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GK > SEC Filings for GK > Form 10-Q on 3-May-2013All Recent SEC Filings

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Form 10-Q for G&K SERVICES INC


3-May-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Unaudited)
Overview
G&K Services, Inc., founded in 1902 and headquartered in Minnetonka, Minnesota, is a service-focused market leader of branded uniform and facility services programs. We deliver value to our customers by enhancing their image and brand, and by promoting workplace safety, security and cleanliness. We accomplish this by providing high quality branded work apparel programs, and a variety of facility products and services including floor mats, towels, mops and restroom hygiene products.
Over the past three years we have made broad-based improvements to our business, by pursuing a strategy which included four key elements: focusing on customer satisfaction; improving day-to-day execution; increasing our focus on cost management; and addressing underperforming locations and assets. Executing this strategy has led to significant improvements in our financial results. We have delivered positive organic revenue growth, expanded operating margins and produced strong cash flows.
We believe it is healthy for a company to regularly evaluate and adjust, as appropriate, its strategy. In fiscal 2013, we modified our strategy, building on the improvements made over the past three years to drive further performance gains. Our approach has four parts:
1. Keep our customer promise

2. Improve how we target customers

3. Drive operational excellence

4. Strengthen our high performing team

To measure the progress of our strategy we have established two primary financial objectives, which include achieving operating income margin of 10% and return on invested capital (ROIC) of 10%. We define ROIC as adjusted net operating income after tax, divided by the sum of total debt less cash plus stockholders' equity. Our goal is to achieve these two financial targets by the end of our fiscal year 2014. In the second quarter of fiscal 2013, we achieved the first of these two targets by achieving a 10% operating income margin. We are also focused on maximizing free cash flow, which we define as net cash provided by operating activities less investments in property, plant and equipment.
Our industry continues to consolidate as many family-owned, local operators and regional companies have been acquired by larger providers. Historically, we have participated in this consolidation with an acquisition strategy focused on expanding our geographic presence and/or expanding our local market share in order to further leverage our existing production facilities. We remain active in evaluating quality acquisitions that would strengthen our business. During the three months ended December 29, 2012 we made one small acquisition. The pro forma effect of this acquisition, had it been acquired at the beginning of each fiscal year, was not material. The total purchase consideration was $18.6 million. The total purchase price exceeded the estimated fair value of assets acquired and liabilities assumed by $10.9 million.
Over the recent past our results have been adversely impacted by rising prices for commodities, especially cotton, polyester and crude oil. This has contributed to the significant increase in merchandise costs. We expect merchandise costs as a percentage of rental revenue to gradually moderate throughout fiscal year 2013.
Critical Accounting Policies
Our significant accounting policies are described in Note 1, "Summary of Significant Accounting Policies" of the Notes to the Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended June 30, 2012. The accounting policies used in preparing our interim fiscal year 2013 Condensed Consolidated Financial Statements are the same as those described in our Annual Report.
The discussion of the financial condition and results of operations are based upon the Condensed Consolidated Financial Statements, which have been prepared in conformity with United States generally accepted accounting principles (GAAP). 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.


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Critical accounting policies are defined as the most important and pervasive accounting policies used, areas most sensitive to material changes from external factors and those that are reflective of significant judgments and estimates. We believe our critical accounting policies are those related to:
Revenue recognition

Employee benefit plans

Income taxes

Share based payments

Derivative financial instruments

Inventories

Goodwill and intangible assets

Results of Operations
The percentage relationships to revenues of certain income and expense items for
the three and nine month periods ended March 30, 2013 and March 31, 2012, and
the percentage changes in these income and expense items between periods are
presented in the following table:

                                    Three Months Ended           Nine Months Ended            Percentage Change
                                                                                         Three Months    Nine Months
                                  March 30,     March 31,     March 30,     March 31,    FY 2013         FY 2013
                                    2013           2012         2013           2012      vs. FY 2012     vs. FY 2012
Revenues:
Rental operations                    92.7 %        91.5  %       91.6 %         91.6 %         4.9  %          5.1  %
Direct sales                          7.3           8.5           8.4            8.4         (10.6 )           4.3
Total revenues                      100.0         100.0         100.0          100.0           3.6             5.1
Expenses:
Cost of rental operations            68.0          69.6          68.1           69.2           2.6             3.4
Cost of direct sales                 74.3          79.7          74.2           78.8         (16.7 )          (1.7 )
Total cost of sales                  68.5          70.4          68.6           70.0           0.7             3.0
Pension withdrawal and
associated expenses                     -          11.0             -            3.7        (100.0 )        (100.0 )
Selling and administrative           22.1          23.0          22.0           22.7          (0.4 )           1.7
Income from operations                9.4          (4.4 )         9.4            3.5         322.4           178.9
Interest expense                      0.5           0.7           0.5            0.7         (26.0 )         (31.6 )
Income before income taxes            8.9          (5.1 )         8.9            2.8         281.7           234.6
Provision for income taxes            2.9          (2.9 )         3.2            0.8         204.6           325.9
Net income                            6.0 %        (2.2 )%        5.7 %          2.0 %       383.0  %        198.6  %

Three months ended March 30, 2013 compared to three months ended March 31, 2012 Revenues. Total revenue in the third quarter of fiscal 2013 increased 3.6% to $226.6 million from $218.8 million in the third quarter of fiscal 2012. Rental revenue increased $9.8 million, or 4.9% in the third quarter of fiscal 2013 compared to the same period of the prior fiscal year. Our organic rental growth rate was 3.8% compared to 4.8% in the same period of the prior fiscal year. The decline in the organic growth rate from the prior year was primarily due to a decrease in new account sales during the first half of fiscal 2013 and a decline in the number of uniform wearers at existing customers, offset by continued improved execution related to merchandise recovery billings, uniform preparation services, increased customer usage of non-garment products and pricing. Our organic rental growth rate is calculated using rental revenue, adjusted to exclude the impact of foreign currency exchange rate changes, divestitures and acquisitions compared to prior-period results. We believe that the organic rental revenue reflects the growth of our existing rental business and is, therefore, useful in analyzing our financial condition and results of operations. Acquisitions, along with currency exchange rates, added 1.1% to rental growth during the quarter.
Direct sale revenue decreased 10.6% to $16.6 million in the third quarter of fiscal 2013 compared to $18.6 million in the same period of fiscal 2012. The decrease in direct sales was primarily driven by lower catalog sales.


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Cost of Rental. Cost of rental operations, which includes merchandise, production and delivery expenses, increased 2.6% to $142.9 million in the third quarter of fiscal 2013 from $139.3 million in the same period of fiscal 2012. As a percentage of rental revenue, our gross margin from rental operations increased to 32.0% in the third quarter of fiscal 2013 from 30.4% in the same period of fiscal 2012. The improvement in rental gross margin was primarily due to the favorable impact of fixed costs absorbed over a higher revenue base, improvements in production and delivery productivity, and lower depreciation expense, lower natural gas costs, health insurance costs and workers' compensation costs. During the quarter, merchandise costs as a percentage of rental revenue continued to moderate and were consistent with the prior year period.
Cost of Direct Sales. Cost of direct sales decreased to $12.3 million in the third quarter of fiscal 2013 from $14.8 million in the same period of fiscal 2012. Gross margin from direct sales increased to 25.7% in the third quarter of fiscal 2013 from 20.3% in the same quarter of fiscal 2012. The higher margin in the current period was primarily due to lower distribution costs due to improved productivity, an increased mix of higher margin products and the absence of certain product launch costs that occurred in the prior year.
Pension Withdrawal and Associated Expenses. As discussed in Note 12, "Employee Benefit Plans," of the Notes to the Condensed Consolidated Financial Statements, we recorded a charge of $24.0 million related to a withdrawal from a multi-employer pension plan (MEPP) in fiscal 2012.
Selling and Administrative. Selling and administrative expenses decreased 0.4% to $50.1 million in the third quarter of fiscal 2013 from $50.3 million in the same period of fiscal 2012. As a percentage of total revenues, selling and administrative expenses decreased to 22.1% in the third quarter of fiscal 2013 from 23.0% in the third quarter of fiscal 2012. The decrease was due to effective cost control as we leveraged fixed costs over a higher revenue base, a decrease in depreciation and amortization expense, lower sales expenses and lower pension related expenses. These improvements were partially offset by higher incentive compensation expense.
Income from Operations. The following is a summary of each operating segment's income (loss) from operations:

Three Months Ended
               March 30, 2013     March 31, 2012     Change
United States $     16.3         $       (13.8 )    $  30.1
Canada               5.0                   4.2          0.8
Total         $     21.3         $        (9.6 )    $  30.9

The increase in consolidated income from operations in the third quarter of fiscal 2013 compared to the same period of the prior fiscal year was primarily due to a $24.0 million charge related to the withdrawal from a MEPP in fiscal 2012, as discussed in Note 12, "Employee Benefit Plans," of the Notes to the Condensed Consolidated Financial Statements. In addition, the increase is due to improved rental gross margins and lower selling and administrative costs noted above.
United States. Income from operations increased $30.1 million to $16.3 million in the third quarter of fiscal 2013 from a $13.8 million loss in the same period of fiscal 2012. The increase was primarily driven by the fiscal 2012 charge associated with the withdrawal from a MEPP noted above, as well as additional income from increased revenue, improved production and delivery productivity, lower depreciation and amortization expense, lower health insurance costs, lower selling expenses and improved direct sales margins in the third quarter of fiscal 2013 compared to the same period of the prior fiscal year. Canada. Income from operations increased $0.8 million to $5.0 million in the third quarter of fiscal 2013 from $4.2 million in the same period of fiscal 2012. The increase was primarily driven by additional income from increased revenue, improved production and delivery productivity, lower selling expenses and improved direct sales margins. These improvements were partially offset by higher merchandise costs in the current year.
Interest Expense. Interest expense was $1.1 million in the third quarter of fiscal 2013, a decrease from the $1.5 million reported in the same period of fiscal 2012. The decreased interest expense was due to lower average interest rates, the maturity of certain interest rate swap agreements and a reduction in the amortization of debt closing costs resulting from the renewal of our unsecured revolving credit facility. These decreases were partially offset by higher average debt balances.
Provision for Income Taxes. Our effective tax rate decreased to 32.7% in the third quarter of fiscal 2013 from 56.8% in the same period of fiscal 2012. The current period tax rate is lower than our statutory tax rate, including state income taxes, primarily due to the decrease in reserve for uncertain tax positions due to the settlement of the examination of the fiscal 2010 and 2011 federal income tax returns, as discussed in Note 6, "Income Taxes," of the Notes to the Condensed Consolidated Financial Statements, and expiration of certain tax statutes. The prior period tax rate was higher than our statutory tax rate


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primarily due to a decrease in tax reserves for uncertain tax positions due to the expiration of certain tax statutes and a $1.4 million benefit related to the final disposition of a subsidiary, both of which have the effect of increasing the effective tax rate in periods with a pretax loss.
Nine months ended March 30, 2013 compared to nine months ended March 31, 2012 Revenues. Total revenue for the first nine months of fiscal 2013 increased 5.1% to $678.2 million compared to $645.6 million for the same period in the prior fiscal year.
Rental revenue increased $30.3 million, or 5.1% in the first nine months of fiscal 2013 compared to the same period of the prior fiscal year. Our organic rental growth rate was 4.6% compared to 5.4% in the same period of the prior fiscal year. The decline in the organic growth rate from the prior year was primarily due to a decrease in new account sales, slight decline in the number of uniform wearers at existing customers and a deterioration in our customer retention rate, offset by continued improved execution related to merchandise recovery billings, uniform preparation services, increased customer usage of non-garment products and pricing. The impact of acquisitions added approximately 0.7% to our rental operations growth rate.
Direct sale revenue increased 4.3% to $56.9 million in the first nine months of fiscal 2013 compared to $54.5 million in the same period of fiscal 2012. This increase was primarily driven by several large new accounts offset by a decline in uniform purchases by existing customers in our program business as well as lower catalog sales.
Cost of Rental. Cost of rental operations, which includes merchandise, production and delivery expenses, increased 3.4% to $423.3 million in the first nine months of fiscal 2013 from $409.2 million in the same period of fiscal 2012. As a percentage of rental revenue, our gross margin from rental sales increased to 31.9% in the first nine months of fiscal 2013 from 30.8% in the same period of fiscal 2012. The improvement in rental gross margin was primarily due to the favorable impact of fixed costs absorbed over a higher revenue base, continued improvements in production and delivery productivity, lower depreciation expense and lower natural gas, motor fuel and health insurance costs. These favorable variances were partially offset by a continued and expected increase in merchandise costs and higher workers' compensation costs. Cost of Direct Sales. Cost of direct sales decreased to $42.2 million in the first nine months of fiscal 2013 from $43.0 million in the same period of fiscal 2012. Gross margin from direct sales increased to 25.8% in the first nine months of fiscal 2013 from 21.2% reported in the same period of fiscal 2012. The improved margin in the current year period was due to lower product costs, increased mix of higher margin business, lower freight costs and lower distribution costs due to improved productivity.
Pension Withdrawal and Associated Expenses. As discussed in Note 12, "Employee Benefit Plans," of the Notes to the Condensed Consolidated Financial Statements, we recorded a charge of $24.0 million related to a withdrawal from a MEPP in fiscal 2012.
Selling and Administrative. Selling and administrative expenses increased 1.7% to $149.0 million in the first nine months of fiscal 2013 from $146.5 million in the same period of fiscal 2012. As a percentage of total revenues, selling and administrative expenses decreased to 22.0% in the first nine months of fiscal 2013 from 22.7% in the same period of fiscal 2012. The decrease was due to effective cost control as we leveraged fixed costs over a higher revenue base, a decrease in depreciation and amortization expense, lower sales expenses and lower group health insurance costs. These improvements were partially offset by higher incentive compensation and bad debt expense.
Income from Operations. The following is a summary of each operating segment's income from operations:

                           Nine Months Ended
                March 30, 2013            March 31, 2012     Change
United States $           50.5          $           11.5    $  39.0
Canada                    13.2                      11.3        1.9
Total         $           63.7          $           22.8    $  40.9

The increase in consolidated income from operations in the first nine months of fiscal 2013 compared to the same period of fiscal year 2012 was primarily due to a $24.0 million charge related to the withdrawal from a MEPP in fiscal 2012, as discussed in Note 12, "Employee Benefit Plans," of the Notes to the Condensed Consolidated Financial Statements, as well as additional income from increased revenue, improved production and delivery productivity, lower depreciation and amortization expense and lower selling expenses in the first nine months of fiscal 2013 compared to the same period of fiscal 2012. In addition, the increase is due to improved rental gross margins and lower selling and administrative costs noted above.


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United States. Income from operations increased $39.0 million to $50.5 million in the first nine months of fiscal 2013 from $11.5 million in the same period of fiscal 2012. The increase was driven by the fiscal 2012 charge associated with the withdrawal from a MEPP noted above, as well as additional income from increased revenue, improved production and delivery productivity, lower depreciation and amortization expense, lower health insurance costs, lower selling expenses and improved direct sales margins in the first nine months of fiscal 2013 compared to the same period of fiscal 2012. These improvements were partially offset by higher merchandise costs in the current year. Canada. Income from operations increased $1.9 million to $13.2 million in the first nine months of fiscal 2013 from $11.3 million in the same period of fiscal 2012. The increase was primarily driven by additional income from increased revenue, improved production and delivery productivity, lower selling expenses and improved direct sales margins. These improvements were partially offset by higher merchandise costs in the current year.
Interest Expense. Interest expense was $3.3 million in the first nine months of fiscal 2013, a decrease from the $4.8 million reported in the same period of fiscal 2012. The decreased interest expense was due to lower average interest rates, the maturity of certain interest rate swaps agreements and a reduction in the amortization of debt closing costs resulting from the renewal of our unsecured revolving credit facility. These decreases were partially offset by higher average debt balances.
Provision for Income Taxes. Our effective tax rate increased to 36.0% for the nine months ended March 30, 2013 from 28.3% in the nine months ended March 31, 2012. The current year tax rate is lower than our statutory rate, including state income taxes, primarily due to the decrease in reserves for uncertain tax positions due to the settlement of certain federal income tax examinations, as discussed in Note 6 "Income Taxes," of the Notes to the Condensed Consolidated Financial Statements, and expiration of certain tax statutes. The prior year tax rate was lower than our statutory rate primarily due to a $1.4 million benefit related to the final disposition of a subsidiary, the decrease in tax reserves for uncertain tax positions due to the expiration of certain tax statutes, and lower pretax income, offset by the write-off of deferred tax assets associated with equity compensation.
Liquidity, Capital Resources and Financial Condition Our primary sources of cash are net cash flows from operations and borrowings under our debt arrangements. Primary uses of cash are working capital needs, payments on indebtedness, capital expenditures, acquisitions, dividends and general corporate purposes.
Working capital at March 30, 2013 was $159.8 million, a $23.4 million decrease from $183.2 million at June 30, 2012. The decrease in working capital is primarily due to the reclassification of the debt outstanding under our accounts receivable securitization facility to current from long-term and a decrease in new goods inventory, partially offset by an increase in cash.
Operating Activities. Net cash provided by operating activities increased $43.2 million to $82.6 million in the first nine months of fiscal 2013 from $39.4 million in the same period of fiscal 2012. The increase was due to higher net income and and lower inventory purchases, partially offset by higher tax payments in the current year.
Investing Activities. Net cash used for investing activities increased to $46.2 million in the first nine months of fiscal 2013 compared to $25.9 million in the same period of fiscal 2012. The increase was primarily due to an acquisition in the second quarter of fiscal 2013, which totaled $18.6 million.
Financing Activities. Cash used for financing activities was $27.0 million in the first nine months of fiscal 2013 compared to $18.7 million in fiscal 2012. The increased use of cash was primarily due to higher debt payments as a result of stronger cash flow, offset by cash used for the acquisition and proceeds from the issuance of common stock under stock option plans. During the first nine months of fiscal 2013 and 2012, we paid dividends of $11.3 million and $7.3 million, respectively.
We have a $250.0 million, unsecured revolving credit facility with a syndicate of banks, which expires on March 7, 2017. Borrowings in U.S. dollars under this credit facility, at our election, bear interest at (a) the adjusted London Interbank Offered Rate ("LIBOR") for specified interest periods plus a margin, which can range from 1.00% to 2.00%, determined with reference to our consolidated leverage ratio or (b) a floating rate equal to the greatest of
(i) JPMorgan's prime rate, (ii) the federal funds rate plus 0.50% and (iii) the adjusted LIBOR for a one month interest period plus 1.00%, plus, in each case, a margin determined with reference to our consolidated leverage ratio. Base rate loans will, at our election, bear interest at (i) the rate described in clause
(b) above or (ii) a rate to be agreed upon by us and JPMorgan. Borrowings in Canadian dollars under the credit facility will bear interest at (a) the Canadian deposit offered rate plus 0.10% for specified interest periods plus a margin determined with reference to our consolidated leverage ratio or (b) a floating rate equal to the greater of (i) the Canadian prime rate and (ii) the Canadian deposit offered rate for a one month interest period plus 1.00%, plus, in each case, a margin determined with reference to our consolidated leverage ratio.


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As of March 30, 2013, borrowings outstanding under the revolving credit facility were $88.5 million. The unused portion of the revolver may be used for general corporate purposes, acquisitions, share repurchases, dividends, working capital needs and to provide up to $50.0 million in letters of credit. As of March 30, 2013, letters of credit outstanding against the revolver totaled $0.6 million and primarily related to our property and casualty insurance programs. No amounts have been drawn upon these letters of credit. Availability of credit under this facility requires that we maintain compliance with certain covenants. The covenants under this agreement are the most restrictive when compared to our other credit facilities. The following table illustrates compliance with regard to the material covenants required by the terms of this facility as of March 30, 2013:

                                                           Required      Actual
Maximum Leverage Ratio (Debt/EBITDA)                            3.50       1.78
Minimum Interest Coverage Ratio (EBITDA/Interest Expense)       3.00      26.38
Minimum Net Worth                                         $    379.8    $ 450.3

Our maximum leverage ratio and minimum interest coverage ratio covenants are calculated by adding back certain non-cash charges, as defined in our debt agreement.
Borrowings outstanding as of March 30, 2013 bear interest at a weighted average all-in rate of 1.70%. We also pay a fee on the unused daily balance of the revolving credit facility based on a leverage ratio calculated on a quarterly basis. At March 30, 2013 this fee was 0.25% of the unused daily balance. On April 12, 2013, we amended our $250.0 million unsecured revolving credit facility to remove the minimum net worth covenant. The effective date of the change in this covenant is the earlier of June 30, 2015 or the date of full repayment of the $75.0 million variable rate unsecured private placement notes. We have $75.0 million of variable rate unsecured private placement notes. The notes bear interest at 0.60% over LIBOR and are scheduled to mature on June 30, 2015. The notes do not require principal payments until maturity. Interest payments are reset and paid on a quarterly basis. As of March 30, 2013, the outstanding balance of the notes was $75.0 million at an all-in rate of 0.91%. We maintain a $50.0 million accounts receivable securitization facility, which expires on September 27, 2013. Under the terms of the facility, we pay interest at a rate per annum equal to a margin of 0.76%, plus LIBOR. The facility is subject to customary fees for the issuance of letters of credit and any unused portion of the facility. As is customary with transactions of this nature, our eligible accounts receivable are sold to a consolidated subsidiary. As of . . .

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