ITEM 1. BUSINESS
G&K Services, Inc., founded in 1902 and headquartered in Minnetonka, Minnesota, is a market leader in providing branded identity apparel and facility services programs that enhance image and safety in the workplace. We serve a wide variety of North American industrial, service and high-technology companies providing them with rented uniforms and facility services products such as floor mats, dust mops, wiping towels, restroom supplies and selected linen items. We also sell uniforms and other apparel items to customers in our direct sale programs. The North American rental market is approximately $6.5-$7.0 billion, while the portion of the direct sale market targeted by us is approximately $4.5-$5.0 billion in size.
Through internal growth and acquisitions, we have steadily expanded our operations into additional geographic markets. We operate out of over 130 North American locations serving customers in 46 states and 3 Canadian provinces.
We target our marketing efforts on customers, industries and geographic locations that are expanding and are in need of a quality-oriented corporate identity or facility services program that provides high levels of product quality, consistent customer-centric service levels, multi-channel sales, service, reporting and outsourced program management. Our experience with both existing and potential customers, large and small, confirms that a large segment of the market is willing to pay a premium price to a vendor that can consistently supply these features.
Customers, Products and Services
We serve over 160,000 customers, from Fortune 100 companies to fast-growing small and midsize firms. No single customer represents more than 1.0% of our total revenues. We serve customers in virtually all industries including automotive, warehousing, distribution, transportation, energy, manufacturing, pharmaceutical, semi-conductor, restaurants and hospitality, and many others. Over one million people wear our uniforms every day.
Our full-service business apparel and facility services programs provide rental-lease or purchase options to meet varied customer needs including heavy-industrial, light-manufacturing, service businesses, corporate casual and executive apparel markets. In addition, we offer cleanroom garments and process control services to meet the needs of high-technology customers.
We believe that customers use business apparel programs to meet a variety of critical business needs that enhance image and safety in the workplace, including:
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Company identity and security - uniforms help identify employees working for a particular company or department. Uniformed employees are perceived as trained, competent and dependable.
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Brand awareness - uniforms promote a company’s brand identity and employees serve as “walking billboards.”
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Image - uniforms help companies project a professional image through their employees and frame the perception of credibility, knowledge, trust and a commitment to quality to their customers.
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Employee retention - uniforms enhance worker morale and help build a teamwork attitude in addition to being an employee benefit.
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Worker protection - uniforms help protect workers from difficult environments such as heavy soils, heat, flame or chemicals.
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Product protection - uniforms and facility services help protect products against contamination in the food, pharmaceutical, electronics and health care industries.
We provide our apparel-rental customers with a full range of services and solutions. A consultative approach is used to advise and assist our customers in creating tailored solutions including determining garment application and choosing the appropriate fabrics, styles and colors to meet their branding, identity and safety needs. We have a large stock of new and used garments to provide rapid response as customer needs
change due to increases, decreases or turnover in their work force. Professional cleaning, finishing, repair and replacement of uniforms in use is a normal part of the rental service. Soiled uniforms are picked up at the customer’s location and returned clean and in good condition on a weekly cycle.
We also believe that for most customers, uniform rental programs provide significant advantages over ownership. Renting eliminates investment in uniforms; offers flexibility in styles, colors and quantities as customer requirements change; assures consistent professional cleaning, finishing, repair and replacement of items in use; and provides freedom from the expense and management time necessary to administer a uniform program.
Our facility services programs provide a wide range of dust control, maintenance and hygiene products and services. They include several floor mat offerings (traction control, logo, message, scraper and anti-fatigue), dust and wet mops, wiping towels, fender covers, selected linen items and several restroom hygiene products. These products support customers’ efforts in maintaining a clean, safe and attractive environment within their facilities.
We also offer direct sale and custom-embroidered logo apparel programs to meet customer identity needs. The direct sale programs can be used for departments and/or customers that require highly customized and branded apparel or for workers who don’t start at the same location each day and need uniform apparel they can care for themselves. It can be a more economical approach for high turnover positions and can be used for employee rewards and recognition or customer and vendor appreciation programs.
Acquisitions
We made several small acquisitions in each of the past three fiscal years. All acquisitions were accounted for using the purchase method. The pro forma effect of these acquisitions, had they been acquired at the beginning of each fiscal year, were not material. The total purchase consideration, including related acquisition costs of these transactions, was $24.9 million, $88.7 million and $69.7 million in fiscal 2004, 2003 and 2002, respectively. The total purchase price exceeded the estimated fair values of assets acquired and liabilities assumed by $19.3 million in fiscal 2004, $63.2 million in fiscal 2003 and $52.1 million in fiscal 2002.
Competition
Customers in the corporate identity apparel and facility services industry choose suppliers primarily based upon the quality, price and breadth of products offered and the comprehensive nature of the services provided. While we rank among the nation’s largest garment rental suppliers, we encounter competition from a number of companies in the geographic areas we serve. Major competitors include publicly held companies such as ARAMARK (a division of ARAMARK Corporation), Cintas Corporation and UniFirst Corporation. We also compete with a multitude of regional and local competitors that vary by market. We believe that we compete effectively in our line of business because of the quality and breadth of our product line, the comprehensive customer service levels we provide and our proven ability as an outsource partner. In addition, our competitors generally compete with us for acquisition candidates, which can reduce the number of acquisition candidates available to us.
Manufacturing and Suppliers
We manufactured approximately one-half of the uniform garments placed into service in fiscal 2004. These garments are manufactured in three Company owned facilities located in the Continental U.S. and Dominican Republic. Various outside vendors are used to supplement our additional rental needs, including garments, floor mats, dust mops, wiping towels, linens and related products. We are not aware of any circumstances that would limit our ability to obtain raw materials to support the manufacturing process or to obtain garments or other rental items to meet our customers’ needs.
Environmental Matters
Our operations are subject to various federal, state and/or local laws regulating the discharge of materials into the environment. This includes discharges into wastewater and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. We generate modest amounts of waste in connection with our laundry operations, specifically detergent wastewater, wastewater sludge, waste oil and other residues. Some of these wastes are classified as hazardous wastes under these laws. We have continued to make significant investments in properly handling and disposing of these wastes.
We have been identified as a potentially responsible party (“PRP”) under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (“CERCLA”), or similar state laws, at a number of waste disposal sites. Under such laws, PRP’s typically are jointly and severally liable for any investigation and remediation costs incurred with respect to such sites. Therefore, there can be no assurance that we will not have to contribute material amounts for future remediation that could be greater than the share of waste contributed by us would otherwise indicate. Additionally, environmental laws may impose liability for cost of removal or remediation of certain hazardous wastes located on or in or emanating from owned or leased real estate, whether or not we knew of or were responsible for the presence of such wastes. While we take appropriate steps when acquiring or leasing new properties, there can be no assurance that this risk has been eliminated.
We have been placed on notice by the owners of a Wayzata, Minnesota shopping center regarding the alleged presence of solvents in the ground water in the vicinity of the shopping center, where certain affiliates of ours formerly operated a dry cleaning establishment in the shopping center. At this time, no demand has been made and no action has been commenced against us. The owners of the shopping center have informed us that they are pursuing cleanup through state funding mechanisms. Since little information is available at this time, we are unable to predict what, if any, liability we may have in this matter.
Although any ultimate liability arising from environmental related matters described herein could result in significant expenditures that, if aggregated and assumed to occur within a single fiscal year, could be material to our results of operation or financial position, the likelihood of such occurrence is considered remote. Based on information currently available and our best assessment of the ultimate amount and timing of environmental-related events, we believe that the cost of these environmental-related matters are not reasonably likely to have a material adverse effect on our results of operations or financial position.
Employees
Our U.S. operations had a total of 7,235 employees as of July 3, 2004, consisting of 4,078 production employees and 3,157 sales, office, route and management personnel. Unions represent approximately 14.5% of our U.S. employees. Management believes its domestic employee relations are satisfactory.
Our Canadian operations had a total of 1,030 employees as of July 3, 2004, consisting of 541 production employees and 489 sales, office, route and management personnel. Unions represent approximately 69.4% of our Canadian employees. Management believes Canadian employee relations are satisfactory.
Foreign and Domestic Operations
Financial information relating to foreign and domestic operations is set forth in Note 10 of our consolidated financial statements included in Item 8 of this Form 10-K.
Additional Information
We own a portfolio of registered trademarks, trade names and licenses, and certain U.S. and foreign process and manufacturing patents relating to our business as we currently conduct it. These proprietary properties, in the aggregate, constitute a valuable asset. Among these are the trademarks and trade names G&K Services, G&K TeamWear® and G&K First Step® Facility Services brands, various logos and marketing themes and collateral. We do not believe, however, that our business is dependent upon any single proprietary property or any particular group of proprietary properties. We do not consider our business to be seasonal to any extent or subject to any unusual working capital requirements.
Available Information
We make available free of charge our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. These reports are available on our website at http://www.gkservices.com. In addition, you may request a copy of these filings, excluding exhibits, by contacting our Investor Relations group at (952) 912-5500 or at G&K Services, Inc., 5995 Opus Parkway, Minnetonka, Minnesota 55343. Information included on our website is not deemed to be incorporated into this Annual Report on Form 10-K.
ITEM 2.
ITEM 2. PROPERTIES
We occupy 155 facilities located in the United States and Canada. These facilities include our processing, branch, garment manufacturing, distribution and administrative support locations. We own approximately 80.0% of our processing facilities, each of which average over 43,000 square feet in size. We clean and supply rental items principally from 57 industrial garment, cleanroom garment, dust control and linen supply plants located in 48 cities in the United States and 6 cities in Canada.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We are involved in a variety of legal actions relating to personal injury, customer contracts, employment, trade practices, environmental and other legal matters that arise in the normal course of business. These legal actions include but are not limited to those items set forth in Item 1. Business - Environmental Matters and lawsuits that challenge the practice of charging for certain environmental services on invoices. None of these legal actions are expected to have a material adverse effect on our results of operations or financial position.
We are also involved in a lawsuit in California that alleges G&K violated certain state wage and hour laws applicable to its route sales representatives. Subsequent to July 3, 2004, we reached a tentative settlement of this case for a payment of approximately $1.25 million, subject to court approval. The settlement resulted in the recording of a one-time charge of $1.25 million in the fourth quarter of fiscal 2004.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of our security holders during the fourth quarter of fiscal 2004.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
Our Class A Common Stock is quoted on the Nasdaq National Market under the symbol “GKSRA”. Our Class B Common Stock is not registered and no active trading market exists for the Class B Common Stock. The following table sets forth the high and low reported sales prices for the Class A Common Stock as quoted on the Nasdaq National Market for the periods indicated.
As of August 30, 2004, we had approximately 549 registered holders of record of our common stock.
We have declared cash dividends of $0.0175 per share in each of the quarters for the fiscal years ended July 3, 2004 and June 28, 2003. Our debt agreements contain various restrictive covenants, which, among other things, limit the payment of cash dividends we declare during any fiscal year.
The following table sets forth certain information as of July 3, 2004 with respect to equity compensation plans under which securities are authorized for issuance:
The following table includes information about our share repurchases for the year ended July 3, 2004; all transactions took place during the 3rd quarter of fiscal 2004.
(1) All repurchased shares were initially issued under the Employee Plans as restricted stock grants subject to forfeiture upon termination of employment. All repurchases were made upon forfeiture of shares by the recipient of such restricted stock grants. Pursuant to the Restricted Stock Agreements governing such grants, the repurchase price for all shares was $0.50, which represents the per share amount paid by the restricted stock grant recipient on the date of grant.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth certain selected financial data. All amounts are in thousands, except per share data.
See Note 1 of our consolidated financial statements included in Item 8 of this Form 10-K for an explanation of the method employed to determine the number of shares used to compute per share amounts. We utilize a 52-53 week fiscal year ending on the Saturday nearest June 30. Fiscal 2004 and 2000 were 53-week years.
The fiscal 2002 results include the impact of the adoption of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” under which goodwill and intangible assets with indefinite lives are no longer amortized. See Note 3 of the consolidated financial statements included in Item 8 of this Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes thereto which are included herein. We utilize a 52-53 week fiscal year ending on the Saturday nearest June 30. The fiscal year ended July 3, 2004 was a 53-week year with the extra week reported in the fourth quarter.
Overview
G&K Services, Inc., founded in 1902 and headquartered in Minnetonka, Minnesota, is a market leader in providing branded identity apparel and facility services programs that enhance image and safety in the workplace. We serve a wide variety of North American industrial, service and high-technology companies providing them with rented uniforms and facility services products such as floor mats, dust mops, wiping towels, restroom supplies and selected linen items. We also sell uniforms and other apparel items to customers in our direct sale programs. The North American rental market is approximately $6.5-$7.0 billion, while the portion of the direct sale market targeted by us is approximately $4.5-$5.0 billion in size.
In fiscal 2004, revenue grew to $733.4 million, up 3.9% over the prior year. Excluding the impact of the 53rd week, full year revenues were up 2.0%. Revenue growth continued to be negatively impacted by weak economic conditions and declining employment levels within our existing customer base. These negative impacts were more than offset by several small acquisitions completed over the past two fiscal years.
Our primary goal in fiscal 2004 was to restore earnings momentum in the business. Fiscal 2004 net income grew by 5.0% to $35.4 million. This improvement in earnings was the result of the attention we placed on internal operating initiatives such as plant consolidations, labor efficiency, merchandise cost controls and general and administrative cost reductions. In addition, we placed a large emphasis on working capital management during the fiscal year, resulting in significant levels of cash flows from operations and reductions in interest expense. These improvements, along with the impact of the extra week of operations, were partially offset by higher energy and employee benefit costs, lost margin from lower employment levels within our customer base, expenses associated with a transfer of production within our manufacturing facilities and costs accrued in connection with a tentative settlement of a wage and hour dispute.
We made several small acquisitions in each of the past three fiscal years. All acquisitions were accounted for using the purchase method. The pro forma effect of these acquisitions, had they been acquired at the beginning of each fiscal year, were not material. The total purchase consideration, including related acquisition costs of these transactions, was $24.9 million, $88.7 million and $69.7 million in fiscal 2004, 2003 and 2002, respectively. The total purchase price exceeded the estimated fair values of assets acquired and liabilities assumed by $19.3 million in fiscal 2004, $63.2 million in fiscal 2003 and $52.1 million in fiscal 2002.
Critical Accounting Policies
The discussion of the financial condition and results of operations are based upon the consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States. As such, management is required to make certain estimates, judgments and assumptions that are believed to be reasonable based on the information available. These estimates and assumptions affect the reported amount of assets and liabilities, revenues and expenses, and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results may differ from these estimates under different assumptions or conditions.
Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. See Note 1 to the consolidated financial statements for additional discussion of the application of these and other accounting policies.
Revenue Recognition and Allowance for Doubtful Accounts
Our rental operations business is largely based on written service agreements whereby we agree to collect, launder and deliver uniforms and other related products. The service agreements provide for weekly billing upon completion of the laundering process and delivery to the customer. Accordingly, we recognize revenue from rental operations in the period in which the services are provided. Revenue from rental operations also includes billings to customers for lost or abused merchandise. Direct sale revenue is recognized in the period in which the product is shipped.
Estimates are used in determining the collectibility of billed accounts receivable. Management analyzes specific accounts receivable and historical bad debt experience, customer credit worthiness, current economic trends and the age of outstanding balances when evaluating the adequacy of the allowance for doubtful accounts. Significant management judgments and estimates are used in connection with establishing the allowance in any accounting period. While we have been consistent in applying our judgments and in making our estimates over the past three fiscal years, material differences may result in the amount and timing of bad debt expense recognition for any given period if management makes different judgments or utilizes different estimates.
Inventories
Our inventories consist of new goods and rental merchandise in service. Estimates are used in determining the likelihood that new goods on hand can be sold to customers or used in rental operations. Historical inventory usage and current revenue trends are considered in estimating both obsolete and excess inventories. New goods are stated at lower of cost or market, net of any reserve for obsolete or excess inventory. Merchandise placed in service to support rental operations is amortized into cost of rental operations over the estimated useful lives of the underlying inventory items, primarily on a straight-line basis, which results in a matching of the cost of the merchandise with the weekly rental revenue generated by merchandise. Estimated lives of rental merchandise in service range from nine months to three years. In establishing estimated lives for merchandise in service, management considers historical experience and the intended use of the merchandise. Material differences may result in the amount and timing of operating profit for any period if management makes different judgments or utilizes different estimates.
Goodwill, Intangibles and Other Long-Lived Assets
We adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) at the beginning of fiscal 2002 and as a result no longer amortize goodwill. SFAS 142 also requires that companies test goodwill for impairment on an annual basis and when events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit to which goodwill is assigned below its carrying amount. Our evaluation considers changes in the operating environment, competitive information, market trends, operating performance and cash flow modeling. Management completes its annual impairment test in the fourth quarter of each fiscal year and there have been no impairments of goodwill or definite-lived intangible assets in fiscal 2004, 2003 or 2002. Future events could cause management to conclude that impairment indicators exist and that goodwill and other intangibles associated with acquired businesses are impaired. Any resulting impairment loss could have a material impact on our financial condition and results of operations.
Property, plant and equipment and definite-lived intangible assets are depreciated or amortized over their useful lives. Useful lives are based on management estimates of the period that the assets will generate revenue. Long-lived assets are evaluated for impairment whenever events and circumstances indicate an asset may be impaired. There have been no write-downs of any long-lived assets in fiscal 2004, 2003 or 2002.
Insurance
We self-insure for certain obligations related to health and workers’ compensation programs. We purchase stop-loss insurance policies to protect us from catastrophic losses. Estimates are used in determining the potential liability associated with reported claims and for losses that have occurred, but have not been reported. Management estimates consider historical claims experience, escalating medical cost trends, expected timing of claim payments and an actuarial analysis provided by a third party. During fiscal 2002, we changed certain assumptions utilized in evaluating our workers’ compensation self-insurance liability and began to apply a discounting factor to estimated future payments. The impact of these changes was not material to our consolidated balance sheets or statements of operations for any period presented. Changes in the cost of medical care, our ability to settle claims and the estimates and judgments used by management could have a material impact on the amount and timing of expense for any period.
Income Taxes
In the normal course of business, we are subject to audits from federal, state, Canadian provincial and other tax authorities regarding various tax liabilities. These audits may alter the timing or amount of taxable income or deductions, or the allocation of income among tax jurisdictions. The amount ultimately paid upon resolution of issues raised may differ from the amount accrued. We believe that taxes accrued on our consolidated balance sheets fairly represent the amount of future tax liability due.
We utilize income tax planning to reduce our overall cost of income taxes. Upon audit, it is possible that certain strategies might be disallowed resulting in an increased liability for income taxes. We believe that the provision for liabilities resulting from the implementation of income tax planning is appropriate. To date, we have not experienced an examination by governmental revenue authorities that would lead management to believe that our past provisions for exposures related to income tax planning are not appropriate.
Deferred income taxes are determined in accordance with SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, using statutory rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. We record valuation allowances to reduce deferred tax assets when it is more likely than not that some portion of the asset may not be realized. As such, we have established a valuation allowance for all foreign tax credit carryforwards due to the uncertainty of the use of the tax benefit in future periods. We evaluate our deferred tax assets and liabilities on a periodic basis. We believe that we have adequately provided for our future tax consequences based upon current facts, circumstances and tax law.
Results of Operations
The percentage relationships to revenues of certain income and expense items for the three fiscal years ended July 3, 2004, June 28, 2003 and June 29, 2002, and the percentage changes in these income and expense items between years are presented in the following table:
Fiscal 2004 Compared to Fiscal 2003
Fiscal Years. We operate on a fiscal year ending on the Saturday closest to June 30. As a result, periodically we will have a fiscal year with 53 weeks of results. Fiscal 2004 was a 53-week year. We estimate that the extra week of operation generated incremental earnings of approximately $0.07 - $0.08 per share.
Revenues. Total revenues in fiscal 2004 rose 3.9% to $733.4 million from $705.6 million in fiscal 2003. Excluding the extra week, revenues were up 2.0% over fiscal 2003. Rental revenue was up $27.0 million in fiscal 2004, a 4.0% increase over fiscal 2003. Rental revenue increased 2.1% when excluding the impact of the extra week recorded in the current year. The organic industrial rental growth rate, which is calculated
using industrial rental revenue adjusted for foreign currency exchange rate differences, revenue from newly acquired business and an extra week recorded in the current year compared to prior year results, was approximately negative 2.0%. We believe that the organic industrial rental growth rate better reflects the growth of our existing business and is therefore useful in analyzing our financial condition and results of operations. Organic industrial rental revenue continues to be negatively impacted by lost uniform wearers due to reduced employment levels within our existing customer base.
Direct sale revenue was $24.7 million in fiscal 2004, a 3.5% increase over $23.9 million in fiscal 2003. The increase in direct sale revenue was driven by a focused effort to provide direct sale garments to our existing rental customers.
Cost of Rental and Direct Sale. Cost of rental operations increased 5.1% to $448.1 million in fiscal 2004 from $426.6 million in fiscal 2003. Gross margin from rental sales decreased to 36.8% in fiscal 2004 from 37.4% in the prior year. The decrease in rental gross margins was due to employee benefit costs (including pension), higher energy costs and lost margin from lower employment levels within our existing customer base.
Cost of direct sales increased to $18.9 million in fiscal 2004 from $17.9 million in fiscal 2003. Gross margin from direct sales decreased in fiscal 2004 to 23.6% from 24.9% in fiscal 2003. The decrease in gross margin was due primarily to product mix and merchandise cost increases.
Selling and Administrative. Selling and administrative expenses increased 2.3% to $158.0 million in fiscal 2004 from $154.5 million in fiscal 2003. As a percentage of total revenues, selling and administrative expenses decreased to 21.5% in fiscal 2004 from 21.9% in fiscal 2003. The decrease as a percent of revenue was due to reduced expenses related to uncollectible accounts receivable and reduced selling expenses, which were partially offset by increased employee benefit costs. Also offsetting this improvement was the tentative settlement of a wage and hour dispute in California, which represented one-time costs of $1.25 million in the current year.
Depreciation. Depreciation expense increased 3.3% to $31.4 million in fiscal 2004 from $30.4 million in fiscal 2003. As a percentage of total revenues, depreciation expense remained constant at 4.3% in both fiscal 2004 and fiscal 2003. Capital expenditures for fiscal 2004, excluding acquisition of businesses, were $17.3 million compared to $31.4 million in fiscal 2003 as we continued to prudently manage our strategic investments.
Amortization. Amortization expense increased to $7.9 million in fiscal 2004 from $7.3 million in fiscal 2003. As a percent of total revenues, amortization expense increased to 1.1% in fiscal 2004 compared to 1.0% in fiscal 2003.
Interest Expense. Interest expense was $12.0 million in fiscal 2004 as compared to $13.7 million in fiscal 2003. The decrease was due primarily to lower debt levels associated with significant levels of cash flow.
Provision for Income Taxes. Our effective tax rate for fiscal 2004 decreased to 38.0% from 39.0% in fiscal 2003 largely due to decreases in Canadian statutory income tax rates.
Fiscal 2003 Compared to Fiscal 2002
Revenues. Total revenues in fiscal 2003 rose 4.1% to $705.6 million from $677.6 million in fiscal 2002. Rental revenue rose $25.6 million in fiscal 2003, a 3.9% increase over fiscal 2002. The organic industrial rental growth rate, which is calculated using industrial rental revenue adjusted for foreign currency exchange rate differences and revenue from newly acquired business compared to prior year results, was approximately negative 2.5%. Rental revenue continues to be negatively impacted by lost uniform wearers due to reduced employment levels within our existing customer base.
Direct sale revenue was $23.9 million in fiscal 2003, an 11.3% increase over $21.5 million in fiscal 2002. Direct sale revenue increased as a result of initiatives to penetrate direct sale opportunities with existing customers such as our annual winter outerwear promotion.
Cost of Rental and Direct Sale. Cost of rental operations increased 5.8% to $426.6 million in fiscal 2003 from $403.1 million in fiscal 2002. Gross margin from rental sales decreased to 37.4% in fiscal 2003 from 38.6% in the prior year. Both rental and direct sale margins were impacted during the year by the closing of a Canadian manufacturing facility. Total one-time expenses related to closing the facility reduced the overall combined margin by approximately $1.0 million and had minimal impact on future results of operations. Rental gross margins were also impacted by increasing energy and employee benefit costs as well as continued lost margin from lower employment levels within our existing customer base.
Cost of direct sales increased to $17.9 million in fiscal 2003 from $15.7 million in fiscal 2002. Gross margin from direct sales decreased in fiscal 2003 to 24.9% from 27.0% in fiscal 2002. The decrease in gross margin was due primarily to product mix and pricing pressures, partially offset by increased volume in conjunction with the successful winter outerwear promotion in the second quarter of fiscal 2003.
Selling and Administrative. Selling and administrative expenses increased 5.6% to $154.5 million in fiscal 2003 from $146.3 million in fiscal 2002. As a percentage of total revenues, selling and administrative expenses increased to 21.9% in fiscal 2003 from 21.6% in fiscal 2002. During fiscal 2003 we took actions to reduce certain selling and administrative costs, including the closing of the Canadian manufacturing facility, and incurred severance and other employee-related costs. These actions had an impact of increasing selling and administrative expenses by $0.9 million and did not have a significant impact on results of operations in subsequent periods. Selling and administrative expenses also increased due to higher expenses related to uncollectible accounts receivable and increasing property and casualty insurance costs.
Depreciation. Depreciation expense increased 2.7% to $30.4 million in fiscal 2003 from $29.6 million in fiscal 2002. As a percentage of total revenues, depreciation expense decreased to 4.3% in fiscal 2003 compared to 4.4% in fiscal 2002. Capital expenditures for fiscal 2003, excluding acquisition of businesses, was $31.4 million compared to $29.2 million in fiscal 2002.
Amortization. Amortization expense increased to $7.3 million in fiscal 2003 from $6.1 million in fiscal 2002. As a percent of total revenues, amortization expense increased to 1.0% in fiscal 2003 compared to 0.9% in fiscal 2002.
Interest Expense. Interest expense was $13.7 million in fiscal 2003 as compared to $13.6 million in fiscal 2002. The increase in interest expense was primarily due to higher debt levels in connection with our acquisition activities throughout fiscal 2003, partially offset by lower effective interest rates.
Provision for Income Taxes. Our effective tax rate for fiscal 2003 decreased to 39.0% from 39.5% in fiscal 2002 largely due to decreases in Canadian statutory income tax rates.
Liquidity, Capital Resources and Financial Condition
Our primary sources of cash are net cash flows from operations and borrowings under our credit facilities. Primary uses of cash are interest payments on indebtedness, capital expenditures, acquisitions and general corporate purposes.
Operating Activities. Net cash provided by operating activities was $96.3 million in fiscal 2004, $96.9 million in fiscal 2003 and $79.7 million in fiscal 2002. Solid earnings along with effective working capital management have been a large contributor to the high levels of operating cash flow over each of the past three fiscal years. We have paid particular attention to management of new and in-service inventories, a continued focus on timely collection of accounts receivable and enhancing payment terms related to trade and accrued payables.
Working capital at July 3, 2004 was $79.0 million, a $6.1 million decrease from $85.1 million at June 28, 2003. This decrease is due to an increase in the current maturities of long-term debt associated with scheduled debt payments and an increase in income tax payable due to timing of payments.
Investing Activities. Net cash used for investing activities was $43.9 million in fiscal 2004, $121.5 million in fiscal 2003 and $100.1 million in fiscal 2002. In fiscal 2004, 2003 and 2002 cash was largely used for acquisitions and property, plant and equipment additions.
Financing Activities. Financing activities used cash of $37.3 million in fiscal 2004, provided cash of $26.0 million in fiscal 2003 and $15.2 million in fiscal 2002. Cash used in fiscal 2004 was primarily related to the repayment of long-term debt. Cash provided in both fiscal 2003 and 2002 was from debt proceeds used primarily for acquisitions of businesses. We paid dividends of $1.5 million in both fiscal 2004 and fiscal 2003 and $1.4 million in fiscal 2002.
We maintain a $325.0 million term loan and revolving credit facility expiring July 2, 2007. The facility provides for a $75.0 million term loan and a $250.0 million revolving credit facility. As of July 3, 2004, borrowings outstanding under the term loan were $56.3 million and under the revolving credit facility were $99.6 million at rates ranging from 2.40% to 2.86%. Borrowings under this facility are unsecured. The unused portion of the revolver may be used for general corporate purposes, acquisitions, working capital needs and to provide up to $30.0 million in letters of credit. As of July 3, 2004, letters of credit outstanding against the revolver were $17.0 million.
We have a $50.0 million, 8.4% private debt placement with certain institutional investors. The 10-year notes have a seven-year average life with a final maturity on July 20, 2010. Beginning on July 20, 2004, and annually thereafter to maturity, we will repay $7.1 million of the principal amount at par. We used the net proceeds from the sale of the notes to reduce other indebtedness and for general corporate purposes.
The credit facilities and the fixed rate notes contain various restrictive covenants that among other matters require us to maintain a minimum fixed charge coverage ratio, minimum stockholders’ equity and a maximum leverage ratio, all as defined. These debt arrangements also provide for certain limits related to additional indebtedness, investments and dividends. At July 3, 2004, we were in compliance with all debt covenants and only a material adverse change in our financial performance and condition could result in a potential event of default. In the unlikely event that an event of default would be imminent, management believes that we would be able to successfully negotiate amended covenants or obtain waivers; however, certain financial concessions might be required. Our results of operations and financial condition could be adversely affected if amended covenants or waivers in acceptable terms could not be successfully negotiated.
Cash Obligations. Under various agreements, we are obligated to make future cash payments in fixed amounts. These include payments under the variable rate term loan and revolving credit facility, the fixed rate term loan, capital lease obligations and rent payments required under non-cancelable operating leases with initial or remaining terms in excess of one year.
The following table summarizes our fixed cash obligations as of July 3, 2004 for the next five fiscal years and thereafter (in thousands):
Also, at July 3, 2004, we had stand-by letters of credit totaling $17.0 million issued and outstanding, primarily in connection with our property and casualty insurance programs. No amounts have been drawn upon these letters of credit.
At July 3, 2004, we had available cash on hand of $26.9 million and approximately $130.0 million of available capacity under our revolving credit facility. We anticipate that we will generate sufficient cash flows from operations to satisfy our cash commitments and capital requirements for fiscal 2005 and to significantly reduce the amounts outstanding under the revolving credit facility; however, we may utilize borrowings under the revolving credit facility to supplement our cash requirements from time to time. We estimate that capital expenditures in fiscal 2005 will be approximately $25.0 million to $30.0 million.
The amount of cash flow generated from operations is subject to a number of risks and uncertainties. In fiscal 2005, we may actively seek and consider acquisitions of business assets; the consummation of any acquisition could affect our liquidity profile and level of outstanding debt. We believe that our earnings and cash flow from operations, existing credit facilities and our ability to obtain additional debt or equity capital, if necessary, will be adequate to finance acquisition opportunities.
Pension Obligations
We account for our defined benefit pension plan using SFAS No. 87 “Employer’s Accounting for Pensions” (“SFAS 87”). Under SFAS 87, pension expense is recognized on an accrual basis over employees’ approximate service periods. Pension expense calculated under SFAS 87 is generally independent of funding decisions or requirements. We recognized expense for our defined benefit pension plan of $6.1 million, $3.1 million and $2.0 million in fiscal 2004, 2003 and 2002, respectively. At July 3, 2004, the fair value of our pension plan assets totaled $26.7 million. We anticipate making a cash contribution of approximately $1.3 million in fiscal 2005.
The calculation of pension expense and the corresponding liability requires the use of a number of critical assumptions, including the expected long-term rate of return on plan assets and the assumed discount rate. Changes in these assumptions can result in different expense and liability amounts, and future actual experience can differ from these assumptions. Pension expense increases as the expected rate of return on pension plan assets decreases. At July 3, 2004, we estimate that the pension plan assets will generate a long-term rate of return of 8.0%. This rate is consistent with the assumed rate used at both June 28, 2003 and June 29, 2002 and was developed by evaluating input from our actuary as well as long-term inflation assumptions. The expected long-term rate of return on plan assets at July 3, 2004 is based on an allocation of U.S. equities and U.S. fixed income securities. Decreasing the expected long-term rate of return by 0.5% (from 8.0% to 7.5%) would increase our estimated 2005 pension expense by approximately $0.1 million. Pension liability and future pension expense increase as the discount rate is reduced. We discounted future pension obligations using a rate of 6.25% at July 3, 2004, 6.0% at June 28, 2003 and 7.5% at June 29, 2002. The discount rate is determined based on the current rates earned on high quality long-term bonds. Decreasing the discount rate by 0.5% (from 6.25% to 5.75%) would increase our accumulated benefit obligation at July 3, 2004 by approximately $3.8 million and increase the estimated fiscal 2005 pension expense by approximately $0.9 million.
Future changes in plan asset returns, assumed discount rates and various other factors related to the participants in our pension plan will impact our future pension expense and liabilities. We cannot predict with certainty what these factors will be in the future.
Impact of Inflation
In general, management believes that our results of operations are not dependent on moderate changes in the inflation rate. Historically, we have been able to manage the impacts of more significant changes in inflation rates through our customer relationships, customer agreements that generally provide for price increases consistent with the rate of inflation or 5.0%, whichever is greater, and continued focus on improvements of operational productivity.
Significant increases in energy costs, specifically natural gas and gasoline, can materially affect our results of operations and financial condition. Currently, energy costs represent between 3-4% of our total revenue.
Litigation
We are involved in a variety of legal actions relating to personal injury, customer contracts, employment, trade practices, environmental and other legal matters that arise in the normal course of business. These legal actions include lawsuits that challenge the practice of charging for certain environmental services on invoices, and being named, along with other defendants, as a potentially responsible party at certain waste disposal sites where ground water contamination has been detected or is suspected. None of these legal actions are expected to have a material adverse effect on our results of operations or financial position.
We are also involved in a lawsuit in California that alleges G&K violated certain state wage and hour laws applicable to its route sales representatives. Subsequent to July 3, 2004, we reached a tentative settlement of this case for a payment of approximately $1.25 million, subject to court approval. The settlement resulted in the recording of a one-time charge of $1.25 million in the fourth quarter of fiscal 2004.
Recent Accounting Pronouncements
In December 2003, the Financial Accounting Standards Board (“FASB”) revised SFAS No. 132, “Employer’s Disclosures About Pensions and Other Postretirement Benefits” (“SFAS 132”). The FASB’s revision of Statement No. 132 requires new annual disclosures about the types of plan assets, investment strategy, measurement date, plan obligations and cash flows as well as the components of the net periodic benefit cost recognized in interim periods. We adopted the disclosure requirements of SFAS 132 (revised) beginning with the third quarter ended March 27, 2004.
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which clarifies the financial reporting guidance associated with the consolidation of another entity. In December 2003, the FASB revised and superceded FIN 46 with the issuance of FIN 46R in order to address certain implementation issues. We have adopted FIN 46R effective March 31, 2004. The impact of adopting FIN 46R was not material.
Cautionary Statement Regarding Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 (the “Act”) provides companies with a “safe harbor” when making forward-looking statements as a way of encouraging them to furnish their shareholders with information regarding expected trends in their operating results, anticipated business developments and other prospective information. Statements made in this report concerning our intentions, expectations or predictions about future results or events are “forward-looking statements” within the meaning of the Act. These statements reflect our current expectations or beliefs, and are subject to risks and uncertainties that could cause actual results or events to vary from stated expectations, which could be material and adverse. Given that circumstances may change, and new risks to the business may emerge from time to time, having the potential to negatively impact our business in ways we could not anticipate at the time of making a forward-looking statement, you are cautioned not to place undue reliance on these statements, and we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Some of the factors that could cause actual results or events to vary from stated expectations include, but are not limited to, the following: unforeseen operating risks; the effects of overall economic conditions and employment levels; fluctuations in costs of insurance and energy; acquisition integration costs; the performance of acquired businesses; preservation of positive labor relationships; competition, including pricing, within the branded identity apparel and facility services industry; and the availability of capital to finance planned growth.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We are exposed to market risks. Market risk is the potential loss arising from adverse changes in interest rates and foreign currency exchange rates. We do not enter into derivative or other financial instruments for speculative purposes.
Interest Rate Risk
We are subject to market risk exposure related to changes in interest rates. We use financial instruments, including fixed and variable rate debt, as well as interest rate swaps to manage interest rate risk. Interest rate swap agreements are entered into for periods consistent with related underlying exposures and do not constitute positions independent of those exposures. Assuming the current level of borrowings, a one percentage point increase in interest rates under these borrowings would have increased our interest expense for fiscal 2004 by approximately $0.9 million. This estimated exposure considers the mitigating effects of interest rate swap agreements outstanding at July 3, 2004 on the change in the cost of variable rate debt.
The following table provides information about our derivative financial instruments and other financial instruments that are sensitive to changes in interest rates. The fair values were estimated by discounting the projected cash flows using the current rate applicable to similar transactions. For debt obligations, the following table presents principal cash flow and related weighted average interest rates by expected maturity dates by fiscal year.
For interest rate swaps, the following table presents notional amounts and weighted average interest rates by expected (contractual) maturity dates by fiscal year. Notional amounts are used to calculate the contractual payments to be exchanged under the contract.
Foreign Currency Exchange Risk
We have a significant foreign subsidiary located in Canada. The assets and liabilities of this subsidiary are denominated in the Canadian dollar and as such are translated into U.S. dollars at the exchange rate in effect at the balance sheet date. Results of operations are translated using the average exchange rates throughout the period. The effect of exchange rate fluctuations on translation of assets and liabilities are recorded as a component of stockholders’ equity. Gains and losses from foreign currency transactions are included in results of operations.
We may periodically hedge firm commitments with our foreign subsidiary, generally with foreign currency contracts. These agreements are recorded at current market values and the gains and losses are included in earnings. Gains and losses on such transactions were not significant in fiscal 2004. Notional amounts outstanding under foreign currency contracts at July 3, 2004 were $0.4 million, all of which will mature during fiscal 2005. Notional amounts outstanding under foreign currency contracts at June 28, 2003 were $2.7 million, all of which matured during fiscal 2004. Notional amounts outstanding under foreign currency contracts at June 29, 2002 were $4.8 million, all of which matured during fiscal 2003. Foreign currency contracts were recorded at fair value as of July 3, 2004.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Reference is made to the Consolidated Financial Statements and Notes beginning on page.
Following is a summary of the results of operations for each of the quarters within fiscal years ended July 3, 2004 and June 28, 2003. All amounts are in thousands, except per share data.
QUARTERLY FINANCIAL DATA
G&K Services, Inc. and Subsidiaries
We utilize a 52-53 week fiscal year ending on the Saturday nearest June 30. The fiscal year ended July 3, 2004 was 53-week year with the extra week reported in the fourth quarter.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Evaluation of Disclosure Controls and Procedures
We have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of July 3, 2004. Based on that evaluation, the president and chief executive officer, and the chief financial officer concluded that our disclosure controls and procedures are effective in recording, processing, summarizing and timely reporting information required to be disclosed in our reports to the Securities and Exchange Commission.
Changes in Internal Controls
There were no changes in our internal controls over financial reporting during the fourth quarter of fiscal 2004 that have materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Reference is made to information with respect to the Company’s Proxy Statement for the 2004 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Reference is made to information with respect to the Company’s Proxy Statement for the 2004 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Form 10-K.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Reference is made to information with respect to the Company’s Proxy Statement for the 2004 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Form 10-K.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Reference is made to information with respect to the Company’s Proxy Statement for the 2004 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Form 10-K.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Reference is made to information with respect to the Company’s Proxy Statement for the 2004 Annual Meeting of Shareholders to be filed pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Form 10-K.
PART IV, ITEM 15
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)
The following documents are filed as a part of this report:
(1)
Financial Statements
The following consolidated financial statements of G&K are part of this report and are submitted in a separate section of this report.
99.1
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm and Schedule II *
Footnotes:
* Filed herewith
** Compensatory plan or arrangement
(b)
Reports filed on Form 8-K
(d)
Financial Statement Schedules
SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, this report on Form 10-K has been signed below on the 16th day of September 2004, by the following persons in the capacity indicated:
/s/ Richard M. Fink
Richard M. Fink
Chairman of the Board and Director
/s/ Richard L. Marcantonio
President and Chief Executive Officer (Principal Executive Officer)
Richard L. Marcantonio
*
Director
Michael G. Allen
*
Director
Paul Baszucki
*
Director
John S. Bronson
*
Director
Wayne M. Fortun
*
Director
Donald W. Goldfus
*
Director
Thomas R. Moberly
*
Director
M. Lenny Pippin
*
Director
Alice M. Richter
*By:
/s/ Richard L. Marcantonio
Richard L. Marcantonio
Attorney-in-fact
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF OPERATIONS
G&K Services, Inc. and Subsidiaries
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED BALANCE SHEETS
G&K Services, Inc. and Subsidiaries
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
G&K Services, Inc. and Subsidiaries
(In thousands, except per share data)
[Additional columns below]
[Continued from above table, first column(s) repeated]
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
G&K Services, Inc. and Subsidiaries
The accompanying notes are an integral part of these consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Amounts in thousands, except share and per share data)
1. Summary of Significant Accounting Policies
Nature of Business
G&K Services, Inc. (the “Company”) is a market leader in providing branded identity apparel and facility services programs that enhance image and safety in the workplace. The Company serves a wide variety of industrial, service and high-technology companies providing them with rented uniforms or purchase options as well as facility services products such as floor mats, dust mops, wiping towels, selected linen items and several restroom products. The Company also manufactures certain uniform garments that it uses to support its garment rental programs. The Company has two operating segments, United States and Canada, which have been identified as components of the Company that are reviewed by the Company’s Chief Executive Officer to determine resource allocation and evaluate performance.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned. Significant intercompany balances and transactions have been eliminated in consolidation.
Fiscal Year
The Company operates on a fiscal year ending on the Saturday closest to June 30. Fiscal years for the consolidated financial statements included herein ended on July 3, 2004 (53 weeks), June 28, 2003 (52 weeks) and June 29, 2002 (52 weeks).
Cash and Cash Equivalents
The Company considers all short-term, highly liquid investments with a maturity of three months or less, at the date of acquisition, to be cash equivalents.
Accounts Receivable
Accounts receivable is recorded net of an allowance for expected losses. The allowance, recognized as an amount equal to the anticipated future write-offs, is based on age of outstanding balances, analysis of specific accounts and historical bad debt expense and current economic trends.
Inventories
Inventories consist of new goods and rental merchandise in service. Estimates are used in determining the likelihood that new goods on hand can be sold to customers or used in rental operations. Historical inventory usage and current revenue trends are considered in estimating both obsolete and excess inventories. New goods are stated at lower of first-in, first-out (FIFO) cost or market, net of any reserve for obsolete or excess inventory. Merchandise placed in service to support rental operations is amortized into cost of rental operations over the estimated useful lives of the underlying inventory items, primarily on a straight-line basis, which results in a matching of the cost of the merchandise with the weekly rental revenue generated by merchandise. Estimated lives of rental merchandise in service range from nine months to three years. In establishing estimated lives for merchandise in service, management considers historical experience and the intended use of the merchandise. The components of inventories as of July 3, 2004 and June 28, 2003 are as follows:
Property, Plant and Equipment
Property, plant and equipment are stated at cost and depreciated for financial reporting purposes generally using the straight-line method over the estimated useful lives as follows:
Costs of significant additions, renewals and betterments, including external and certain internal computer software development costs, are capitalized. When an asset is sold or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and the gain or loss on disposition is reflected in earnings. Maintenance and repairs are charged to expense when incurred.
Goodwill, Intangible and Long-Lived Assets
The cost of acquisitions in excess of the fair value of the underlying net assets is recorded as goodwill. Non-competition agreements that limit the seller from competing with the Company for a fixed period of time and acquired customer contracts and related customer relationships are stated at cost less accumulated amortization and are amortized over the terms of the respective agreements or estimated average life of an account, primarily five to 11 years.
The carrying value of goodwill is evaluated on an annual basis and when events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit to which goodwill is assigned below its carrying amount. When evaluating whether goodwill is impaired, the fair value of the reporting unit to which goodwill is assigned is compared to its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss would be calculated by comparing the implied fair value of the goodwill with its carrying amount. In calculating the implied fair value of goodwill, the fair value of the reporting unit is allocated to all of the other assets and liabilities of that unit based on their fair values. The excess of the fair value of a reporting unit over the amount assigned to its other assets and liabilities is the implied fair value of goodwill. Management completes its annual goodwill impairment test in the fourth quarter of each fiscal year and there have been no impairments of goodwill in fiscal 2004, 2003 or 2002.
The Company reviews all other long-lived assets, including definite-lived intangible assets, for impairment in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets” (“SFAS 144”). Under SFAS 144, impairment losses are recorded on long-lived assets used in operations when events and circumstances indicate the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. The Company also performs a periodic assessment of the useful lives assigned to intangible assets. All of the Company’s intangibles are subject to amortization.
Retirement Plan Assets
Retirement plan assets consist primarily of mutual funds and cash equivalents, which are stated at their fair value as determined by quoted market prices and the cash surrender values of life insurance policies.
Foreign Currency
Foreign currency denominated assets and liabilities are translated into U.S. dollars using the exchange rates in effect at the balance sheet date. Results of operations are translated using the average exchange rates throughout the period. The effect of exchange rate fluctuations on translation of assets and liabilities are recorded as a component of stockholders’ equity. Gains and losses from foreign currency transactions are included in results of operations and were not material in fiscal 2004, 2003 or 2002.
Revenue Recognition
The Company’s rental operations business is largely based on written service agreements whereby it agrees to collect, launder and deliver uniforms and other related products. The service agreements provide for weekly billing upon completion of the laundering process and delivery to the customer. Accordingly, the Company recognizes revenue from rental operations in the period in which the services are provided. Revenue from rental operations also includes billings to customers for lost or abused merchandise. Direct sale revenue is recognized in the period in which the product is shipped.
Insurance
The Company self-insures for certain obligations related to health and workers’ compensation programs. The Company purchases stop-loss insurance policies to protect it from catastrophic losses. The Company periodically evaluates its liabilities under such programs based on a third party actuarial analysis. Management’s estimates consider historical claims experience, escalating medical cost trends and the expected timing of claim payments. During fiscal 2002, the Company changed certain assumptions utilized in evaluating its workers’ compensation self-insurance liability and began to apply a discount factor to estimated future payments. The impact of these changes was not material to the Company’s consolidated balance sheets and statements of operations.
Income Taxes
Deferred income taxes are determined in accordance with SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, using statutory rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. The Company records valuation allowances to reduce deferred tax assets when it is more likely than not that some portion of the asset may not be realized and as such, has established a valuation allowance for all foreign tax credit carryforwards due to the uncertainty of the use of the tax benefit in future periods.
Per Share Data
Basic earnings per common share was computed by dividing net income by the weighted average number of shares of common stock outstanding during the year. Diluted earnings per common share was computed similarly to the computation of basic earnings per share, except that the denominator is increased for the assumed exercise of dilutive options and other dilutive securities, including nonvested restricted stock, using the treasury stock method.
Potential common shares of 335,000, 562,000 and 464,000 related to the Company’s outstanding stock options and restricted stock grants were excluded from the computation of diluted earnings per share for fiscal 2004, 2003 and 2002, respectively. Inclusion of these shares would have been anti-dilutive as the exercise price of these shares exceeded market value.
Stock-Based Compensation
The Company maintains Stock Option and Compensation Plans (the “Employee Plans”), which are more fully described in Note 6. The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations in accounting for its stock option plans. Accordingly, only compensation cost related to restricted stock issued under the Employee Plans has been recognized in the accompanying consolidated statements of operations. Compensation cost related to the restricted shares was $937, $990 and $937 in fiscal 2004, 2003 and 2002, respectively. Had compensation cost been recognized based on the fair values of options at the grant dates consistent with the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company’s net income and net income per common share would have been adjusted as follows:
The weighted average fair value of options granted in fiscal 2004, 2003 and 2002 was $10.83, $12.28 and $11.73, respectively. The weighted average exercise price was $32.81, $33.66 and $28.02 for fiscal 2004, 2003 and 2002, respectively.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used: risk-free interest rates of 3.48% for fiscal 2004, 3.27% for fiscal 2003 and 4.45% for fiscal 2002; expected dividends of $0.07 per share; expected lives of five years for fiscal 2004, 2003 and 2002; and expected volatility of 30.93% for fiscal 2004 grants, 36.56% for fiscal 2003 grants and 41.42% for fiscal 2002 grants.
Comprehensive Income
The Company has chosen to disclose comprehensive income, which consists of net income, foreign currency translation adjustment, unrealized gains/losses on interest rate swap agreements and minimum pension liability adjustments, in the consolidated statements of stockholders’ equity and comprehensive income.
Financial Instruments
The Company accounts for financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) and related authoritative guidance. The statement requires that all derivative financial instruments that qualify for hedge accounting, such as interest rate swap contracts, be recognized in the financial statements and measured at fair value regardless of the purpose or intent for holding them. Changes in the fair value of derivative financial instruments are either recognized periodically in income or stockholders’ equity (as a component of other comprehensive income).
Recent Accounting Pronouncements
In December 2003, the Financial Accounting Standards Board (“FASB”) revised SFAS No. 132, “Employer’s Disclosures About Pensions and Other Postretirement Benefits” (“SFAS 132”). The FASB’s revision of Statement No. 132 requires new annual disclosures about the types of plan assets, investment strategy, measurement date, plan obligations and cash flows as well as the components of the net periodic benefit cost recognized in interim periods. The Company adopted the disclosure requirements of SFAS 132 (revised) beginning with the third quarter ended March 27, 2004.
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which clarifies the financial reporting guidance associated with the consolidation of another entity. In December 2003, the FASB revised and superceded FIN 46 with the issuance of FIN 46R in order to address certain implementation issues. The Company has adopted FIN 46R effective March 31, 2004. The impact of adopting FIN 46R was not material.
Reclassifications
Certain prior period amounts have been reclassified to conform with the current year presentation. These reclassifications did not impact current or historical net income or stockholders’ equity.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
2. Acquisitions
During each of fiscal 2004, 2003 and 2002, the Company made several small acquisitions. All acquisitions were accounted for using the purchase method. The total purchase consideration, including related acquisition costs, as well as the amounts exceeding the estimated fair values of assets acquired and liabilities assumed were as follows:
The pro forma effects of these acquisitions, had they been acquired at the beginning of the fiscal year, were not material to the Company.
3. Goodwill and Intangible Assets
The Company adopted SFAS No. 141, “Business Combinations” (“SFAS 141”) and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”) effective July 1, 2001. SFAS 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. Under SFAS 142, goodwill is no longer amortized but reviewed annually, or more frequently if certain indicators arise, for impairment. The Company periodically evaluates the carrying value and remaining useful lives of amortizable intangible assets. There have been no impairments of goodwill and useful lives were deemed appropriate on amortizable intangible assets in fiscal 2004, 2003 and 2002.
The changes in the carrying amount of goodwill for the fiscal years ended July 3, 2004 and June 28, 2003, by operating segment, are as follows:
Information regarding the Company’s other intangible assets are as follows:
Total amortization expense was $7,929 in fiscal 2004, $7,289 in fiscal 2003 and $6,057 in fiscal 2002. Estimated amortization expense for each of the five succeeding fiscal years based on intangible assets as of July 3, 2004 is as follows:
4. Long-Term Debt
Debt as of July 3, 2004 and June 28, 2003 includes the following:
The Company maintains a $325,000 term loan and revolving credit facility. The credit facility includes (i) a $75,000 term loan facility with maturities of the remaining balance in fiscal years 2005 through 2007 of $15,000, $18,750 and $22,500, respectively, and (ii) a $250,000 revolving credit facility expiring on July 2, 2007. As of July 3, 2004, borrowings outstanding under the term loan were $56,250 and under the revolving credit facility were $99,600. The unused portion of the revolver may be used for general corporate purposes, acquisitions, working capital needs and to provide up to $30,000 in letters of credit. As of July 3, 2004, letters of credit outstanding against the revolver were $17,040.
Borrowings under the term loan and revolving credit facility bear interest at 1.00% to 1.75% over the rate offered to major banks in the London Interbank Eurodollar market (“Eurodollar Rate”), or the Canadian prime rate for Canadian borrowings, based on a leverage ratio calculated on a quarterly basis. Advances outstanding as of July 3, 2004 bear interest at the Eurodollar Rate or Canadian prime rate plus 1.25%. The Company also pays a fee on the unused daily balance of the revolver based on a leverage ratio calculated on a quarterly basis.
The Company has a $50,000, 8.4% private debt placement with certain institutional investors. The 10-year notes have a seven-year average life with a final maturity on July 20, 2010. Beginning on July 20, 2004, and annually thereafter to maturity, the Company will repay $7,143 of the principal amount at par. The Company used the net proceeds from the sale of the notes to reduce other indebtedness and for general corporate purposes.
The credit facilities and the fixed rate notes contain various restrictive covenants that among other matters require the Company to maintain a minimum fixed charge coverage ratio, minimum stockholders’ equity and a maximum leverage ratio, all as defined. These debt arrangements also provide for certain limits related to additional indebtedness, investments and dividends. As of July 3, 2004, the Company was in compliance with all financial debt covenants.
The fair value of the Company’s long-term debt is determined using quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. The fair value of the long-term debt under the term loan and revolving credit facility approximates the carrying value as of July 3, 2004 and June 28, 2003. The fair value of the fixed rate term loan is $56,745 as of July 3, 2004.
The following table summarizes payments due on long-term debt, including capital leases, as of July 3, 2004 for the next five fiscal years and thereafter:
5. Derivative Financial Instruments
The Company uses derivative financial instruments principally to manage the risk that changes in interest rates will affect the amount of its future interest payments. Interest rate swap contracts are used to balance the proportion of total debt that is subject to variable and fixed interest rates. The interest rate swap contracts are reflected at fair value in the consolidated balance sheets and the related gains or losses on these contracts are deferred in stockholders’ equity (as a component of other comprehensive income). Amounts to be paid or received under the contracts are accrued as interest rates change and are recognized over the life of the contracts as an adjustment to interest expense. The net effect of this accounting is that interest expense on the portion of variable rate debt being hedged is generally recorded based on fixed interest rates.
At July 3, 2004, the Company had interest rate swap contracts to pay fixed rates of interest (average rate of 2.85%) and receive variable rates of interest based on three-month London Interbank Offered Rate (“LIBOR”) on $65,000 notional amount of indebtedness. The $65,000 notional amount of outstanding contracts will mature $25,000 during fiscal 2005 and $40,000 thereafter. At June 28, 2003, the Company had interest rate swap contracts on $85,000 notional amount of indebtedness. These swap contracts have been designated as highly effective cash flow hedges and accordingly, gains or losses on any ineffectiveness was not material to any period. If these swap agreements were to be terminated, the Company would have incurred an after-tax loss on the contracts of $110 and $1,231 at July 3, 2004 and June 28, 2003, respectively.
The Company may periodically hedge firm commitments with its foreign subsidiary, generally with foreign currency contracts. These agreements are recorded at current market values and the gains and losses are included in earnings. Gains and losses on such transactions were not significant in fiscal 2004 or 2003. Notional amounts outstanding under foreign currency contracts at July 3, 2004 were $409, all of which will mature during fiscal 2005. Notional amounts outstanding under foreign currency contracts at June 28, 2003 were $2,742, all of which matured during fiscal 2004. Foreign currency contracts were recorded at fair value as of July 3, 2004.
6. Stockholders’ Equity
Each share of Class A common stock is entitled to one vote and is freely transferable. Each share of Class B is entitled to 10 votes and can be converted to Class A common stock on a share-for-share basis. Until converted to Class A common stock, however, Class B shares are not freely transferable. No cash dividends can be paid on Class B common stock unless dividends of at least an equal amount per share are paid on Class A shares. A majority of the Class B shares are held by an officer of the Company.
Stock Award Plans
The Company maintains Stock Option and Compensation Plans (the “Employee Plans”) to grant certain stock awards, including stock options at fair market value and restricted shares, to key employees of the Company. Exercise periods for stock options are limited to a maximum of 10 years and a minimum of one year. A maximum of 3,000,000 stock awards can be granted under the Employee Plans and 1,546,497 awards were available for grant as of July 3, 2004.
The Company also maintains the 1996 Director Stock Option Plan (the “Directors’ Plan”). The Directors’ Plan provides for automatic grants of 3,000 nonqualified stock options (initial grants) to nonemployee directors of the Company as of the later of August 1996 or the date such individuals became directors of the Company and 1,000 nonqualified stock options on each subsequent annual shareholder meeting date. The Company has reserved 100,000 shares of Class A common stock for issuance under the Directors’ Plan. These options expire within 10 years of grant and are exercisable one year from the date of grant, except for the initial grants, of which, one-third of the total options are exercisable each year beginning with the first anniversary of the date of grant. The option price will be the average market price of the Class A common stock during the 10 business days preceding the date of grant.
The following schedule summarizes activity in the plans:
The following schedule summarizes the information related to stock options outstanding at July 3, 2004:
Under the Employee Plans, the Company grants restricted stock to key employees for nominal consideration. The restrictions lapse over periods up to seven years. During fiscal 2004, 2003 and 2002 the Company granted 5,000, 25,000 and 33,580 shares of restricted stock, respectively. The weighted average grant date fair value per share of restricted stock granted during fiscal 2004, 2003 and 2002 was $31.18, $33.07 and $32.67, respectively. The Company records deferred compensation to stockholders’ equity at the time of grant for the difference between the par value and fair market value as of the grant date. Compensation expense is recognized as the restrictions are removed from the stock for the difference between the par value and fair market value as of the grant date. Total compensation expense related to restricted stock was $937, $990 and $937 in fiscal 2004, 2003 and 2002, respectively.
7. Income Taxes
The components of the provision for income taxes are as follows:
The reconciliation between income taxes using the statutory federal income tax rate and the recorded income tax provision is as follows:
Significant components of the Company’s deferred tax assets and deferred tax liabilities as of July 3, 2004 and June 28, 2003 are as follows:
The Company has foreign tax credit carryforwards of $1,436, which expire in fiscal 2008. A valuation allowance has been established for all foreign tax credit carryforwards due to the uncertainty of the use of the tax benefit in future periods.
8. Employee Benefit Plans
Pension Plan
The Company has a noncontributory defined benefit pension plan (the “Plan”) covering substantially all employees, except certain employees who are covered by union-administered plans. Benefits are based on the number of years of service and each employee’s compensation near retirement. The Company makes annual contributions to the Plan consistent with federal funding requirements.
Supplemental Executive Retirement Plan
Annual benefits under the Supplemental Executive Retirement Plan (“SERP”) are based on years of service and individual compensation near retirement. The Company has purchased life insurance contracts that may be used to fund the retirement benefits. The net cash surrender value of the contracts as of July 3, 2004 and June 28, 2003 was $10,603 and $8,139, respectively, and is included in other assets in the accompanying consolidated balance sheets.
Obligations and Funded Status at July 3, 2004 and June 28, 2003
Amounts recognized in the statements of financial position consist of:
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for the pension plans with an accumulated benefit obligation in excess of plans assets were $43,899, $36,494 and $26,674, respectively, as of July 3, 2004 and $40,629, $30,876 and $16,839, respectively as of June 28, 2003. No pension plans had plan assets in excess of accumulated benefit obligations at July 3, 2004 or June 28, 2003.
Components of Net Periodic Benefit Cost
Assumptions
The following weighted average assumptions were used to determine benefit obligations for the plans at July 3, 2004 and June 28, 2003:
The following weighted average assumptions were used to determine net periodic benefit cost for the plans for the years ended July 3, 2004 and June 28, 2003:
To develop the expected long-term rate of return on asset assumptions, the Company considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocation of the pension portfolio. This resulted in the selection of the 8.00% long-term rate of return on assets assumption.
Additional Information
The pension plan weighted average asset allocations at July 3, 2004 and June 28, 2003 are as follows:
The asset allocation strategy for 2004 targets 25.0%-30.0% in high-quality fixed income instruments with the balance of the portfolio to be invested in a diversified and complimentary portfolio of equity vehicles. The objective is to achieve a long-term rate of return of 7.0%-9.5%. In determining investment options, all classes or categories of investments allowed by the Employee Retirement Income Security Act of 1974 (“ERISA”) are acceptable investment choices. As directed by ERISA, no single investment will comprise more than 10.0% of assets, except for certain government backed securities.
Pension assets consist primarily of listed common stocks and U.S. government and corporate obligations. The plan held approximately 67,500 shares of the Company’s Class B common stock at July 3, 2004 and June 28, 2003, with market values of $2,697 and $2,007, respectively. The plan received $5 in dividends on the Company’s Class B common stock during each of fiscal 2004 and 2003.
The Company expects to contribute $1,332 to its pension plan and $361 to the SERP in fiscal year 2005.
Estimated Future Benefit Payments
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
Union Pension Plans
Certain employees of the Company are covered by union-sponsored, collectively bargained, multiemployer pension plans (“Union Plans”). The Company contributed and charged to expense $1,460 in fiscal 2004, $1,189 in fiscal 2003 and $1,062 in fiscal 2002 for such plans. These contributions are determined in accordance with the provisions of negotiated labor contracts and generally are based on the number of hours worked. The Company may be liable for its share of unfunded vested benefits, if any, related to the Union Plans. Information from the Union Plans’ administrators is not available to permit the Company to determine its share, if any, of unfunded vested benefits.
401(k) Plan
All full-time nonunion employees are eligible to participate in a 401(k) plan. The Company matches a portion of the employee’s salary reduction contributions and provides investment choices for the employee. The matching contributions under the 401(k) plan, which vest over a five-year employment period, were $1,712 in fiscal 2004, $1,663 in fiscal 2003 and $1,229 in fiscal 2002.
Executive Deferred Compensation Plan
Under the Executive Deferred Compensation Plan (“DEFCO”) plan, the Company matches a portion of the designated employees’ contributions. The Company’s matching contributions under the DEFCO plan were $528 in fiscal 2004, $476 in fiscal 2003 and $397 in fiscal 2002. The accumulated benefit obligation of $9,492 as of July 3, 2004 and $7,532 as of June 28, 2003 is included in other noncurrent liabilities in the accompanying consolidated balance sheets. The Company has purchased investments, including stable income and stock index managed funds, based on investment elections made by the employees, which may be used to fund the retirement benefits. The investments are recorded at estimated fair value based on quoted market prices and are included in other assets in the accompanying consolidated balance sheets. Unrealized gains and losses are included in income on a current basis. At July 3, 2004 and June 28, 2003, the estimated fair value of the investments was $9,492 and $7,532, and the cost of the investments was $9,305 and $8,576, respectively.
9. Commitments and Contingencies
Litigation
The Company is involved in a variety of legal actions relating to personal injury, customer contracts, employment, trade practices, environmental and other legal matters that arise in the normal course of business. These legal actions include lawsuits that challenge the practice of charging for certain environmental services on invoices, and being named, along with other defendants, as a potentially responsible party at certain waste disposal sites where ground water contamination has been detected or is suspected. None of these legal actions are expected to have a material adverse effect on the Company’s results of operations or financial position.
Leases
The Company leases certain facilities and equipment for varying periods. Most facility leases contain renewal options from one to five years. Management expects that in the normal course of business, leases will be renewed or replaced by other leases.
The following is a schedule of future minimum lease payments for operating leases that had initial or remaining non-cancelable lease terms in excess of one year as of July 3, 2004:
Total rent expense for operating leases, including those with terms of less than one year was $18,547 in fiscal 2004, $17,780 in fiscal 2003 and $15,462 in fiscal 2002.
10. Segment Information
The Company has two operating segments, United States and Canada, which have been identified as components of the Company that are reviewed by the Company’s Chief Executive Officer to determine resource allocation and evaluate performance. Each operating segment derives revenues from the branded identity apparel and facility services industry, which includes garment rental and non-apparel items such as floor mats, dust mops, wiping towels, selected linen items and several restroom products. No one customer’s transactions account for 1.0% or more of the Company’s revenues.
The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 1). Corporate expenses are allocated to the segments based on segment revenue. The Company evaluates performance based on income from operations. Financial information by geographic location is as follows:
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of G&K Services, Inc.:
We have audited the accompanying consolidated balance sheets of G&K Services, Inc. as of July 3, 2004 and June 28, 2003, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended July 3, 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, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of G&K Services, Inc. as of July 3, 2004 and June 28, 2003, and the results of its operations and its cash flows for each of the three fiscal years in the period ended July 3, 2004 in conformity with U.S. generally accepted accounting principles.
As discussed in Note 3 to the consolidated financial statements, effective July 1, 2001, the Company adopted Statement of Financial Accounting Standards (Statement) No. 142, “Goodwill and Other Intangible Assets.”
/s/Ernst & Young LLP
Ernst & Young LLP
Minneapolis, Minnesota
August 13, 2004