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GK > SEC Filings for GK > Form 10-K on 23-Aug-2013All Recent SEC Filings

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Form 10-K for G&K SERVICES INC


23-Aug-2013

Annual Report


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. Fiscal years 2013, 2012 and 2011 were 52 week years. 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.
From fiscal year 2010 through fiscal year 2012, we 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.
In fiscal year 2013, we modified our strategy, building on the improvements made in the past. 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, in fiscal year 2010, we established two primary long-term financial objectives, which were 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. In the second quarter of fiscal year 2013, we achieved the first of these two targets by achieving a 10% operating margin. As of the fourth quarter of fiscal year 2013, our ROIC expanded to 9.2%. Given we had reached one of the long-term goals and we are close to achieving


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the second goal, we recently announced new long-term financial goals. Our new goal is called the "12+ Plan" and includes achieving 12% operating margin, 12% ROIC and a GDP+ revenue growth rate, within a two to four year time frame. 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 fiscal year 2013, we made one acquisition. The proforma effect of this acquisition, had it been acquired at the beginning of the fiscal year was not material. The total purchase consideration was $18.5 million. The total purchase price exceeded the fair value of assets acquired and liabilities assumed by $11.0 million.
In fiscal years 2011 and 2012, our results were adversely impacted by rising prices for commodities, especially cotton, polyester and crude oil. This contributed to a significant increase in merchandise costs. As expected, merchandise costs as a percentage of rental revenue began to gradually moderate throughout fiscal year 2013 after peaking in the first quarter. We periodically adjust our operations to serve our customers in the most efficient and cost effective manner. As part of these adjustments, we may realign our workforce, close production or branch facilities or divest operations. We are continuously assessing our business and making adjustments as necessary.
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 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.
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 uncertainties. See Note 1, "Summary of Significant Accounting Policies" of the Notes 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 pick-up soiled merchandise, launder and then deliver clean uniforms and other related products. The service agreements generally 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 damaged uniforms and replacement fees for non-personalized merchandise that is lost or damaged. Direct sale revenue is recognized in the period in which the product is shipped. Total revenues do not include sales tax as we consider ourselves a pass-through conduit for collecting and remitting sales tax.
During the fourth quarter of fiscal year 2010, we changed our business practices regarding the replacement of certain lost or damaged in-service towel and linen inventory. Transactions entered into prior to the fourth quarter of 2010 included the potential for future adjustments to our customer billings, including, in some cases, refunds for a number of items, including actual experience of lost or damaged goods. For these transactions, we did not meet all of the requirements for revenue recognition at the time of our initial billing because our fees were not fixed or determinable and collectability was not reasonably assured, as evidenced by subsequent adjustments, including refunds in certain cases. As a result, we deferred the revenue for these transactions until such time as we could determine that the fees were no longer subject to adjustment or refund and were fixed and determinable and collectability was reasonably assured.
Beginning in the fourth quarter of 2010, our invoicing for lost and damaged in-service towel and linen inventory (replacement fees) is no longer subject to adjustment or refund. For these transactions, revenue is recognized at the time of billing when service performance and delivery of the in service inventory to the customer occurs because the fee is fixed and determinable and collectability is reasonably assured.
As a result of the change described above, we began to immediately recognize revenue related to all new invoicing for lost and damaged in service towel and linen inventory. In addition, during the three month periods ended July 3, 2010, October 2, 2010


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and January 1, 2011, we continued to recognize and earn revenue (legacy revenue) associated with the refundable fees that had been collected prior to the change in business practices. As a result, we had a dual, non-recurring revenue stream occurring in these periods. As of January 1, 2011, all deferred revenue previously recorded prior to the change in business practices had either been earned or refunded to the customers. For fiscal year 2011, the effect of this change in business practice increased revenue and income from operations by $5.9 million, net income by $3.7 million and basic and diluted earnings per common share by $0.20. There were no comparable amounts recognized in fiscal years 2012 or 2013.
Estimates are used in determining the collectability of 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. We generally write-off uncollectible accounts receivable after all avenues of collection have been exhausted.
Inventories
Inventories consist of new goods and rental merchandise in service. New goods are stated at the 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 our 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 the merchandise. Estimated lives of rental merchandise in service range from six months to four years. In establishing estimated lives for merchandise in service, management considers historical experience and the intended use of the merchandise.
We review the estimated useful lives of our in-service inventory assets on a periodic basis or when trends in our business indicate that the useful lives for certain products might have changed. During the fourth quarter of fiscal year 2013, we completed an analysis of certain in-service inventory assets which resulted in the estimated useful lives for these assets being extended to better reflect the estimated periods in which the assets will remain in service. The effect of the change in estimate increased income from operations by $2.6 million, net income by $1.7 million and basic and diluted earnings per common share by $0.09 in fiscal year 2013. In addition, based on historical purchase levels, the change is expected to increase income from operations, net income and basic and diluted earnings per common share in fiscal year 2014 by $6.4 million, $3.9 million and $0.20, respectively. The effect on years after 2014 is not expected to be material.
We estimate our reserves for inventory obsolescence by examining our inventory to determine if there are indicators that carrying values exceed the net realizable value. Significant factors that could indicate the need for additional inventory write-downs include the age of the inventory, anticipated demand for our products, historical inventory usage, revenue trends and current economic conditions. We believe that adequate reserves for inventory obsolescence have been made in the Consolidated Financial Statements; however, in the future, product lines and customer requirements may change, which could result in an increase in obsolete inventory reserves or additional inventory impairments.
During the fourth quarter of fiscal year 2013, we recorded additional inventory reserves of $3.6 million as a result of the restructuring of our Direct Sale business, and an evaluation of the recoverability of certain inventory. See Note 9, "Restructuring and Impairment Charges" of the Notes to the Consolidated Financial Statements for additional details. Environmental Costs
We accrue various environmental related costs, which consist primarily of estimated clean-up costs, fines and penalties, when it is probable that we have incurred a liability and the amount can be reasonably estimated. When a single amount cannot be reasonably estimated but the cost can be estimated within a range, we accrue the minimum estimated amount. This accrued amount reflects our assumptions regarding the nature of the remedy and the outcome of discussions with regulatory agencies. Changes in the estimates on which the accruals are based, including unanticipated government enforcement actions or changes in environmental regulations, could result in higher or lower costs. Accordingly, as investigations and other actions proceed, it is likely that adjustments in our accruals will be necessary to reflect new information. The amounts of any such adjustments could have a material adverse effect on our results of operations or cash flows in a given period. We cannot predict the ultimate outcome of any of these matters with certainty and it is possible that we may incur additional losses in excess of established reserves. However, we believe the possibility of a material adverse effect on our results of operations or financial position is remote.
Accruals for environmental liabilities are included in the "Accrued expenses - Other" line item in the Consolidated Balance Sheets. Environmental costs are capitalized if they extend the life of the related property, increase its capacity and/or mitigate or prevent future contamination. The cost of operating and maintaining environmental control equipment is charged to expense in the period incurred.


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For additional information see Note 13, "Commitments and Contingencies" of the Notes to the Consolidated Financial Statements. Goodwill and Intangible 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 us for a fixed period of time and acquired customer contracts are stated at cost less accumulated amortization and are amortized over the terms of the respective agreements or estimated average life of an account, which ranges from five to twenty years.
We test goodwill for impairment in the fourth quarter of each fiscal year or upon the occurrence of events or changes in circumstances that indicate that the asset might be impaired. We have determined that the reporting units for our goodwill impairment review are our operating segments, or components of an operating segment, that constitute a business for which discrete financial information is available, and for which segment management regularly reviews the operating results. Based on this analysis, we have identified three reporting units within our operating segments as of the fiscal year 2013 testing date. Our reporting units are U.S. Rental operations, Canadian Rental operations and Direct Sales operations. The associated goodwill balances were $270.3 million, $64.1 million and $0, respectively, at June 29, 2013. There have been no changes to our reporting units or in the allocation of goodwill to each respective reporting unit in fiscal years 2013, 2012 or 2011.
The goodwill impairment test is performed using a two-step process. In the first step, we determine the estimated fair value of each reporting unit and compare it to the carrying value of the reporting unit, including goodwill. If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that unit, goodwill is not considered impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value of the reporting unit, then we must perform the second step of the impairment test in order to determine the implied fair value of the reporting unit's goodwill. In the second step, we determine the implied fair value of the reporting unit's goodwill which is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The implied fair value is compared to the carrying amount and if the carrying amount of the reporting unit's goodwill exceeds the implied fair value of its goodwill, an impairment loss is recognized for the excess.
We used a market valuation approach to determine the fair value of each reporting unit for our annual impairment test in the fourth quarter of fiscal 2013, 2012 and 2011. The results of this test indicated that the estimated fair value exceeded the carrying value of our goodwill by more than 50% for our U.S. Rental and Canadian Rental reporting units for all fiscal years and therefore no impairment existed. All goodwill associated with our Direct Sales reporting unit had been previously impaired and written off.
Long-lived assets, including definite-lived intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability is measured by comparison of the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. During the fourth quarter of fiscal year 2013, we recorded an impairment loss related to customer contracts totaling $1.6 million. See Note 9, "Restructuring and Impairment Charges" of the Notes to the Consolidated Financial Statements for details on the impairment. There were no impairment charges for intangible assets in fiscal years 2012 or 2011.
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.
As of June 29, 2013, cumulative goodwill impairment losses total $107.0 million. Of this amount, $100.0 million was associated with our U.S. Rental operations and $7.0 million was related to our Direct Sales operations. Insurance
We carry large deductible insurance policies for certain obligations related to health, workers' compensation, auto and general liability programs. These deductibles range from $0.4 million to $0.8 million. 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 generally consider historical claims experience, escalating medical cost trends, expected timing of claim payments and actuarial analyses provided by third parties. Changes in the cost of medical care, our ability to settle claims and the present value estimates and judgments used by management could have a material impact on the amount and timing of expense for any period.


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Income Taxes
Provisions for federal, state, and foreign income taxes are calculated based on reported pre-tax earnings and current tax law. Significant judgment is required in determining income tax provisions and evaluating tax positions. We periodically assess our liabilities and contingencies for all periods that are currently open to examination or have not been effectively settled based on the most current available information. If it is not more likely than not that our tax position will be sustained, we record our best estimate of the resulting tax liability and any applicable interest and penalties in the Consolidated Financial Statements.

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. We present the tax effects of these deferred tax assets and liabilities separately for each major tax jurisdiction. 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 the changes are enacted. 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. We evaluate our deferred tax assets and liabilities on a periodic basis. We believe that we have adequately provided for our future income tax obligations 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 June 29, 2013, June 30, 2012 and July 2, 2011, and the percentage changes in these income and expense items between years are presented in the following table:

                                                                                   Percentage Change
                                           Percentage of Revenues                    Between Years
                                                Years Ended                   FY 2013 vs.     FY 2012 vs.
                                 Fiscal 2013    Fiscal 2012    Fiscal 2011      FY 2012         FY 2011
Revenues:
Rental operations                     91.8 %          91.4 %         91.7 %         4.8  %        4.6  %
Direct sales                           8.2             8.6            8.3          (0.3 )         9.0
Total revenues                       100.0           100.0          100.0           4.3           5.0
Operating expenses:
Cost of rental operations             67.5            69.1           68.0           2.4           6.4
Cost of direct sales                  79.4            77.5           74.1           2.1          14.1
Total cost of sales                   68.5            69.8           68.5           2.4           7.1
Pension withdrawal and
associated expenses                      -             2.8              -        (100.0 )           -
Selling and administrative            22.9            22.5           23.7           6.0             -
Income from operations                 8.6             4.9            7.9          84.6         (35.3 )
Interest expense                       0.5             0.7            1.2         (20.0 )       (40.6 )
Income before income taxes             8.1             4.2            6.7         102.2         (34.4 )
Provision for income taxes             2.9             1.4            2.7         119.6         (45.2 )
Net income                             5.1 %           2.8 %          4.0 %        93.5  %      (27.2 )%

Fiscal Year 2013 Compared to Fiscal Year 2012 Fiscal Years. Our fiscal year ends on the Saturday closest to June 30. As a result, we will periodically have a fiscal year that consists of 53 weeks. Fiscal years 2013 and 2012 both had 52 weeks.
Revenues. Total revenues in fiscal year 2013 increased 4.3% to $907.7 million from $869.9 million in fiscal year 2012.
Rental revenue increased $38.0 million in fiscal year 2013, a 4.8% increase from fiscal year 2012. The increase in rental revenue was primarily driven by organic growth. Our organic rental growth rate was 4.2% compared to 5.5% in the prior fiscal year. The decline in the rental organic growth rate from the prior year was primarily due to slight decreases in new account sales and the number of uniform wearers at existing customers, offset by continued improved execution related to merchandise recovery billings and uniform preparation services. The impact of acquisitions added approximately 0.8% to our rental operations growth rate. Our organic rental growth rate is calculated using rental revenue, adjusted to exclude the impact of foreign currency exchange rate changes, divestitures, acquisitions and the previously noted modification of our revenue


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recognition policy 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.
Direct sale revenue was $74.5 million in fiscal year 2013, a 0.3% decrease from $74.7 million in fiscal year 2012. The decrease resulted from a decline in uniform purchases by existing customers in our program business, the loss of one large customer and lower catalog sales, partially offset by several large new accounts. The organic direct sale growth rate was a negative 0.3% in fiscal year 2013 compared to 9.1% in fiscal year 2012.
Cost of Rental. Cost of rental operations, which includes merchandise, production and delivery expenses, increased 2.4% to $562.7 million in fiscal year 2013 from $549.6 million in fiscal year 2012. As a percentage of rental revenue, our gross margin from rental sales improved to 32.5% in fiscal year 2013 from 30.9% in the prior fiscal year. Cost of rental was favorably impacted by $2.6 million or 0.3% of rental revenue due to the change in the estimated useful lives for certain in-service assets, as discussed in Note 1, "Summary of Significant Accounting Policies - Inventories" of the Notes to the Consolidated Financial Statements. Excluding this benefit, gross margin from rental sales was 32.1% and represented an improvement of 1.2%. This improvement was primarily due to continued improvements in production and delivery productivity, the favorable impact of fixed costs absorbed over a higher revenue base, 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.
Cost of Direct Sales. Cost of direct sales increased to $59.2 million in fiscal year 2013 from $57.9 million in fiscal year 2012. Gross margin from direct sales decreased in fiscal year 2013 to 20.6% from 22.5% in fiscal year 2012. Cost of direct sales included a $3.6 million restructuring and impairment charge as discussed in Note 9, "Restructuring and Impairment Charges" of the Notes to the Consolidated Financial Statements, which represented 4.8% of direct sales revenue. Excluding these charges, gross margin from direct sales was 25.5% and represented an increase of 3.0%. This improvement was due to lower product costs, improved distribution productivity, lower freight costs and improved pricing discipline.
Pension Withdrawal and Associated Expenses. As discussed in Note 12, "Employee Benefit Plans" of the Notes to the Consolidated Financial Statements, we recorded a charge of $24.0 million related to a withdrawal from a multi-employer pension plan in fiscal year 2012.
Selling and Administrative. Selling and administrative expenses increased to $207.8 million in fiscal year 2013 from $196.1 million in fiscal year 2012. As a percentage of total revenues, selling and administrative expenses increased to 22.9% in fiscal year 2013 from 22.5% in fiscal year 2012. The increase was primarily driven by restructuring and impairment charges, as discussed in Note 9, "Restructuring and Impairment Charges" of the Notes to the Consolidated Financial Statements. The restructuring costs included in selling and administrative expenses totaled $6.2 million or 0.7% of revenue. Excluding these restructuring and impairment charges, selling and administrative costs were 22.2% of total revenue and represented a decrease of 0.3% from fiscal year 2012. This 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 (in thousands):

For the Fiscal Years
                    2013            2012       Change
United States $    60,173         $ 26,157    $ 34,016
. . .
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