financial Statements, the Company reached a
comprehensive agreement with the Internal Revenue Service regarding its
examination of the Company's federal income taxes through the year 2002. As a
result of this agreement, certain deferred tax assets which had previously not
been recorded, due to uncertainties associated with the complexity of the
matters under review and the extended period of time effectively covered by the
examination were recorded.
The Company adjusts tax estimates when required to reflect changes based on
factors such as changes in tax laws, results of tax authority reviews and
statutory limitations. As occurred this year when the IRS audit concluded, the
Company reflected the changes from estimated amounts in the period that the need
for adjustment was identified.
Fixed assets, and intangible assets with finite lives, are depreciated and
amortized on a straight-line basis over their estimated useful lives. These
lives are based on the Company's previous experience for similar assets,
potential market obsolescence, and other industry and business data. The Company
also periodically reviews the assets for impairment and a loss would be recorded
if and when the Company determined that the book value of the asset exceeded its
fair value. Changes in the estimated useful lives or in asset values would cause
the Company to adjust its book value or future expense accordingly.
The Company reviews its goodwill and trade names at least once a year for
impairment. An impairment loss would be recorded if and when the Company
determines that the expected present value of the future cash flows deemed to be
derived from the asset is less than its corresponding book value. As permitted
under SFAS 142, the Company carries forward a reporting unit's valuation from
the most recent valuation under the following conditions; the assets and
liabilities of the reporting unit have not changed significantly since the most
recent fair value calculation, the most recent fair value calculation resulted
in an amount that exceeded the carrying amount of the reporting unit by a
substantial margin, and based on the facts and circumstances of events that have
occurred since the last fair value determination, the likelihood that a
13
current fair value calculation would result in an impairment would be remote.
For the 2004 goodwill and trade name impairment review, the Company carried
forward the valuations for all reporting units except ARS. A valuation analysis
performed for ARS indicated no impairment issue.
Revenue from lawn care, pest control, liquid and fumigation termite
applications, as well as heating/air conditioning and plumbing services are
recognized as the services are provided. Revenue from landscaping services are
recognized as they are earned based upon monthly contract arrangements or when
services are performed for non-contractual arrangements. Revenue from the
Company's commercial installation contracts, primarily relating to HVAC and
electrical installations are recognized on the percentage of completion method
in the ratio that total incurred costs bear to total estimated costs. The
Company eradicates termites through the use of baiting stations, as well as
through non-baiting methods (e.g., fumigation or liquid treatments). Termite
services using baiting stations, as well as home warranty services, frequently
are sold through annual contracts for a one-time, upfront payment. Direct costs
of these contracts (service costs for termite contracts and claim costs for
warranty contracts) are expensed as incurred. The Company recognizes revenue
over the life of these contracts in proportion to the expected direct costs.
Revenue from trade name licensing arrangements is recognized when earned.
Franchised revenue consists principally of monthly fee revenue, which is
recognized when the related customer level revenue is reported by the franchisee
and collectibility is assured. Franchise revenue also includes initial fees
resulting from the sale of franchises. These fees are fixed and are recognized
as revenue when collectibility is assured and all material services or
conditions relating to the sale have been substantially performed.
Customer acquisition costs, which are incremental and direct costs of obtaining
a customer, are deferred and amortized over the life of the related contract in
proportion to revenue recognized. These costs include sales commissions and
direct selling costs which can be shown to have resulted in a successful sale.
NEWLY ISSUED ACCOUNTING STATEMENTS AND POSITIONS
In December 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards 123 (revised 2004), "Share-Based
Payment" (SFAS 123 (R)). This Statement replaces SFAS 123, "Accounting for
Stock-Based Compensation", and supercedes APB Opinion No. 25, "Accounting for
Stock Issued to Employees". SFAS 123 (R) requires that stock options and share
grants be recorded at fair value and this value is recognized as compensation
expense over the vesting period. The Statement requires that compensation
expense be recorded for newly issued awards as well as the unvested portion of
previously issued awards that remain outstanding as of the effective date of
this Statement. The provisions of this Statement become effective with the
Company's third quarter 2005 Consolidated Financial Statements. The Company is
presently assessing the impact of this Statement, and currently estimates that
its adoption would reduce annual earnings per share by approximately $.01 to
$.02. This Statement permits the restatement of periods prior to its adoption.
Upon adoption, the Company expects to restate prior periods as if the Statement
were in effect for all periods, resulting in dilution for those periods of a
comparable amount as in 2005.
FORWARD-LOOKING STATEMENTS
THE COMPANY'S ANNUAL REPORT CONTAINS OR INCORPORATES BY REFERENCE STATEMENTS
CONCERNING FUTURE RESULTS AND OTHER MATTERS THAT MAY BE DEEMED TO BE
"FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995. THE COMPANY INTENDS THAT THESE FORWARD-LOOKING
STATEMENTS, WHICH LOOK FORWARD IN TIME AND INCLUDE EVERYTHING OTHER THAN
HISTORICAL INFORMATION, BE SUBJECT TO THE SAFE HARBORS CREATED BY SUCH
LEGISLATION. THE COMPANY NOTES THAT THESE FORWARD-LOOKING STATEMENTS INVOLVE
RISKS AND UNCERTAINTIES THAT COULD AFFECT ITS RESULTS OF OPERATIONS, FINANCIAL
CONDITION OR CASH FLOWS. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER
MATERIALLY FROM THOSE EXPRESSED OR IMPLIED IN A FORWARD-LOOKING STATEMENT
INCLUDE THE FOLLOWING (AMONG OTHERS): WEATHER CONDITIONS THAT AFFECT THE DEMAND
FOR THE COMPANY'S SERVICES; CHANGES IN COMPETITION IN THE MARKETS SERVED BY THE
COMPANY; LABOR SHORTAGES OR INCREASES IN WAGE RATES; UNEXPECTED INCREASES IN
OPERATING COSTS, SUCH AS HIGHER INSURANCE PREMIUMS, SELF INSURANCE AND
HEALTHCARE CLAIM COSTS; HIGHER FUEL PRICES; CHANGES IN THE TYPES OR MIX OF THE
COMPANY'S SERVICE OFFERINGS OR PRODUCTS; INCREASED GOVERNMENTAL REGULATION,
INCLUDING TELEMARKETING; GENERAL ECONOMIC CONDITIONS IN THE UNITED STATES,
ESPECIALLY AS THEY MAY AFFECT HOME SALES OR CONSUMER SPENDING LEVELS; AND OTHER
FACTORS DESCRIBED FROM TIME TO TIME IN DOCUMENTS FILED BY THE COMPANY WITH THE
SECURITIES AND EXCHANGE COMMISSION.
14
FIVE-YEAR FINANCIAL SUMMARY
(In thousands, except per share data) 2004 2003 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------------------
OPERATING RESULTS:
Operating revenue $3,758,568 $3,568,586 $3,500,721 $3,476,811 $3,347,114
Operating income (loss) (1) 336,556 (166,243) 335,393 (30,400) 313,762
PERCENTAGE OF OPERATING REVENUE 9.0% (4.7%) 9.6% (0.9%) 9.4%
Non-operating expense 53,464 58,394 93,152 127,527 103,733
Provision (benefit) for income taxes (2) (40,965) (2,662) 84,938 14,292 90,008
------------------------------------------------------------------------
Income (loss) from continuing operations (2) 324,057 (221,975) 157,303 (172,219) 120,021
Income (loss) from discontinued operations, net of
income taxes (2) 7,170 (2,712) (309) 288,603 44,821
Cumulative effect of accounting change,
net of income taxes - - - - (11,161)
------------------------------------------------------------------------
Net income (loss) $331,227 $(224,687) $156,994 $116,384 $153,681
Earnings (loss) per share:
Basic $1.14 $(0.76) $0.52 $0.39 $0.51
Diluted: (1, 2)
Income (loss) from continuing operations $1.08 $(0.75) $0.51 $(0.58) $0.39
Income (loss) from discontinued operations 0.02 (0.01) - 0.97 0.15
Cumulative effect of accounting change - - - - (0.04)
------------------------------------------------------------------------
Diluted earnings (loss) per share $1.11 $(0.76) $0.51 $0.39 $0.50
Shares used to compute basic earnings per share 290,514 295,610 300,383 298,659 302,487
Shares used to compute diluted earnings per share 303,568 295,610 305,912 298,659 305,518
SHARES OUTSTANDING, NET OF TREASURY SHARES 290,524 292,868 298,253 300,531 298,474
Cash dividends per share $0.43 $0.42 $0.41 $0.40 $0.38
Share price range:
High price $13.87 $12.10 $15.50 $14.20 $14.94
Low price $10.65 $8.95 $8.89 $9.84 $8.25
FINANCIAL POSITION:
Current assets $978,752 $890,774 $925,496 $1,126,266 $701,898
Current liabilities 1,027,927 818,240 839,064 805,298 675,902
Working capital (49,175) 72,534 86,432 320,968 25,996
Current ratio 1.0 - 1 1.1 - 1 1.1 - 1 1.4 - 1 1.0 - 1
Total assets (1) $3,140,202 $2,956,426 $3,414,938 $3,621,245 $3,939,710
Total liabilities 2,048,667 2,039,600 2,095,929 2,311,381 2,753,226
TOTAL DEBT OUTSTANDING 805,088 819,271 835,475 1,155,193 1,833,556
Minority interest 100,000 100,309 100,309 102,677 5,933
Shareholders' equity (1, 2) 991,535 816,517 1,218,700 1,207,187 1,180,551
(1) In accordance with SFAS 142, the Company's goodwill and intangible assets
that are not amortized are subject to at least an annual assessment for
impairment by applying a fair-value based test. During the third quarter of
2003, the Company recorded a non-cash impairment charge associated with
goodwill and intangible assets at its American Residential Services,
American Mechanical Services and TruGreen LandCare business units of $481
million pre-tax ($383 million after-tax). The impact on diluted earnings
per share of this charge was $1.30. See the "Goodwill and Intangible
Assets" note in the Notes to Consolidated Financial Statements. In the
fourth quarter of 2001, the Company recorded a pre-tax charge of $345
million ($279 million, after-tax) or $.94 per diluted share related
primarily to goodwill and asset impairments as well as other items.
(2) In January 2005, the Company announced that it had reached a comprehensive
agreement with the Internal Revenue Service regarding its examination of
the Company's federal income taxes through the year 2002. As a result of
this agreement, the Company recorded a non-cash reduction in its fourth
quarter and full year 2004 tax provision, thereby increasing net income by
approximately $159 million. Approximately $150 million related to
continuing operations ($.49 per diluted share) and $9 million related to
discontinued operations ($.03 per diluted share). See the "Income Taxes"
note in the Notes to the Consolidated Financial Statements.
15
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
For years ended December 31, 2004 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------------
OPERATING REVENUE $3,758,568 $3,568,586 $3,500,721
OPERATING COSTS AND EXPENSES:
Cost of services rendered and products sold 2,525,029 2,430,523 2,398,952
Selling and administrative expenses 890,954 817,719 760,934
Amortization expense 6,029 5,917 7,442
Charge (credit) for impaired assets and other items (1) - 480,670 (2,000)
- -----------------------------------------------------------------------------------------------------------------------------------
Total operating costs and expenses 3,422,012 3,734,829 3,165,328
- -----------------------------------------------------------------------------------------------------------------------------------
OPERATING INCOME (LOSS) 336,556 (166,243) 335,393
NON-OPERATING EXPENSE (INCOME)
Interest expense 60,708 65,255 92,901
Interest and investment income (15,469) (15,012) (6,431)
Minority interest and other expense, net 8,225 8,151 6,682
- -----------------------------------------------------------------------------------------------------------------------------------
INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE INCOME TAXES 283,092 (224,637) 242,241
Provision (benefit) for income taxes (2) (40,965) (2,662) 84,938
- -----------------------------------------------------------------------------------------------------------------------------------
INCOME (LOSS) FROM CONTINUING OPERATIONS (2) 324,057 (221,975) 157,303
Income (loss) from discontinued operations, net of income taxes (2) 7,170 (2,712) (309)
- -----------------------------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) $331,227 $(224,687) $156,994
===================================================================================================================================
BASIC EARNINGS (LOSS) PER SHARE:
Income (loss) from continuing operations $1.12 $(0.75) $0.52
Income (loss) from discontinued operations 0.02 (0.01) -
- -----------------------------------------------------------------------------------------------------------------------------------
BASIC EARNINGS (LOSS) PER SHARE $1.14 $(0.76) $0.52
===================================================================================================================================
DILUTED EARNINGS (LOSS) PER SHARE:(1, 2)
Income (loss) from continuing operations $1.08 $(0.75) $0.51
Income (loss) from discontinued operations 0.02 (0.01) -
- -----------------------------------------------------------------------------------------------------------------------------------
DILUTED EARNINGS (LOSS) PER SHARE $1.11 $(0.76) $0.51
===================================================================================================================================
(1) In accordance with SFAS 142, the Company's goodwill and intangible assets
that are not amortized are subject to at least an annual assessment for
impairment by applying a fair-value based test. During the third quarter of
2003, the Company recorded a non-cash impairment charge associated with
goodwill and intangible assets at its American Residential Services,
American Mechanical Services and TruGreen LandCare business units of $481
million pre-tax ($383 million after-tax). The impact on diluted earnings
per share of this charge was $1.30. See the "Goodwill and Intangible
Assets" note in the Notes to Consolidated Financial Statements.
(2) In January 2005, the Company announced that it had reached a comprehensive
agreement with the Internal Revenue Service regarding its examination of
the Company's federal income taxes through the year 2002. As a result of
this agreement, the Company recorded a non-cash reduction in its fourth
quarter and full year 2004 tax provision, thereby increasing net income by
approximately $159 million. Approximately $150 million related to
continuing operations ($.49 per diluted share) and $9 million related to
discontinued operations ($.03 per diluted share). See the "Income Taxes"
note in the Notes to the Consolidated Financial Statements.
See accompanying Notes to the Consolidated Financial Statements.
16
CONSOLIDATED STATEMENTS OF FINANCIAL POSITION
(In thousands, except per share data)
As of December 31, 2004 2003
- -----------------------------------------------------------------------------------------------------------------------------------
ASSETS:
CURRENT ASSETS:
Cash and cash equivalents $256,626 $228,161
Marketable securities 103,681 90,540
Receivables, less allowances of $25,183 and $26,220, respectively 369,026 333,834
Inventories 66,657 70,163
Prepaid expenses and other assets 27,456 33,408
Deferred customer acquisition costs 41,574 41,806
Deferred taxes and income taxes receivable 108,780 87,589
Assets of discontinued operations 4,952 5,273
- -----------------------------------------------------------------------------------------------------------------------------------
Total Current Assets 978,752 890,774
- -----------------------------------------------------------------------------------------------------------------------------------
PROPERTY AND EQUIPMENT:
At cost 405,655 387,569
Less: accumulated depreciation (218,838) (208,054)
- -----------------------------------------------------------------------------------------------------------------------------------
Net Property and Equipment 186,817 179,515
- -----------------------------------------------------------------------------------------------------------------------------------
OTHER ASSETS:
Goodwill 1,568,044 1,516,206
Intangible assets, primarily trade names, net 220,780 216,453
Notes receivable 35,411 46,441
Long-term marketable securities 135,824 92,562
Other assets 14,574 14,475
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $3,140,202 $2,956,426
===================================================================================================================================
LIABILITIES AND SHAREHOLDERS' EQUITY:
CURRENT LIABILITIES:
Accounts payable $76,053 $86,963
Accrued liabilities:
Payroll and related expenses 113,366 89,427
Self-insured claims and related expenses 86,554 73,320
Income taxes payable 152,841 -
Other 111,092 100,454
Deferred revenue 443,238 419,915
Liabilities of discontinued operations 21,536 14,380
Current portion of long-term debt 23,247 33,781
- -----------------------------------------------------------------------------------------------------------------------------------
Total Current Liabilities 1,027,927 818,240
- -----------------------------------------------------------------------------------------------------------------------------------
LONG-TERM DEBT 781,841 785,490
LONG-TERM LIABILITIES:
Deferred taxes 88,100 276,000
Liabilities of discontinued operations 9,057 34,396
Other long-term obligations 141,742 125,474
- -----------------------------------------------------------------------------------------------------------------------------------
Total Long-Term Liabilities 238,899 435,870
- -----------------------------------------------------------------------------------------------------------------------------------
MINORITY INTEREST 100,000 100,309
COMMITMENTS AND CONTINGENCIES (See Note)
SHAREHOLDERS' EQUITY:
Common stock $0.01 par value, authorized 1,000,000 shares; issued
318,559 and 317,315, respectively 3,186 3,173
Additional paid-in capital 1,083,057 1,061,640
Retained earnings 212,116 6,365
Accumulated other comprehensive income 10,804 7,932
Restricted stock (12,857) (4,368)
Treasury stock (304,771) (258,225)
- -----------------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 991,535 816,517
- -----------------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $3,140,202 $2,956,426
===================================================================================================================================
See accompanying Notes to the Consolidated Financial Statements
17
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(In thousands)
Additional Accumulated
Common Paid-in Retained Comprehensive Restricted Treasury Total
Stock Capital Earnings Income Stock Stock Equity
(Loss)
====================================================================================================================================
BALANCE DECEMBER 31, 2001 $3,145 $1,039,228 $322,103 $(2,496) $(581) $(154,212) $1,207,187
====================================================================================================================================
Net income 2002 156,994 156,994
Other comprehensive income, net of tax:
Net unrealized (loss) on securities,
net of reclassification adjustment (1) (3,869) (3,869)
Foreign currency translation 5,516 5,516
- ------------------------------------------------------------------------------------------------------------------------------------
Total comprehensive income 156,994 1,647 158,641
Shareholders' dividends (123,204) (123,204)
Shares issued under options, grant plans,
and other (2,706 shares) 15 15,044 (1,407) 14,482 28,134
Treasury shares purchased (4,985 shares) (52,058) (52,058)
====================================================================================================================================
BALANCE DECEMBER 31, 2002 $3,160 $1,054,272 $355,893 $(849) $(1,988) $(191,788) $1,218,700
====================================================================================================================================
Net loss 2003 (224,687) (224,687)
Other comprehensive income, net of tax:
Net unrealized gain on securities,
net of reclassification adjustment (1) 7,022 7,022
Foreign currency translation 1,759 1,759
- ------------------------------------------------------------------------------------------------------------------------------------
Total comprehensive income (loss) (224,687) 8,781 (215,906)
Shareholders' dividends (124,841) (124,841)
Shares issued under options, grant plans,
and other (2,700 shares) 13 7,368 (2,380) 19,144 24,145
Treasury shares purchased (8,084 shares) (85,581) (85,581)
====================================================================================================================================
BALANCE DECEMBER 31, 2003 $3,173 $1,061,640 $6,365 $7,932 $(4,368) $(258,225) $816,517
====================================================================================================================================
Net income 2004 331,227 331,227
Other comprehensive income, net of tax:
Net unrealized gain on securities,
net of reclassification adjustment (1) 826 826
Foreign currency translation 2,046 2,046
- ------------------------------------------------------------------------------------------------------------------------------------
Total comprehensive income 331,227 2,872 334,099
Shareholders' dividends (125,476) (125,476)
Shares issued under options, grant plans,
and other (2,711 shares) 13 21,273 (8,489) 13,937 26,734
Treasury shares purchased (5,353 shares) (63,814) (63,814)
Shares issued for acquisitions (297 shares) 144 3,331 3,475
====================================================================================================================================
BALANCE DECEMBER 31, 2004 $3,186 $1,083,057 $212,116 $10,804 $(12,857) $(304,771) $991,535
====================================================================================================================================
(1) Disclosure of reclassification amounts (net of tax) relating to
comprehensive income:
2004 2003 2002
====================================================================================================================================
Unrealized holding gains (losses) arising in period $ 4,647 $9,335 $(4,745)
Less: (Gains) losses realized (3,821) (2,313) 876
- ------------------------------------------------------------------------------------------------------------------------------------
Net unrealized gains (losses) on securities $ 826 $7,022 $(3,869)
====================================================================================================================================
See accompanying Notes to the Consolidated Financial Statements.
18
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
For years ended December 31, 2004 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT JANUARY 1 $228,161 $227,177 $402,642
CASH FLOWS FROM OPERATING ACTIVITIES:
NET INCOME (LOSS) 331,227 (224,687) 156,994
Adjustments to reconcile net income (loss) to net cash
provided from operating activities:
(Income) loss from discontinued operations (7,170) 2,712 309
Non-cash reduction in continuing operations tax expense (149,722) - -
Non-cash charge (credit) for impaired assets and other items, net of tax - 383,152 (1,200)
Depreciation expense 49,596 49,861 48,866
Amortization expense 6,029 5,917 7,442
Deferred income tax expense 91,639 65,256 65,799
Change in working capital, net of acquisitions:
Receivables (20,922) (17,640) 14,408
Inventories and other current assets 6,962 5,946 (7,694)
Accounts payable (5,009) (4,168) (4,233)
Deferred revenue 15,178 22,773 49,849
Accrued liabilities 48,862 (6,884) 33,699
Other, net 9,215 1,300 9,952
- -----------------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED FROM OPERATING ACTIVITIES 375,885 283,538 374,191
- -----------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Property additions (53,062) (39,243) (60,113)
Sale of equipment and other assets 7,395 11,090 4,565
Business acquisitions, net of cash acquired (40,184) (28,875) (13,003)
Proceeds from business sales - 21,106 30,500
Notes receivable, financial investments and securities (45,580) (23,499) (2,117)
- -----------------------------------------------------------------------------------------------------------------------------------
NET CASH USED FOR INVESTING ACTIVITIES (131,431) (59,421) (40,168)
- -----------------------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net payments of debt (37,042) (31,216) (345,142)
Shareholders' dividends (125,476) (124,841) (123,204)
Purchase of ServiceMaster stock (63,085) (85,581) (52,058)
Other, net 16,631 16,330 19,140
- -----------------------------------------------------------------------------------------------------------------------------------
NET CASH USED FOR FINANCING ACTIVITIES (208,972) (225,308) (501,264)
- -----------------------------------------------------------------------------------------------------------------------------------
NET CASH PROVIDED FROM (USED FOR) DISCONTINUED OPERATIONS (7,017) 2,175 (8,224)
- -----------------------------------------------------------------------------------------------------------------------------------
CASH INCREASE (DECREASE) DURING THE YEAR 28,465 984 (175,465)
- -----------------------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT DECEMBER 31 $256,626 $228,161 $227,177
===================================================================================================================================
See accompanying Notes to the Consolidated Financial Statements.
19
SIGNIFICANT ACCOUNTING POLICIES
SUMMARY: The consolidated financial statements include the accounts of
ServiceMaster and its majority-owned subsidiary partnerships and corporations,
collectively referred to as the Company. Intercompany transactions and balances
have been eliminated.
The preparation of the consolidated financial statements requires management to
make certain estimates and assumptions required under generally accepted
accounting principles ("GAAP") which may differ from actual results. The more
significant areas requiring the use of management estimates relate to the
allowance for receivables, accruals for self-insured retention limits related to
medical, workers' compensation, auto and general liability insurance claims,
accruals for home warranty claims, the possible outcomes of outstanding
litigation, accruals for income tax liabilities as well as deferred tax
accounts, useful lives for depreciation and amortization expense, and the
valuation of tangible and intangible assets. In 2004, there have been no changes
in the significant areas that require estimates or in the methodologies which
underlie these associated estimates.
The allowance for receivables is developed based on several factors including
overall customer credit quality, historical write-off experience and specific
account analyses that project the ultimate collectibility of the outstanding
balances. As such, these factors may change over time causing the reserve level
to vary.
The Company carries insurance policies on insurable risks at levels which it
believes to be appropriate, including workers' compensation, auto and general
liability risks. The Company has self-insured retention limits and insured
layers of excess insurance coverage above those limits. Accruals for
self-insurance losses and warranty claims in the American Home Shield business
are made based on the Company's claims experience and actuarial projections.
Current activity could differ causing a change in estimates. The Company has
certain liabilities with respect to existing or potential claims, lawsuits, and
other proceedings. The Company accrues for these liabilities when it is probable
that future costs will be incurred and such costs can be reasonably estimated.
Any resulting adjustments, which could be material, are recorded in the period
identified.
The Company records deferred income tax balances based on the net tax effects of
temporary differences between the carrying value of assets and liabilities for
financial reporting purposes and income tax purposes. There are significant
amortizable intangible assets for tax reporting purposes (not for financial
reporting purposes) which arose as a result of the Company's reincorporation
from partnership to corporate form in 1997. The Company records its deferred tax
items based on the estimated value of the tax basis. As discussed in the "Income
Taxes" note to the Consolidated Financial Statements, the Company reached a
comprehensive agreement with the Internal Revenue Service (IRS) regarding its
examination of the Company's federal income taxes through the year 2002. As a
result of this agreement, certain deferred tax assets which had previously not
been recorded, due to uncertainties associated with the complexity of the
matters under review and the extended period of time effectively covered by the
examination were recorded.
The Company adjusts tax estimates when required to reflect changes based on
factors such as changes in tax laws, results of tax authority reviews and
statutory limitations. As occurred this year when the IRS audit concluded, the
Company reflected the changes from previously estimated amounts in the period
that the need for adjustment was identified.
Fixed assets and intangible assets with finite lives are depreciated and
amortized on a straight-line basis over their estimated useful lives. These
lives are based on the Company's previous experience for similar assets, the
potential for market obsolescence and other industry and business data. An
impairment loss would be recognized if and when the undiscounted future cash
flows derived from the asset are less than its carrying amount. Changes in the
estimated useful lives or in the asset values could cause the Company to adjust
its book value or future expense accordingly.
The Company does not amortize its goodwill or indefinite-lived intangible
assets. The Company tests these assets for impairment, at a minimum, on an
annual basis by applying a fair-value based test. An impairment loss would be
recorded if and when the Company determines that the expected present value of
the future cash flows is less than the book value. As permitted under SFAS 142,
the Company carries forward a reporting unit's valuation from the most recent
valuation under the following conditions; the assets and liabilities of the
reporting unit have not changed significantly since the most recent fair value
calculation, the most recent fair value calculation resulted in an amount that
exceeded the carrying amount of the reporting unit by a substantial margin, and
based on the facts and circumstances of events that have occurred since the last
fair value determination, the likelihood that a current fair value calculation
would result in an impairment would be remote.
REVENUE: Revenue from lawn care, pest control, liquid and fumigation termite
applications, as well as heating/air conditioning and plumbing services are
recognized as the services are provided. Revenue from landscaping services are
recognized as they are earned based upon monthly contract arrangements or when
services are performed for non-contractual arrangements. Revenue from the
Company's commercial installation contracts, primarily relating to HVAC and
electrical installations are recognized using the percentage of completion
method in the ratio that total incurred costs bear to total estimated costs. The
Company eradicates termites through the use of baiting stations, as well as
through non-baiting methods (e.g., fumigation or liquid treatments). Termite
services using baiting stations as well as home warranty services frequently are
sold through annual contracts for a one-time, upfront payment. Direct costs of
these contracts (service costs for termite contracts and claim costs for
warranty contracts) are expensed as incurred. The Company recognizes revenue
over the life of these contracts in proportion to the expected direct costs.
Revenue from trade name licensing arrangements is recognized when earned.
Franchised revenue (which in the aggregate represents less than three percent of
consolidated revenue) consists principally of continuing
20
monthly fees based upon the franchisee's customer level revenue. Monthly fee
revenue is recognized when the related customer level revenue is reported by the
franchisee and collectibility is assured. Franchise revenue also includes
initial fees resulting from the sale of a franchise. These fees are fixed and
are recognized as revenue when collectibility is assured and all material
services or conditions relating to the sale have been substantially performed.
Total franchise fee profits (excluding trade name licensing) comprised 10.1,
10.5 and 9.4 percent of consolidated operating income (without the impairment
charge in 2003) before headquarter overheads in 2004, 2003 and 2002,
respectively.
The Company had $443 million and $420 million of deferred revenue at December
31, 2004 and 2003, respectively, which consist primarily of payments received
for annual contracts relating to home warranty, termite baiting, pest control
and lawn care services. The revenue related to these services is recognized over
the contractual period as the direct costs emerge, such as when the services are
performed or claims are incurred.
DEFERRED CUSTOMER ACQUISITION COSTS: Customer acquisition costs, which are
incremental and direct costs of obtaining a customer, are deferred and amortized
over the life of the related contract in proportion to revenue recognized. These
costs include sales commissions and direct selling costs which can be shown to
have resulted in a successful sale.
INTERIM REPORTING: TruGreen ChemLawn has significant seasonality in its
business. In the winter and early spring, this business sells a series of lawn
applications to customers which are rendered primarily in March through October.
This business incurs incremental selling expenses at the beginning of the year
that directly relate to successful sales for which the revenues are recognized
in later quarters. TruGreen ChemLawn also defers, on an interim basis,
pre-season advertising costs and annual repairs and maintenance procedures that
are performed in the first quarter. These costs are deferred and recognized in
proportion to the contract revenue over the production season, and are not
deferred beyond the calendar year-end. Other business segments of the Company
also defer, on an interim basis, advertising costs incurred early in the year.
These costs are deferred and recognized approximately in proportion to revenue
over the balance of the year, and are not deferred beyond the calendar year-end.
ADVERTISING: As discussed in the "Interim Reporting" note above, certain
pre-season advertising costs are deferred and recognized approximately in
proportion to the contract revenue over the year. Certain other advertising
costs are expensed when the advertising occurs. The cost of direct-response
advertising at Terminix is capitalized and amortized over its expected period of
future benefits. This direct-response advertising consists primarily of
direct-mail promotions, for which the cost is capitalized and amortized over the
one-year customer contract life.
INVENTORY VALUATION: Inventories are valued at the lower of cost (primarily on a
weighted average cost basis) or market. The inventory primarily represents
finished goods to be used on the customers' premises or sold to franchisees.
PROPERTY AND EQUIPMENT, INTANGIBLE ASSETS AND GOODWILL: Buildings and equipment
used in the business are stated at cost and depreciated over their estimated
useful lives using the straight-line method for financial reporting purposes.
The estimated useful lives for building and improvements range from 10 to 40
years, while the estimated useful lives for equipment range from three to 10
years. Leasehold improvements relating to leased facilities are depreciated over
the remaining life of the lease. Technology equipment as well as software and
development have an estimated useful life of three to seven years. Intangible
assets consist primarily of goodwill ($1.6 billion), trade names ($205 million)
and other intangible assets ($16 million).
As required by SFAS 142, goodwill is not subject to amortization and intangible
assets with indefinite useful lives are not amortized until their useful lives
are determined to no longer be indefinite. Goodwill and intangible assets that
are not subject to amortization are subject to an assessment for impairment by
applying a fair-value based test on an annual basis or more frequently if
circumstances indicate a potential impairment. As permitted under SFAS 142, the
Company carries forward a reporting unit's valuation from the most recent
valuation under the following conditions; the assets and liabilities of the
reporting unit have not changed significantly since the most recent fair value
calculation, the most recent fair value calculation resulted in an amount that
exceeded the carrying amount of the reporting unit by a substantial margin, and
based on the facts and circumstances of events that have occurred since the last
fair value determination, the likelihood that a current fair value calculation
would result in an impairment would be remote. For the 2004 goodwill and trade
name impairment review, the Company carried forward the valuations for all
reporting units except ARS. A valuation analysis performed for ARS indicated no
impairment issue. As discussed in the "Goodwill and Intangible Assets" note to
the Consolidated Financial Statements, during the third quarter of 2003 the
Company recorded a pre-tax, non-cash impairment charge of $481 million relating
to TruGreen LandCare, ARS and AMS.
As required by SFAS 144 "Accounting for the Impairment or Disposal of Long-Lived
Assets", the Company's long-lived assets, including fixed assets and intangible
assets (other than goodwill), are tested for recoverability whenever events or
changes in circumstances indicate that their carrying amounts may not be
recoverable. Based on these reviews, when the undiscounted future cash flows
derived from using the asset are less than the carrying amount of the asset, an
impairment loss is recognized based on the asset's fair value, and the carrying
amount of the asset is reduced accordingly.
FAIR VALUE OF FINANCIAL INSTRUMENTS AND CREDIT RISK: The carrying amounts of
receivables, accounts payable, and accrued liabilities approximate fair value
because of the short maturity of these instruments. The carrying amounts of
long-term receivables approximate fair value as the effective interest rates for
these instruments are comparable to market rates at year-end. The carrying
amount of current and long-term marketable securities also approximate fair
value, with unrealized gains and losses reported net-of-tax as a component of
accumulated
21
comprehensive income (loss). The carrying amount of total debt is $805 million
and $819 million and the estimated fair value is approximately $875 million and
$882 million at December 31, 2004 and 2003, respectively. The estimated fair
value of debt is based upon borrowing rates currently available to the Company
for long-term borrowings with similar terms and maturities.
The Company does not hold or issue financial instruments for trading or
speculative purposes. The Company has entered into specific financial
arrangements in the normal course of business to manage certain market risks,
with a policy of matching positions and limiting the terms of contracts to
relatively short durations. The effect of derivative financial instrument
transactions is not material to the Company's consolidated financial statements.
In accordance with SFAS 133 "Accounting for Derivative Instruments and Hedging
Activities", the Company's interest rate swap agreements are classified as fair
value hedges and, as such, gains and losses on the swaps as well as the gains
and losses on the related hedged items are recognized in current earnings.
Financial instruments, which potentially subject the Company to financial and
credit risk, consist principally of investments and receivables. Investments
consist primarily of publicly traded debt and common equity securities. The
Company periodically reviews its portfolio of investments to determine whether
there has been an other than temporary decline in the value of the investments
from factors such as deterioration in the financial condition of the issuer or
the market(s) in which it competes. Receivables have little concentration of
credit risk due to the large number of customers with relatively small balances
and their dispersion across geographical areas. The Company maintains an
allowance for losses based upon the expected collectibility of receivables.
INCOME TAXES: The Company accounts for income taxes under SFAS 109, "Accounting
for Income Taxes." This Statement uses an asset and liability approach for the
expected future tax consequences of events that have been recognized in the
Company's financial statements or tax returns. Deferred income taxes are
provided to reflect the differences between the tax bases of assets and
liabilities and their reported amounts in the financial statements.
EARNINGS PER SHARE: Basic earnings per share is based on the weighted-average
number of common shares outstanding during the year. The weighted average number
of common shares used in the diluted earnings per share calculation include the
incremental effect related to outstanding options whose market price is in
excess of the exercise price, as well as shares potentially issuable under
convertible securities. In computing diluted earnings per share, the after-tax
interest expense related to convertible securities is added back to net income
in the numerator, while the number of shares used in the denominator include the
shares issuable upon conversion of the securities. Due to the fact that losses
from continuing operations were incurred in 2003, diluted shares do not include
the effects of options, because doing so would result in a less dilutive
computation. Shares potentially issuable under convertible securities have not
been considered outstanding in the diluted earnings per share computation for
2003 and 2002 as their inclusion would result in a less dilutive computation.
STOCK-BASED COMPENSATION: Beginning in 2003, the Company has been accounting for
employee stock options as compensation expense in accordance with SFAS 123,
"Accounting for Stock-Based Compensation." SFAS 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure, an amendment of FASB Statement No.
123", provides alternative methods of transitioning to the fair-value based
method of accounting for employee stock options as compensation expense. The
Company is using the "prospective method" of SFAS 148 and is expensing the fair
value of new employee option grants awarded subsequent to 2002.
Prior to 2003, the Company had accounted for employee share options under the
intrinsic method of Accounting Principles Board Opinion 25, as permitted under
GAAP. Compensation expense determined under the fair-value based method of SFAS
123 relating to newly issued awards as well as the unvested portion of the
previously issued awards would have resulted in proforma reported net income and
net earnings per share as follows:
(In thousands, except per share data) 2004 2003 2002
=============================================================================
Net income (loss) as reported $331,227 $(224,687) $156,994
Add back: Stock-based
compensation expense included in
reported net income, net of related
tax effects 1,729 609 -
Deduct: Stock-based
compensation expense determined
under fair-value method, net
of related tax effects (6,346) (6,179) (7,576)
- -----------------------------------------------------------------------------
Proforma net income (loss) $326,610 $(230,257) $149,418
Basic Earnings Per Share:
As reported $1.14 $(0.76) $0.52
Proforma 1.12 (0.78) 0.50
Diluted Earnings Per Share:
As reported $1.11 $(0.76) $0.51
Proforma 1.09 (0.78) 0.49
=============================================================================
SEE THE "SHAREHOLDERS' EQUITY" NOTE TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR
A DESCRIPTION OF THE ASSUMPTIONS USED TO COMPUTE THE ABOVE STOCK BASED
COMPENSATION EXPENSE.
NEWLY ISSUED ACCOUNTING STATEMENTS AND POSITIONS: In December 2004, the FASB
issued SFAS 123 (revised 2004), "Share-Based Payment" (SFAS 123(R)). This
Statement replaces SFAS 123, "Accounting for Stock-Based Compensation", and
supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees". SFAS
123(R) requires that stock options and share grants be recorded at fair value
and this value is recognized as compensation expense over the vesting period.
The Statement requires that compensation expense be recorded for newly issued
awards as well as the unvested portion of previously issued awards that remain
outstanding as of the effective date of this Statement. The provisions of this
Statement become effective beginning with the Company's third quarter 2005
Consolidated Financial Statements. The Company is presently assessing the impact
of this Statement. However, the Company currently estimates that the adoption of
this Statement would reduce annual earnings per
22
share by approximately $.01 to $.02. This Statement permits the restatement of
periods prior to its adoption. Upon adopting this Statement, the Company expects
to restate prior periods as if the Statement were in effect for all periods,
resulting in dilution for those periods of a comparable amount as in 2005.
RECENTLY ADOPTED ACCOUNTING PRINCIPLES: In 2003, the Financial Accounting
Standards Board (FASB) issued FASB Interpretation No. 46, "Consolidation of
Variable Interest Entities" (FIN 46) and FASB Interpretation No. 46, Revised
(FIN 46(R)). Under these Interpretations, certain entities known as "variable
interest entities" (VIE) must be consolidated by the "primary beneficiary" of
the entity. The primary beneficiary is generally defined as having the majority
of the risks and rewards arising from the VIE. The requirements of FIN 46 and
FIN 46(R) have been adopted by the Company and their adoption did not have a
material impact on the Company's Consolidated Financial Statements.
BUSINESS SEGMENT REPORTING
The business of the Company is conducted through five operating segments:
TruGreen, Terminix, American Home Shield, ARS/AMS and Other Operations. In
accordance with Statement of Financial Accounting Standards No. 131, the
Company's reportable segments are strategic business units that offer different
services. The TruGreen segment provides residential and commercial lawn care and
landscaping services through the TruGreen ChemLawn and TruGreen LandCare
companies. The Terminix segment provides termite and pest control services to
residential and commercial customers. The American Home Shield segment provides
home warranties to consumers that cover heating, ventilation, air conditioning
(HVAC), plumbing and other home systems and appliances. This segment also
includes home inspection services provided by AmeriSpec. The ARS/AMS segment
provides HVAC and plumbing installation and repair services provided under the
ARS Service Express, American Mechanical Services and Rescue Rooter brand names.
The Other Operations segment includes the franchise and company-owned operations
of ServiceMaster Clean, Furniture Medic and Merry Maids, which provide disaster
restoration, cleaning, furniture repair and maid services. This segment also
includes the Company's headquarters operations, which provide various
technology, marketing, finance, legal and other support services to the business
units.
Information regarding the accounting policies used by the Company is described
in the Significant Accounting Policies Note. The Company derives substantially
all of its revenue from customers in the United States with less than one
percent generated in foreign markets. Operating expenses of the business units
consist primarily of direct costs. Identifiable assets are those used in
carrying out the operations of the business unit and include intangible assets
directly related to its operations.
Segment information for the years ended December 31, 2004, 2003, and 2002 is
presented below.
23
BUSINESS SEGMENT TABLE
(In thousands) 2004 % Change 2003 % Change 2002
=====================================================================================================================
OPERATING REVENUE:
TruGreen $1,419,649 5% $1,347,400 5% $1,284,616
Terminix 996,900 5 945,258 2 924,384
American Home Shield 487,395 8 450,264 6 423,526
ARS/AMS 690,500 3 673,558 (6) 718,892
Other Operations 164,124 8 152,106 2 149,303
- ---------------------------------------------------------------------------------------------------------------------
Total Operating Revenue $3,758,568 5% $3,568,586 2% $3,500,721
=====================================================================================================================
OPERATING INCOME (LOSS):
TruGreen (1) $171,184 N/M $(34,017) N/M $165,292
TRUGREEN WITHOUT IMPAIRMENT CHARGE (1) $171,184 11% $154,853 (6%) $165,292
Terminix 132,827 1 131,044 3 127,441
American Home Shield 71,986 24 58,154 21 47,890
ARS/AMS (1) 5,534 N/M (281,777) N/M 17,342
ARS/AMS WITHOUT IMPAIRMENT CHARGE (1) 5,534 (45) 10,023 (42) 17,342
Other Operations (44,975) (13) (39,647) (76) (22,572)
- ---------------------------------------------------------------------------------------------------------------------
Total Operating Income (Loss) (1) $336,556 N/M $(166,243) N/M $335,393
=====================================================================================================================
CAPITAL EMPLOYED: (2)
TruGreen $828,974 1% $821,412 (16%) $979,932
Terminix 631,370 6 596,535 - 599,433
American Home Shield 168,223 25 134,372 34 100,026
ARS/AMS 88,692 2 86,764 (78) 398,982
Other Operations 179,364 85 97,014 27 76,111
- ---------------------------------------------------------------------------------------------------------------------
Total Capital Employed $1,896,623 9% $1,736,097 (19%) $2,154,484
=====================================================================================================================
IDENTIFIABLE ASSETS:
TruGreen $957,683 5% $911,958 (13%) $1,053,099
Terminix 843,272 3 822,407 (2) 841,437
American Home Shield 474,326 12 422,765 12 376,059
ARS/AMS 191,618 3 185,528 (62) 489,366
Other Operations 673,303 10 613,768 (6) 654,977
- ---------------------------------------------------------------------------------------------------------------------
Total Identifiable Assets $3,140,202 6% $2,956,426 (13%) $3,414,938
=====================================================================================================================
DEPRECIATION & AMORTIZATION EXPENSE:
TruGreen $22,546 (1%) $22,764 (4%) $23,595
Terminix 11,441 11 10,328 (7) 11,150
American Home Shield 7,860 15 6,829 22 5,583
ARS/AMS 6,939 (18) 8,439 (8) 9,166
Other Operations 6,839 (8) 7,418 9 6,814
- ---------------------------------------------------------------------------------------------------------------------
Total Depreciation & Amortization Expense $55,625 - % $55,778 (1%) $56,308
=====================================================================================================================
CAPITAL EXPENDITURES:
TruGreen $12,888 (9%) $14,197 25% $11,317
Terminix 11,202 117 5,169 (70) 17,013
American Home Shield 5,490 (17) 6,619 38 4,794
ARS/AMS 7,716 25 6,160 9 5,658
Other Operations 15,766 122 7,098 (67) 21,331
- ---------------------------------------------------------------------------------------------------------------------
Total Capital Expenditures $53,062 35% $39,243 (35%) $60,113
=====================================================================================================================
N/M = Not meaningful
(1) In the third quarter of 2003, the Company recorded a non-cash, pre-tax
impairment charge of $481 million related to its goodwill and intangible
assets. Approximately $189 million of the charge is associated with the
TruGreen LandCare operations reported in the TruGreen segment, and the
remaining $292 million relates to the ARS/AMS segment. In order to
facilitate comparisons of ongoing operating performance of continuing
operations, the Company also has presented segment results after adjusting
for the impact of the impairment charge.
(2) Capital employed is a non-U.S. GAAP measure that is defined as the
segment's total assets less liabilities, exclusive of debt balances. The
Company believes this information is useful to investors in helping them
compute return on capital measures and therefore better understand the
performance of the Company's business segments.
The combined franchise operations of ServiceMaster Clean and Merry Maids
comprised approximately 4% of the consolidated revenue in 2004, 2003, and 2002.
These operations comprised approximately 11%, 11%, and 10% of the consolidated
operating income (without the 2003 impairment charge) before headquarter
overheads for 2004, 2003, and 2002, respectively.
The following table summarizes the segment goodwill that is not amortized. See
the "Acquisitions" note and the "Goodwill and Intangible Assets" note in the
Notes to Consolidated Financial Statements for information relating to goodwill
acquired and amounts impaired, respectively.
(In thousands) 2004 % Change 2003 % Change 2002
====================================================================================================================
TruGreen $681,954 5% $652,534 (16%) $780,043
Terminix 643,567 3 622,351 1 618,055
American Home Shield 72,085 - 72,085 - 72,085
ARS/AMS 56,171 - 56,171 (83) 337,491
Other Operations 114,267 1 113,065 1 112,106
- --------------------------------------------------------------------------------------------------------------------
Total $1,568,044 3% $1,516,206 (21%) $1,919,780
====================================================================================================================
24
GOODWILL AND INTANGIBLE ASSETS
In accordance with SFAS 142, "Goodwill and Other Intangible Assets", the Company
discontinued the amortization of goodwill and indefinite lived intangible assets
effective January 1, 2002. Goodwill and intangible assets that are not amortized
are subject to assessment for impairment by applying a fair-value based test on
an annual basis or more frequently if circumstances indicate a potential
impairment. The Company completed its annual assessment of impairment as of
October 1.
In the third quarter of 2003, the Company recorded a non-cash impairment charge
associated with the goodwill and intangible assets of its ARS, AMS and TruGreen
LandCare business units of $481 million pre-tax, $383 million net of tax, or
$1.30 per diluted share. The pre-tax charge consisted of $224 million at
American Residential Services, $68 million at American Mechanical Services and
$189 million at TruGreen LandCare. The impairment charge included a portion of
goodwill that was not deductible for tax purposes, resulting in a tax benefit of
$98 million or only approximately 20 percent of the pre-tax charge amount.
Throughout the first half of 2003, management believed that the significant
declines in the operating results of these businesses were due to temporary
conditions and that the operations, with an anticipated good summer season,
would show ongoing improvement which would support the amount of goodwill and
intangible assets on the balance sheet. The Company had discussed such events
and trends in its press releases and periodic filings with the Securities and
Exchange Commission. In the third quarter of 2003, the results did not improve.
In addition, the Company identified certain branch closures at ARS and announced
the sale of its utility line clearing operations at TruGreen LandCare. The lack
of a good 2003 summer season, combined with declining profitability in the base
businesses, led management to conclude that the businesses were unlikely to meet
the previous projections which had supported the carrying value. A valuation was
performed during the third quarter of 2003 which incorporated third quarter 2003
performance. The fair value of the reporting units was determined primarily by
utilizing a discounted cash flow methodology. The Company used an independent
valuation firm to confirm the Company's assessment of the fair value of its
reporting units. Based on the evaluation, it was determined that the fair values
of the ARS, AMS, and TruGreen LandCare reporting units were less than their
carrying values. As a result, in the third quarter of 2003, the Company
reassessed the fair value of the assets and liabilities of these units and
recorded a non-cash impairment charge of $481 million pre-tax, $383 million net
of tax, to reduce the carrying value of the intangible assets to $56 million,
their estimated fair value.
In April 2004, TruGreen ChemLawn acquired the assets of Greenspace Limited,
Canada's largest professional lawn care service company. Intangible assets
recorded were less than $16 million. The balance of goodwill and intangible
assets that was added during 2004 relate to tuck-in acquisitions completed by
Terminix and TruGreen ChemLawn.
The table below summarizes the goodwill and intangible asset balances:
(In thousands) 2004 2003 2002
====================================================================
Goodwill (1) $1,568,044 $1,516,206 $1,919,780
Trade names (1) 204,793 204,793 238,550
Other intangible assets 45,788 35,432 78,284
Accumulated amortization (2) (29,801) (23,772) (59,053)
- --------------------------------------------------------------------
Net other intangibles 15,987 11,660 19,231
- --------------------------------------------------------------------
Total $1,788,824 $1,732,659 $2,177,561
====================================================================
(1) Not subject to amortization.
(2) Amortization expense of $6 million, $6 million and $7 million was recorded
in 2004, 2003 and 2002, respectively. Annual amortization expense of
approximately $6 million in 2004 is expected to decline over the next five
years.
INCOME TAXES
In January 2005, the Company reached a comprehensive agreement with the IRS
regarding its examination of the Company's federal income taxes through the year
2002. As previously disclosed, the Company had not been audited by the IRS
during the period in which it operated as a master limited partnership (1987
through 1997) or in subsequent years. Consequently, the examination covered
numerous matters, including the tax consequences resulting from the Company's
reincorporation in 1997, and the sale of its large Management Services segment
in November 2001. The principal terms of the agreement were as follows:
1. The agreement affirmed the previously identified step-up in the tax
basis of the Company's assets which occurred upon reincorporation. For
income tax reporting purposes, this step-up is generally being
amortized and deducted over the 15 year period ending December 31,
2012.
2. The agreement increased taxes and interest due on the 2001 sale of the
Company's Management Services business. This occurred primarily as a
result of changes in the timing of certain items which were previously
netted against the gain and will now be amortized as additional
deductions over the 15 year period ending December 31, 2016.
3. The agreement resolved all other matters in the years under review.
For 2004, the IRS agreement resulted in a $25 million favorable timing
difference in fourth quarter 2004 tax payments. Pursuant to the agreement, the
Company paid taxes and interest (primarily in February 2005) to the IRS and
various states in the amount of $133 million ($113 million of increased taxes
and $20 million of interest). Existing financial resources were utilized to fund
the payment and the Company does not believe that the payment significantly
impaired its financial flexibility. Also related to the agreement, the Company
will realize an approximate $45 million reduction in estimated tax payments for
2005 that would otherwise have been paid in the second half of 2005. Finally,
the agreement resulted in incremental future tax benefits of approximately $57
million, which will be recovered on the Company's tax returns over the 11 year
period ending in 2016.
As a result of this agreement, certain deferred tax assets, primarily related to
intangible assets, which had previously not been recorded due to uncertainties
associated with the
25
complexity of the matters under review and the extended period of time
effectively covered by the examination were recorded. This resulted in a
non-cash reduction in the Company's 2004 income tax provision, thereby
increasing 2004 consolidated net income by approximately $159 million ($150
million related to continuing operations and $9 million related to discontinued
operations).
In the ordinary course, the Company is subject to review by domestic and foreign
taxing authorities, including the IRS. The Company has been notified by the IRS
that it intends to commence the audits of the Company's 2003, 2004, and 2005
fiscal years in the second quarter of 2005.
The reconciliation of income tax computed at the U.S. federal statutory tax rate
to the Company's effective income tax rate for continuing operations is as
follows:
2004 2003 2002
=================================================================
Tax at U.S. federal
statutory rate 35.0% (35.0%) 35.0%
State and local income taxes
net of U.S. federal benefit 3.6 (0.8) 3.5
Adjustment related to the
IRS agreement (52.9) - -
Net operating loss and
tax credits (0.7) (0.5) (4.1)
Impairment of non-
deductible goodwill - 36.9 -
Other 0.5 (1.8) 0.7
- -----------------------------------------------------------------
Effective rate (14.5%) (1.2%) 35.1%
=================================================================
The effective tax rate for discontinued operations reflected a benefit of
288.1%, 39.5% and 32.4%, in 2004, 2003 and 2002, respectively. In 2004, the
difference between these rates and the federal statutory tax rate of 35%
reflects the impact of the IRS agreement, state taxes, net of federal benefit,
and permanent items.
Income tax expense from continuing operations is as follows:
(In thousands) 2004
----------------------------------
CURRENT DEFERRED TOTAL
U.S. federal $134,047 $(155,901) $(21,854)
State and local 11,139 (30,250) (19,111)
- -----------------------------------------------------------
$145,186 $(186,151) $(40,965)
===========================================================
2003
-----------------------------------
CURRENT DEFERRED Total
U.S. federal $9,820 $(8,963) $857
State and local (1,618) (1,901) (3,519)
- -----------------------------------------------------------
$8,202 $(10,864) $(2,662)
===========================================================
2002
-----------------------------------
CURRENT DEFERRED TOTAL
U.S. federal $26,668 $48,998 $75,666
State and local (1,121) 10,393 9,272
- -----------------------------------------------------------
$25,547 $59,391 $84,938
===========================================================
Deferred income tax expense results from timing differences in the recognition
of income and expense for income tax and financial reporting purposes. Deferred
income tax balances reflect the net tax effects of temporary differences between
the carrying amounts of assets and liabilities for financial reporting and
income tax purposes. The deferred tax asset primarily reflects the impact of
future tax deductions related to the Company's accruals and net operating
losses. Management believes that, based upon its history of profitable
operations, it is probable that its deferred tax assets will be realized,
primarily from the generation of future taxable income. The deferred tax
liability is primarily attributable to the basis differences related to
intangible assets. The Company records its deferred tax items based on the
estimated value of the tax basis. In 2002, the Company adopted SFAS 142 which
eliminated the requirement to record in the financial statements amortization
expense related to goodwill and intangible assets with indefinite lives. The
Company is able to continue to amortize the intangible assets for tax purposes
which yields an average annual tax benefit of approximately $57 million through
2012. Subsequent to 2012, the benefit from the step-up in tax basis from
reincorporation will be fully amortized. Accounting standards require that the
Company recognize deferred taxes relating to the differences between the
financial reporting and tax basis of the assets. As the annual tax benefit from
the amortization expense is realized, the deferred tax liability increases
reflecting the declining tax basis compared to the non-amortized book basis.
Significant components of the Company's deferred tax balances are as follows:
(In thousands) 2004 2003
==================================================================
Deferred tax assets (liabilities):
Current:
Prepaid expenses $(11,300) $(8,900)
Receivables allowances 15,700 10,300
Accrued insurance expenses 22,900 11,400
Net operating loss and tax credit
carryforwards 40,640 34,600
Other accrued expenses 40,840 39,100
- ------------------------------------------------------------------
Total current asset 108,780 86,500
==================================================================
Long-Term:
Intangible assets (1) (88,500) (263,000)
Accrued insurance expenses 3,600 21,000
Net operating loss and tax credit
carryforwards 10,100 -
Other long-term obligations (13,300) (34,000)
- ------------------------------------------------------------------
Total long-term liability (88,100) (276,000)
==================================================================
Net deferred tax asset (liability) $20,680 $(189,500)
==================================================================
(1) The deferred tax liability relates primarily to the difference in the tax
versus book basis of intangible assets. The majority of this liability does not
represent expected future cash payments until a business unit of the Company is
sold.
At December 31, 2004, the Company had tax effected federal and state net
operating loss carryforwards of approximately $46 million, expiring at various
dates up to 2023. The Company also had federal and state tax credit
carryforwards of approximately $4 million which expire at various dates up to
2024.
In 2004, total tax payments were $13 million. In 2003, the Company received net
tax refunds of $1 million. Total tax payments in 2002 were $27 million.
ACQUISITIONS
Acquisitions have been accounted for using the purchase method and, accordingly,
the results of operations of the acquired businesses have been included in the
Company's consolidated financial statements since their dates of acquisition.
The assets and liabilities of these businesses were
26
recorded in the financial statements at their estimated fair values as of the
acquisition dates.
CURRENT YEAR
The net purchase price of the 2004 acquisitions was $59 million. During the
second quarter of 2004, the Company acquired the assets of Greenspace Services
Limited, Canada's largest professional lawn care service company. In addition,
the Company acquired several small companies, primarily in the pest control and
lawn care businesses. The Company recorded goodwill of approximately $52 million
and other intangible assets of $10 million related to the 2004 acquisitions. The
impact of these acquisitions was not material to the Company's Consolidated
Financial Statements.
PRIOR YEARS
During 2003, the Company acquired several small companies, primarily in the lawn
care business. The net purchase price of these acquisitions was $38 million. The
Company recorded goodwill of $38 million and other intangible assets of $4
million related to these acquisitions.
During 2002, the Company acquired several small companies, primarily in the pest
control and lawn care businesses. The net purchase price of these acquisitions
was $18 million. The Company recorded goodwill of $12 million and other
intangible assets of $4 million related to these acquisitions.
Supplemental cash flow information regarding the Company's acquisitions is as
follows:
(In thousands) 2004 2003 2002
==================================================================
Purchase price $66,841 $44,667 $18,850
Less liabilities
assumed (7,851) (6,315) (1,207)
- ------------------------------------------------------------------
Net purchase price $58,990 $38,352 $17,643
==================================================================
Net cash paid
for acquisitions $40,184 $28,875 $13,003
Value of shares issued 3,475 - -
Seller financed debt 15,331 9,477 4,640
- ------------------------------------------------------------------
Payment for
acquisitions $58,990 $38,352 $17,643
==================================================================
DISPOSITIONS
2003 DISPOSITIONS
During the third quarter of 2003, the Company sold substantially all of the
assets and related operational obligations of Trees, Inc., the utility line
clearing operations of TruGreen LandCare, to an independent subsidiary of
Asplundh Subsidiary Holdings, Inc., for approximately $20 million in cash. The
impact of the sale was not material to the Company's Consolidated Financial
Statements for 2003.
2002 DISPOSITIONS
In October 2001, the Company's Board of Directors approved a series of strategic
actions, which were the culmination of an extensive portfolio review process. As
part of this portfolio review, the Company sold or exited certain non-strategic
or under-performing businesses in 2001 and 2002. During the second quarter of
2002, the Company completed the sale of its ownership interest in five assisted
living facilities. These properties were financed through an operating lease
arrangement, whereby the Company guaranteed a portion of the residual value of
the properties. In the fourth quarter of 2001, a $13.5 million reserve was
established representing the amount by which the residual value guarantees
exceeded the value of bids to purchase the facilities at that time. The final
sales price was significantly greater than these bid levels and the Company
realized a gain of $3.6 million from the sale of the assisted living properties
in 2002, which is included in operating income from continuing operations.
During the third quarter of 2002, the Company sold its remaining Terminix
operations in the United Kingdom. The sale was not material to the Company's
operating results. Related to this sale, the Company entered into a licensing
agreement with the buyer for the use of the Terminix trade name in the United
Kingdom. This agreement was valued at $6 million and accordingly, a like amount
was allocated from the purchase price. The entire amount was recognized as
income in the third quarter of 2002.
In the fourth quarter of 2002, the purchaser of the Company's European pest
control and property services operations made a claim for a purchase price
adjustment (relating to the sale completed in 2001), relating to an alleged
breach of certain conditions in the purchase agreement. In the course of
responding to that claim, the Company discovered that personnel of the former
operations had made unsupported monthly adjustments to certain accounts. The
Company subsequently agreed to an adjustment to the purchase price consisting of
an $8 million cash payment and the cancellation of a previously reserved note
receivable of $7 million. An $8 million charge was recorded in 2002.
Reported "Discontinued operations" for all periods presented include the
operating results of the sold and discontinued businesses noted above. The
operating results and financial position of discontinued operations are as
follows:
(In thousands, except per share data)
Operating Results: 2004 2003 2002
==================================================================
Operating revenue $1,052 $65,057 $129,060
Income (loss) from
discontinued operations
before income taxes (3,793) (3,482) 7,543
Provision (benefit) for
income taxes (1) (10,963) (1,375) 3,012
- ------------------------------------------------------------------
Income (loss) from
discontinued operations 7,170 (2,107) 4,531
(Loss) on sale of
businesses, net of
income taxes (2) - (605) (4,840)
- ------------------------------------------------------------------
Income (loss) from
discontinued operations $7,170 $(2,712) $(309)
==================================================================
Diluted income (loss)
per share from
discontinued operations $0.02 $(0.01) $ -
==================================================================
(1) 2004 includes a $9 million non-cash reduction in the tax provision of
discontinued operations related to a comprehensive agreement with the IRS
regarding its examination of the Company's federal income taxes through the
year 2002.
(2) Includes a tax benefit of $.4 million and $3 million in 2003 and 2002,
respectively.
27
Financial Position: 2004 2003
==================================================================
Current assets $4,952 $5,273
- ------------------------------------------------------------------
Total assets $4,952 $5,273
==================================================================
Current liabilities $21,536 $14,380
Long-term liabilities 9,057 34,396
- ------------------------------------------------------------------
Total liabilities $30,593 $48,776
==================================================================
The table below summarizes the activity during the twelve months ended December
31, 2004 for the remaining liabilities from the discontinued operations. The
Company believes that the remaining reserves continue to be adequate and
reasonable.
Balance BALANCE
at Cash AT
Dec. 31, Payments Income/ DEC. 31,
(In thousands) 2003 or Other (Expense) 2004
- ----------------------------------------------------------------------
Remaining liabilities
from discontinued
operations:
LandCare Construction $7,152 $4,681 $(2,021) $4,492
LandCare utility line
clearing business 9,011 3,678 (1,283) 6,616
Certified Systems, Inc. 11,024 2,302 303 8,419
Management Services 283 696 (479) 66
International businesses 21,306 1,155 9,151 11,000
COMMITMENTS AND CONTINGENCIES
The Company leases certain property and equipment under various operating lease
arrangements. Most of the property leases provide that the Company pay taxes,
insurance and maintenance applicable to the leased premises. As leases for
existing locations expire, the Company expects to renew the leases or substitute
another location and lease.
Rental expense for 2004, 2003 and 2002 was $169 million, $160 million and $153
million, respectively. Future long-term non-cancelable operating lease payments
are approximately $79 million in 2005, $69 million in 2006, $53 million in 2007,
$38 million in 2008, $28 million in 2009, and $35 million in 2010 and
thereafter.
The majority of the Company's fleet and some equipment are leased through
operating leases. Lease terms are non-cancelable for the first twelve month term
and then are month-to-month leases, cancelable at the Company's option. There
are residual value guarantees (ranging from 70 percent to 87 percent depending
on the agreement) on these vehicles and equipment, which historically have not
resulted in significant net payments to the lessors. There are no net payments
reflected in the future minimum lease obligation as the leases are cancelable
and there are no expected net payments due under the guarantees. At December 31,
2004 there was approximately $260 million of residual value guarantee relating
to the Company's fleet and equipment leases. The fair value of the assets under
the leases is expected to fully mitigate the Company's obligations under the
agreements. Accordingly, no liabilities have been recorded with respect to the
guarantees.
The Company maintains operating lease facilities with banks totaling $68 million
which provide for the financing of branch properties to be leased by the
Company. At December 31, 2004, approximately $68 million was funded under these
facilities. Approximately $15 million of these leases have been included on the
balance sheet as assets with related debt as of December 31, 2004 (the
comparable balances were $20 million as of December 31, 2003). The balance of
the funded amount is treated as operating leases. Approximately $15 million of
the total facility expires in January 2008 and $53 million expires in September
2009. The Company has guaranteed the residual value of the properties under the
leases up to 82 percent of the fair market value at the commencement of the
lease. At December 31, 2004, the Company's residual value guarantee related to
the leased assets totaled $56 million for which the Company has recorded the
estimated fair value of this guarantee (approximately $1.2 million) in the
Consolidated Statements of Financial Position.
In the normal course of business, the Company periodically enters into
agreements that incorporate indemnification provisions. While the maximum amount
which the Company may be exposed under such agreements cannot be estimated, the
Company does not expect these guarantees and indemnifications to have a material
adverse effect on its Consolidated Financial Statements.
The Company carries insurance policies on insurable risks at levels which it
believes to be appropriate, including workers' compensation, auto and general
liability risks. The Company has self-insured retention limits and insured
layers of excess insurance coverage above such self-insured retention limits.
Accruals for self-insurance losses and warranty claims in the American Home
Shield business are made based on the Company's claims experience and actuarial
assumptions. At December 31, 2004, these accruals totaled $188 million, with $79
million included in "Self-insured claims and related expenses" and $109 million
included in "Other long-term obligations" in the accompanying Consolidated
Statements of Financial Position. The Company has certain liabilities with
respect to existing or potential claims, lawsuits, and other proceedings. The
Company accrues for these liabilities when it is probable that future costs will
be incurred and such costs can be reasonably estimated.
In the ordinary course of conducting its business activities, the Company
becomes involved in judicial, administrative and regulatory proceedings
involving both private parties and governmental authorities. These proceedings
include general and commercial liability actions and a small number of
environmental proceedings. The Company does not expect any of these proceedings
to have a material adverse effect on its Consolidated Financial Statements.
EMPLOYEE BENEFIT PLANS
Discretionary contributions to qualified profit sharing and non-qualified
deferred compensation plans were made in the amount of $9.3 million for 2004,
$4.6 million for 2003 and $9.2 million for 2002. Under the Employee Share
Purchase Plan, the Company contributed $.8 million in 2004, $.8 million in 2003
and $.9 million in 2002. These funds defrayed part of the cost of the shares
purchased by employees.
MINORITY INTEREST OWNERSHIP AND RELATED PARTIES
The Company continues to have minority investors in Terminix. This minority
ownership reflects an interest issued to the prior owners of the Allied Bruce
Terminix Companies in connection with the acquisition of that entity. At any
time, the former
28
owners may convert this equity security into eight million ServiceMaster common
shares. The ServiceMaster shares are included in the shares used in the
calculation of diluted earnings per share, when their inclusion has a dilutive
impact. Subsequent to December 31, 2005, ServiceMaster has the ability to
require conversion of the security into ServiceMaster common shares, provided
the closing share price of ServiceMaster's common stock averages at least $15
per share for 40 consecutive trading days.
LONG-TERM DEBT
Long-term debt includes the following:
(In thousands) 2004 2003
=================================================================
8.45% maturing in 2005 $137,499 $137,499
6.95% maturing in 2007 49,225 49,225
7.88% maturing in 2009 179,000 179,000
7.10% maturing in 2018 79,473 79,473
7.45% maturing in 2027 195,000 195,000
7.25% maturing in 2038 82,650 82,650
Other 82,241 96,424
Less current portion (23,247) (33,781)
- -----------------------------------------------------------------
Total long-term debt $781,841 $785,490
=================================================================
The Company is party to a number of debt agreements which require it to maintain
certain financial and other covenants, including limitations on indebtedness
(debt cannot exceed 3.25 times earnings before interest, taxes, depreciation,
and amortization (EBITDA)) and a minimum interest coverage ratio (EBITDA needs
to exceed four times interest expense). In addition, under certain
circumstances, the agreements may limit the Company's ability to pay dividends
and repurchase shares of common stock. These limitations are not expected to be
an inhibiting factor in the Company's future dividend and share repurchase
plans. Failure by the Company to maintain these covenants could result in the
acceleration of the maturity of the debt. Throughout 2004, the Company was in
compliance with the covenants related to these debt agreements and based on its
operating outlook for 2005, expects to be able to maintain compliance in the
future.
The Company does not have any debt agreements that contain put rights or provide
for acceleration of maturity as a result of a change in credit rating. However,
the Company has a number of debt agreements which contain standard ratings-based
"pricing grids" where the interest rate payable under the agreement changes as
the Company's credit rating changes. While the Company does not expect a
negative change in credit ratings, the impact on interest expense resulting from
any changes in credit ratings is not expected to be material to the Company.
Since August 1997, ServiceMaster has issued $1.1 billion of unsecured debt
securities pursuant to registration statements filed with the Securities and
Exchange Commission. As of December 31, 2004, ServiceMaster had $550 million of
senior unsecured debt securities and equity interests available for issuance
under an effective shelf registration statement.
The Company has a committed revolving bank credit facility for up to $500
million that expires in May 2009. The facility can be used for general Company
purposes. As of December 31, 2004, the Company had issued approximately $158
million of letters of credit under the facility and had unused commitments of
approximately $342 million. At the Company's current credit ratings, the
interest rate under the facility is LIBOR plus 125 basis points.
As of December 31, 2004, the Company had approximately $5 million of annually
renewable surety bonds outstanding that primarily support obligations the
Company has under insurance programs. If the surety bonds are not renewed, the
Company expects to replace them with letters of credit issued under its bank
credit facility.
In December 2003 and January 2004, the Company entered into interest rate swap
agreements with a total notional amount of $165 million. Under the terms of
these agreements, the Company pays a floating rate of interest (based on a
specified spread over six-month LIBOR) on the notional amount and the Company
receives a fixed rate of interest at 7.88 percent on the notional amount. The
impact of these swap transactions was to convert $165 million of the Company's
debt from fixed rate at 7.88 percent to a variable rate based on LIBOR. In
accordance with SFAS 133 "Accounting for Derivative Instruments and Hedging
Activities", the Company's interest rate swap agreements are classified as fair
value hedges and, as such, gains and losses on the swaps as well as the gains
and losses on the related hedged items are recognized in current earnings.
Cash interest payments were $60 million in 2004, $61 million in 2003 and $76
million in 2002. There were no material borrowings under the revolving credit
facility in 2004, 2003 and 2002. Future scheduled long-term debt payments are
$160.7 million in 2005 (average rate of 8.0 percent), $12.9 million in 2006
(average rate of 6.4 percent), $62.1 million in 2007 (average rate of 6.7
percent), $25.2 million in 2008 (average rate of 4.0 percent) and $184.5 million
in 2009 (average rate of 7.9 percent). The Company's next public debt maturity
of $138 million is in April 2005 and this amount is included in the 2005
scheduled debt payments above. The Company intends to fund this debt payment
with long-term financing under existing credit facilities. Based on annual
projected cash flows, the amount of the borrowing is expected to be largely
repaid by December 31, 2005.
CASH AND MARKETABLE SECURITIES
Cash, money market funds and certificates of deposits, with maturities of three
months or less, are included in the Statements of Financial Position caption
"Cash and Cash Equivalents." Marketable securities are designated as available
for sale and recorded at current market value, with unrealized gains and losses
reported in a separate component of shareholders' equity. As of December 31,
2004 and 2003, the Company's investments consist primarily of domestic publicly
traded debt of $108.8 million and $94.9 million, respectively and common equity
securities of $130.7 million and $88.2 million, respectively.
The aggregate market value of the Company's short- and long-term investments in
debt and equity securities was $239.5 million and $183.1 million and the
aggregate cost basis was $226.4 million and $173.2 million at December 31, 2004
and 2003, respectively.
29
Interest and dividend income received on cash and marketable securities was
$15.4 million, $13.4 million, and $9.7 million, in 2004, 2003, and 2002,
respectively. Gains and losses on sales of investments, as determined on a
specific identification basis, are included in investment income in the period
they are realized. The Company periodically reviews its portfolio of investments
to determine whether there has been an other than temporary decline in the value
of the investments from factors such as deterioration in the financial condition
of the issuer or the market(s) in which it competes. At December 31, 2004, the
net unrealized gains in the investment portfolio totaled $13 million, while the
unrealized losses in the aggregate were immaterial and totaled less than $2.5
million and the portion of unrealized losses older than one year was less than
$.5 million.
RECEIVABLE SALES
The Company has an agreement to provide for the ongoing revolving sale of a
designated pool of accounts receivable of TruGreen ChemLawn and Terminix to a
wholly-owned, bankruptcy-remote subsidiary, ServiceMaster Funding LLC.
ServiceMaster Funding LLC has entered into an agreement to transfer, on a
revolving basis, an undivided percentage ownership interest in a pool of
accounts receivable to unrelated third party purchasers. ServiceMaster Funding
LLC retains an undivided percentage interest in the pool of accounts receivable
and bad debt losses for the entire pool are allocated first to this retained
interest. During 2004, there were no receivables sold to third parties under
this agreement. However, the Company may sell its receivables in the future
which would provide an alternative funding source. The agreement is a 364-day
facility that is renewable at the option of the purchasers. The Company may sell
up to $65 million of its receivables to these purchasers and therefore has
immediate access to cash proceeds from these sales. The amount of the eligible
receivables varies during the year based on seasonality of the business and will
at times limit the amount available to the Company.
COMPREHENSIVE INCOME
Comprehensive income, which encompasses net income, unrealized gains on
marketable securities, and the effect of foreign currency translation is
disclosed in the Statements of Shareholders' Equity.
OTHER COMPREHENSIVE INCOME
(In thousands) 2004 2003 2002
- ------------------------------------------------------------
Unrealized holding
gains (losses)
arising in period $7,745 $15,559 $(7,941)
Tax expense (benefit) 3,098 6,224 (3,196)
- ------------------------------------------------------------
Net of tax amount $4,647 $9,335 $(4,745)
============================================================
Gains (losses) realized $6,370 $3,855 $(1,460)
Tax expense (benefit) 2,549 1,542 (584)
- ------------------------------------------------------------
Net of tax amount $3,821 $2,313 $(876)
============================================================
Accumulated comprehensive income included the following components as of
December 31:
(In thousands) 2004 2003 2002
- ------------------------------------------------------------
Unrealized gains (losses)
on securities, net of tax $6,812 $5,986 $(1,036)
Foreign currency
translation 3,992 1,946 187
- ------------------------------------------------------------
Total $10,804 $7,932 $(849)
============================================================
SHAREHOLDERS' EQUITY
The Company has authorized one billion shares of common stock with par value of
$.01 and 11 million shares of preferred stock. There were no shares of preferred
stock issued or outstanding. In February 2005, the Company announced the
declaration of a cash dividend of $.11 per share to shareholders of record on
February 14, 2005. This dividend was paid on February 28, 2005.
The Company has an effective shelf registration statement to issue shares of
common stock in connection with future, unidentified acquisitions. This
registration statement allows the Company to issue registered shares much more
efficiently when acquiring privately held companies. The Company plans to use
the shares over time in connection with purchases of small acquisitions. There
were approximately 4.4 million shares available for issuance under this
registration statement at December 31, 2004.
As of December 31, 2004, there were 42.3 million Company shares available for
issuance upon the exercise of employee stock options outstanding and future
grants. Stock options are issued at a price not less than the fair market value
on the grant date and expire within ten years of the grant date. Certain options
may permit the holder to pay the option exercise price by tendering Company
shares that have been owned by the holder without restriction for an extended
period. Share grants and restricted stock awards carry a vesting period and are
restricted as to the sale or transfer of the shares. Restricted stock awards are
non-transferable and subject to forfeiture if the holder does not remain
continuously employed by the Company during the vesting period, or if the
restricted stock is subject to performance measures, if those performance
measures are not attained. The Company includes the vested and unvested portions
of the restricted stock awards in shares outstanding in the denominator of its
earnings per share calculations.
Beginning in 2003, the Company has been accounting for employee stock options as
compensation expense in accordance with SFAS 123, "Accounting for Stock-Based
Compensation." SFAS 148, "Accounting for Stock-Based Compensation - Transition
and Disclosure, an amendment of FASB Statement No. 123", provides alternative
methods of transitioning to the fair-value based method of accounting for
employee stock options as compensation expense. The Company is using the
"prospective method" permitted under SFAS 148 and is expensing the fair value of
new employee option grants awarded subsequent to 2002.
Prior to 2003, the Company accounted for employee share options under the
intrinsic method of Accounting Principles Board Opinion 25, as permitted under
GAAP. Accordingly, no compensation cost had been recognized in the accompanying
financial statements in 2002 related to these options. See the "Stock-Based
Compensation" note in the "Significant
30
Accounting Policies" section for the proforma net income and earnings per share
under the fair-value based method of SFAS 123. In computing this proforma
impact, the fair value of each option is estimated on the date of grant using
the Black-Scholes option pricing model with the following weighted-average
assumptions in 2004, 2003 and 2002: risk-free interest rates of 3.7 percent, 3.6
percent and 4.5 percent, respectively; dividend yields of 4.0 percent, 4.2
percent, and 3.2 percent, respectively; share price volatility of 30.6 percent,
30.8 percent, and 31.4 percent; and average expected lives of six to seven
years. The options granted to employees in 2004, 2003 and 2002 have
weighted-average fair values of $2.35, $2.14 and $3.51, respectively and vest
ratably over five years. The Company has estimated the value of these options
assuming a single weighted-average expected life for the entire award.
Options and grant transactions during the last three years are summarized below:
Stock Price Weighted Avg. Share Grants/ Price
Options Range (1) Exercise Price Restricted Stock Range
================================================================================================================================
Total exercisable, December 31, 2001 15,237,607 $2.25 - 77.56 $12.36 - -
Total outstanding, December 31, 2001 29,331,885 $2.25 - 77.56 $12.40 100,519 $2.86 - 7.96
================================================================================================================================
TRANSACTIONS DURING 2002
Granted to employees 4,939,141 $9.09 - 15.10 $13.08 179,000 $10.51 - 13.80
Exercised or vested (1,586,248) $2.25 - 14.55 $7.60 (46,632) $2.86 - 7.96
Terminated or resigned (871,439) $5.14 - 73.53 $16.37 - -
- --------------------------------------------------------------------------------------------------------------------------------
Total exercisable, December 31, 2002 18,089,830 $2.25 - 77.56 $13.05 - -
Total outstanding, December 31, 2002 31,813,339 $2.25 - 77.56 $12.64 232,887 $2.86 - 13.80
================================================================================================================================
TRANSACTIONS DURING 2003
Granted to employees 2,432,674 $8.40 - 11.21 $9.91 364,419 $9.50 - 11.97
Exercised or vested (1,296,101) $6.44 - 11.50 $7.70 (56,092) $2.86 - 13.80
Terminated or resigned (1,240,146) $2.25 - 37.40 $13.49 (3,514) $9.95
- --------------------------------------------------------------------------------------------------------------------------------
Total exercisable, December 31, 2003 20,346,581 $6.44 - 77.56 $13.16 - -
Total outstanding, December 31, 2003 31,709,766 $6.44 - 77.56 $12.60 537,700 $3.03 - 13.80
================================================================================================================================
TRANSACTIONS DURING 2004
Granted to employees 2,049,680 $8.63 - 13.06 $10.79 988,309 $10.73 - 12.86
Exercised or vested (1,250,434) $6.44 - 11.50 $8.20 (109,827) $3.03 - 13.80
Terminated or resigned (545,085) $6.44 - 37.40 $12.57 (16,491) $9.95 - 11.17
- --------------------------------------------------------------------------------------------------------------------------------
Total exercisable, December 31, 2004 22,573,344 $8.40 - 77.56 $13.26 - -
Total outstanding, December 31, 2004 31,963,927 $8.40 - 77.56 $12.66 1,399,691 $3.82 - 13.80
================================================================================================================================
(1) The options priced at $73.53 to $77.56 are options assumed by the Company as
a result of business acquisitions.
Options outstanding at December 31, 2004:
Number Weighted Average Weighted Number Weighted
Range of Outstanding Remaining Average Exercisable Average
Exercise Prices at 12/31/04 Life Exercise Price at 12/31/04 Exercise Price
====================================================================================================================================
$8.40 - 10.78 13,912,301 5 Years $9.92 8,017,534 $9.70
$10.80 - 15.94 11,894,276 4 Years $12.27 8,398,460 $12.02
$16.12 - 22.32 5,763,479 4 Years $18.15 5,763,479 $18.15
$22.33 - 77.56 393,871 2 Years $40.77 393,871 $40.77
- ------------------------------------------------------------------------------------------------------------------------------------
$8.40 - 77.56 31,963,927 4.4 Years $12.66 22,573,344 $13.26
====================================================================================================================================
31
EARNINGS PER SHARE
Basic earnings per share is computed by dividing income available to common
stockholders by the weighted-average number of shares outstanding for the
period. The weighted average common shares for the diluted earnings per share
calculation includes the incremental effect related to outstanding options whose
market price is in excess of the exercise price. Shares potentially issuable
under convertible securities have been considered outstanding for purposes of
the diluted earnings per share calculations. In computing diluted earnings per
share, the after-tax interest expense related to convertible securities is added
back to net income in the numerator, while the diluted shares in the denominator
include the shares issuable upon conversion of the securities. Due to the losses
incurred in 2003, the denominator does not include the effects of options as it
would result in a less dilutive computation. As a result, 2003 diluted earnings
per share are the same as basic earnings per share. Had the Company recognized
income from continuing operations in 2003, incremental shares attributable to
the assumed exercise of outstanding options would have increased diluted shares
outstanding by 3.9 million shares. Shares potentially issuable under convertible
securities have not been considered outstanding for 2003 and 2002 as their
inclusion results in a less dilutive computation. Had the inclusion of
convertible securities not resulted in a less dilutive computation in 2003 and
2002, incremental shares attributable to the assumed conversion of the
securities would have increased shares outstanding by 8.0 million and 8.2
million shares, respectively, and the after-tax interest expense related to the
convertible securities that would have been added to net income in the numerator
would have been $4.8 million for both 2003 and 2002.
The following table reconciles both the numerator and the denominator of the
basic earnings per share from continuing operations computation to the numerator
and the denominator of the diluted earnings per share from continuing operations
computation.
(In thousands, except per share data)
FOR YEAR ENDED 2004 For year ended 2003 For year ended 2002
CONTINUING OPERATIONS: INCOME SHARES EPS Loss Shares EPS Income Shares EPS
====================================================================================================================================
Basic EPS $324,057 290,514 $1.12 $(221,975) 295,610 $(0.75) $157,303 300,383 $0.52
Effect of Dilutive Securities:
Options 5,054 - 5,529
Convertible securities 4,712 8,000 - -
- ------------------------------------------------------------------------------------------------------------------------------------
Diluted EPS $328,769 303,568 $1.08 $(221,975) 295,610 $(0.75) $157,303 305,912 $0.51
====================================================================================================================================
32
QUARTERLY OPERATING RESULTS (UNAUDITED)
Quarterly operating results and related growth for the last three years in
revenue, gross profit, income from continuing operations, income from
discontinued operations and earnings per share are shown in the table below. As
discussed in the "Interim Reporting" section in the Significant Accounting
Policies, for interim accounting purposes, TruGreen ChemLawn and other business
segments of the Company incur pre-season advertising costs. In addition,
TruGreen ChemLawn incurs costs related to annual repairs and maintenance
procedures that are performed in the first quarter. These costs are deferred and
recognized as expense in proportion to revenue over the balance of the year.
Full year results are not affected. In 2004, the Company corrected the interim
disclosure of one of its key performance indicators. Terminix corrected the
interim calculation of its pest control retention rates which resulted in a
change in the previously reported rates. The restated rates were 78.6% as of
June 30, 2004 and 78.4% as of September 30, 2004. No other periods were
impacted.
=================================================================================================================================
(In thousands, except per share data)
2004 Chg 2003 Chg 2002
=================================================================================================================================
CONTINUING OPERATIONS:
Operating Revenue:
First Quarter $756,891 6% $712,343 0% $711,956
Second Quarter 1,088,716 6 1,031,470 2 1,013,777
Third Quarter 1,053,867 3 1,018,263 3 987,757
Fourth Quarter 859,094 7 806,510 2 787,231
=================================================================================================================================
$3,758,568 5% $3,568,586 2% $3,500,721
=================================================================================================================================
Gross Profit:
First Quarter $211,835 8% $195,989 (2%) $200,944
Second Quarter 391,010 5 373,587 6 353,543
Third Quarter 366,875 5 347,942 8 323,111
Fourth Quarter 263,819 20 220,545 (2) 224,171
=================================================================================================================================
$1,233,539 8% $1,138,063 3% $1,101,769
=================================================================================================================================
Income (Loss) from Continuing Operations:
First Quarter $11,461 137% $4,843 (53%) $10,377
Second Quarter 70,688 7 66,329 8 61,625
Third Quarter (1) 68,343 N/M (316,526) N/M 66,015
Fourth Quarter (2) 173,565 N/M 23,379 21 19,286
=================================================================================================================================
$324,057 N/M $(221,975) N/M $157,303
=================================================================================================================================
Basic Earnings (Loss) Per Share:
First Quarter $0.04 100% $0.02 (33%) $0.03
Second Quarter 0.24 9 0.22 10 0.20
Third Quarter (1) 0.24 N/M (1.08) N/M 0.22
Fourth Quarter (2) 0.60 N/M 0.08 33 0.06
=================================================================================================================================
$1.12 N/M $(0.75) N/M $0.52
=================================================================================================================================
Diluted Earnings (Loss) Per Share:
First Quarter $0.04 100% $0.02 (33%) $0.03
Second Quarter 0.24 9 0.22 10 0.20
Third Quarter (1) 0.23 N/M (1.08) N/M 0.21
Fourth Quarter (2) 0.57 N/M 0.08 33 0.06
=================================================================================================================================
$1.08 N/M $(0.75) N/M $0.51
=================================================================================================================================
DISCONTINUED OPERATIONS:
Income (Loss) from Discontinued Operations:
First Quarter $(262) (56%) $(168) N/M $1,264
Second Quarter (292) 63 (779) N/M 878
Third Quarter (619) 57 (1,440) N/M 2,068
Fourth Quarter (2) 8,343 N/M (325) N/M (4,519)
=================================================================================================================================
$7,170 N/M $(2,712) N/M $(309)
=================================================================================================================================
Diluted Earnings (Loss) Per Share:
First Quarter $ - -% $ - -% $ -
Second Quarter - - - - -
Third Quarter - - - (100) 0.01
Fourth Quarter (2) 0.03 N/M - 100 (0.01)
=================================================================================================================================
$0.02 N/M $(0.01) (100%) $ -
=================================================================================================================================
N/M = Not meaningful
(1) In accordance with SFAS 142, the Company's goodwill and intangible assets
that are not amortized are subject to at least an annual assessment for
impairment by applying a fair-value based test. During the third quarter of
2003, the Company recorded a non-cash impairment charge associated with
goodwill and intangible assets at its American Residential Services,
American Mechanical Services and TruGreen LandCare business units of $481
million pre-tax ($383 million after-tax). The impact on diluted earnings
per share of this charge was $1.30. See the "Goodwill and Intangible
Assets" note in the Notes to Consolidated Financial Statements.
(2) In January 2005, the Company announced that it had reached a comprehensive
agreement with the Internal Revenue Service regarding its examination of
the Company's federal income taxes through the year 2002. As a result of
this agreement, the Company recorded a non-cash reduction in its fourth
quarter and full year 2004 tax provision, thereby increasing net income by
approximately $159 million. Approximately $150 million related to
continuing operations ($.49 per diluted share) and $9 million related to
discontinued operations ($.03 per diluted share). See the "Income Taxes"
note in the Notes to the Consolidated Financial Statements.
33
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of The ServiceMaster Company ("The Company") is responsible for
establishing and maintaining adequate internal control over financial reporting.
The Company's internal control over financial reporting is designed to provide
reasonable assurance to the Company's management and board of directors
regarding the preparation and fair presentation of published financial
statements.
All internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation.
Management assessed the effectiveness of the Company's internal control over
financial reporting as of December 31, 2004. In making this assessment, it used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in INTERNAL CONTROL - INTEGRATED FRAMEWORK. Based on
our assessment we believe that, as of December 31, 2004, the Company's internal
control over financial reporting is effective based on those criteria.
The Company's independent registered public accounting firm has issued an audit
report on our assessment of the Company's internal control over financial
reporting. This report follows.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of the ServiceMaster Company
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control over Financial Reporting, that The
ServiceMaster Company and subsidiaries (the "Company") maintained effective
internal control over financial reporting as of December 31, 2004, based on
criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the
Committee of Sponsoring Organizations of the Treadway Commission. The Company's
management is responsible for maintaining effective internal control over
financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the Company's
internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed by,
or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation
34
of the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
In our opinion, management's assessment that the Company maintained effective
internal control over financial reporting as of December 31, 2004, is fairly
stated, in all material respects, based on the criteria established in INTERNAL
CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Also in our opinion, the Company
maintained, in all material respects, effective internal control over financial
reporting as of December 31, 2004, based on the criteria established in INTERNAL
CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated financial
statements as of and for the year ended December 31, 2004 of the Company and our
report dated February 28, 2005 expressed an unqualified opinion on those
financial statements.
/s/ DELOITTE & TOUCHE LLP
Chicago, Illinois
February 28, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of the ServiceMaster Company
We have audited the accompanying consolidated statements of financial position
of The ServiceMaster Company and subsidiaries (the "Company") as of December 31,
2004 and 2003, and the related consolidated statements of operations,
shareholders' equity, and cash flows for each of the three years in the period
ended December 31, 2004. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the ServiceMaster Company and
subsidiaries as of December 31, 2004 and 2003, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2004, in conformity with accounting principles generally accepted
in the United States of America.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of the Company's
internal control over financial reporting as of December 31, 2004, based on the
criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the
Committee of Sponsoring Organizations of the Treadway Commission and our report
dated February 28, 2005 expressed an unqualified opinion on management's
assessment of the effectiveness of the Company's internal control over financial
reporting and an unqualified opinion on the effectiveness of the Company's
internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Chicago, Illinois
February 28, 2005
35
QUARTERLY CASH DIVIDENDS AND PRICE PER SHARE DATA
2004 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
Cash Dividends Per Share: % Chg % Chg
First Quarter $0.105 0% $0.105 5% $0.10
Second Quarter 0.105 0 0.105 5 0.10
Third Quarter 0.11 5 0.105 0 0.105
Fourth Quarter 0.11 5 0.105 0 0.105
- -----------------------------------------------------------------------------------------------------------------------------
$0.43 2% $0.42 2% $0.41
=============================================================================================================================
The following table sets forth the quarterly prices of ServiceMaster's common
stock, as reported on the New York Stock Exchange Composite Transactions:
2004 2003 2002
- -----------------------------------------------------------------------------------------------------------------------------
Price Per Share: HIGH LOW High Low High Low
First Quarter $12.05 $10.65 $11.41 $8.95 $14.50 $13.16
Second Quarter 12.50 11.35 10.95 8.97 15.50 12.70
Third Quarter 13.25 11.12 10.73 9.35 13.63 10.30
Fourth Quarter 13.87 12.30 12.10 10.20 12.15 8.89
MANAGEMENT CERTIFICATIONS
In May 2004, the Company submitted to the New York Stock Exchange the Annual CEO
Certification required by Section 303A.12(a) of the New York Stock Exchange
Listed Company Manual. The Company has also filed, as exhibits to its Annual
Report on Form 10-K for the year ended December 31, 2004, the certifications of
its Chief Executive Officer and Chief Financial Officer required by Section 302
of the Sarbanes-Oxley Act of 2002.
36