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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
FOR THE TRANSITION PERIOD FROM --------------- TO
---------------
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COMMISSION FILE NUMBER: 000-21173
SERVICE EXPERTS, INC.
(Exact name of registrant as specified in its charter)
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TENNESSEE 62-1639453
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1134 MURFREESBORO ROAD
NASHVILLE, TENNESSEE 37217
(Address of principal executive offices) (Zip Code)
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Registrant's telephone number, including area code: (615) 391-4600
Securities Registered pursuant to Section 12(b) of the Act:
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NONE NONE
(Title of Each Class) (Name of Each Exchange on Which Registered)
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Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE PER SHARE
(Title of Class)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the shares of Common Stock (based upon the
closing sale price of these shares as reported on the Nasdaq Stock Market's
National Market on February 14, 1997) of the registrant held by nonaffiliates on
February 14, 1997, was approximately $230.3 million.
As of February 14, 1997, 11,821,722 shares of the registrant's Common Stock
were outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
Documents incorporated by reference and the part of Form 10-K into which
the document is incorporated:
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Portions of the Company's Proxy Statement relating to its
Annual Meeting of Stockholders to be held on May 2,
1997...................................................... Part III
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FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements regarding the business and
industry of Service Experts, Inc. (the "Company"), including those regarding the
successful integration of the businesses of its subsidiaries, the effective
implementation of the Company's strategy, the availability of additional HVAC
businesses for acquisition, the adequacy of the Company's capital resources and
other statements regarding trends relating to the HVAC industry and various
revenue and expense items. Many factors, including the Company's limited
operating history on a combined basis, its aggressive acquisition strategy and
the uncertainty that acquisitions can be completed and integrated as planned,
the fact that many of the Company's operating and information systems are in the
development or implementation phase, competition, labor availability, regulatory
developments and other uncertainties, could cause actual results to differ
materially from those discussed in the forward-looking statements made in this
report.
PART I
ITEM 1. BUSINESS
GENERAL
The Company is one of the leading providers of residential heating,
ventilating and air conditioning ("HVAC") services and replacement equipment in
the United States, and management believes that the Company will continue to be
a leading consolidator of the fragmented HVAC service and replacement industry.
The Company currently operates 32 HVAC service and replacement businesses
("Service Centers") in 17 states and owns Contractor Success Group, Inc., a
company that provides HVAC businesses proprietary products as well as marketing,
management, educational and advisory services ("CSG"). The Service Centers
install, service and maintain central air conditioners, furnaces and heat pumps,
primarily in existing homes. Management estimates that over 80% of the Company's
pro forma net revenue in 1996, giving effect to all completed and pending
acquisitions, was derived from replacing, maintaining and servicing HVAC
equipment at existing residences.(1) The Company focuses on the service and
replacement segment of the HVAC industry rather than the new construction
segment because management believes that the service and replacement segment
offers higher margins and exposes the Company to less credit risk. The service
and replacement segment offers more attractive pricing because of customers'
demands for immediate, convenient and reliable service.
Management believes that the Company is positioned to capitalize on the
fragmentation and growth of the HVAC service and replacement industry. In
addition, management believes that the Company's visibility within the industry
and its operational philosophy of decentralized operations and centralized
administration provide the Company with a competitive advantage, particularly in
enabling the Company to identify and acquire well-managed, profitable HVAC
businesses. By allowing former owners of Service Centers the opportunity to
continue managing their business after acquisition and to increase their focus
on customer service rather than administration, management believes that the
Company offers owners of independent HVAC businesses an attractive alternative.
Management intends to develop a national presence through acquisitions and a
national reputation for superior, high quality service which will enable the
Company to appeal to a large number of customers. The Company has implemented an
aggressive acquisition strategy, acquiring 23 HVAC businesses (the "Acquired
Companies") since the Company's initial public offering of
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(1) All references herein to the Company's 1996 pro forma results assume the
completion as of January 1,
1996 of the acquisitions being discussed.
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Common Stock completed on August 21, 1996 (the "IPO") with aggregate revenue for
the year ended December 31, 1996 of approximately $76.7 million. The Company
currently has agreements in principle to acquire during the first six months of
1997 eight HVAC businesses (the "Pending Acquisitions") with aggregate revenue
in 1996 of approximately $31.3 million. The Company's 1996 pro forma net
revenue, giving effect to the acquisition of the Service Centers and the
companies included in the Pending Acquisitions, was approximately $171.9
million.
HVAC SERVICE AND REPLACEMENT INDUSTRY
The HVAC industry consists of (i) the installation, replacement,
maintenance, service and repair of HVAC systems at existing residences and
commercial businesses and (ii) the installation of HVAC systems at newly
constructed homes and businesses. The Company primarily provides installation
and replacement services to existing homes and small to medium-sized businesses.
According to Air Conditioning, Heating and Refrigeration News, there are
approximately 43 million central air conditioners, 54 million furnaces and nine
million heat pumps in operation in homes in the United States. Management
estimates, based on industry information, that the market for the service and
replacement of HVAC systems in existing homes is approximately $24 billion
annually. The installation and replacement segment of the industry has increased
in size as a result of the aging of the installed base of residential systems,
the introduction of new, energy efficient systems and the upgrading of existing
homes to central air conditioning. According to the Air Conditioning and
Refrigeration Institute, over 61 million central air conditioners have been
installed in the United States since 1975. Many of the units installed from the
mid-1970s to the mid-1980s are reaching the end of their useful lives, thus
providing a growing replacement market. In addition, in recent years, increased
governmental regulation restricting the use of ozone depleting refrigerants in
HVAC systems has contributed to the growing replacement market. See
"Regulation."
According to Air Conditioning, Heating, and Refrigeration News, over 30,000
HVAC contractors are currently operating in the United States. Management
believes that HVAC businesses are typically closely held, single-center
operations that serve a limited geographic area and are heavily dependent upon
referrals to generate business. Management believes that, in many cases, these
businesses are operated by former service technicians who lack the business and
marketing expertise to expand their businesses, increase their profitability and
compete effectively with larger operators. Management believes that larger
companies are able to operate more efficiently, offer customers a broader array
of products and services and provide a higher level of customer service than
smaller operators. Management believes that these competitive advantages are the
result of greater managerial and financial resources as well as economies of
scale in purchasing and marketing expenses. Management believes that these
factors will continue to promote a trend toward consolidation in the industry
and present an opportunity for well-capitalized operators to acquire additional
businesses on favorable terms.
ACQUISITIONS
The Company's goal is to become the leading provider of residential HVAC
services and replacement equipment in the United States through the acquisition
of CSG members in new markets, the integration of other HVAC businesses and the
continued revenue and profit growth of its Service Centers.
Strategy
The Company has implemented an aggressive acquisition program utilizing a
"hub and spoke" strategy for expansion into new geographic areas and further
penetration into existing markets. The U.S. residential HVAC service industry is
currently highly fragmented. Management believes that many HVAC businesses,
which lack the capital necessary to expand operations and the ability to exit
their business profitably, will desire to affiliate with the Company because the
Company will provide (i) business and marketing systems that enable a company to
operate more profitably, (ii) the opportunity to increase the operator's focus
on customer service rather than administration, (iii) the potential for national
name recognition and (iv) the opportunity for the owner to gain liquidity while,
in some cases, continuing to manage the operations of the
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business. By expanding geographically, management believes the Company will be
able to offset certain seasonal and economic trends that affect different
regions of the country periodically.
Expanding Geographic Presence through Hub Acquisitions. The Company plans
to continue to make "hub" acquisitions of existing HVAC businesses in new
markets that are not being served by the Company. Management targets for
acquisition HVAC businesses that are members of CSG and familiar with the
Company's policies and procedures. Typically, these businesses have annual net
revenue ranging from $2.0 million to $5.0 million. In evaluating such
acquisitions, the Company considers candidates that are in attractive markets,
financially stable, experienced in the industry and characterized by strong
management.
Expanding Market Penetration of Hubs through the Acquisition of Other HVAC
Businesses. The Company expects to increase market share through "spoke"
acquisitions of other HVAC businesses that have large customer bases and that
present opportunities to reduce overhead or dispose of fixed assets to improve
profitability. When acquired, the operations of such businesses will be
integrated into the operations of existing hubs, enabling the Company to reduce
overhead costs, sell redundant assets and consolidate operations within existing
areas served by the Company.
Recent and Pending Acquisitions
Since the IPO, the Company has acquired 23 HVAC businesses. The
consideration paid by the Company for these businesses was approximately $58.6
million, consisting of 3.2 million shares of Common Stock and $5.6 million in
cash. Two of the transactions, Custom Air Conditioning, Inc. and Freschi Air
Systems, Inc. (collectively, the "Pooled Companies"), were accounted for using
the pooling of interests method of accounting, and the remainder were accounted
for using the purchase method. Of the purchase price, $45.1 million was
allocated to intangible assets which are to be amortized over a 40-year period.
On a pro forma basis, these companies, excluding the Pooled Companies,
contributed revenue in 1996 of approximately $63.7 million and contributed
operating income of approximately $4.6 million.
The Company currently has agreements in principle to acquire eight HVAC
businesses. The Pending Acquisitions are expected to close during the first six
months of 1997. The consideration to be paid by the Company for these businesses
is approximately $21.7 million, consisting of 225,406 shares of Common Stock and
$15.4 million cash. All of these transactions are expected to be accounted for
using the purchase method. Of the purchase price, $16.0 million is expected to
be allocated to intangible assets which are to be amortized over a 40-year
period. On a pro forma basis, these companies generated revenue in 1996 of
approximately $31.3 million and contributed operating income of approximately
$3.1 million. The acquisitions are subject to customary conditions, and there
can be no assurance that the Company will be able to consummate all of the
acquisitions or to successfully integrate the businesses of the acquired
companies.
The Company's acquisitions since the IPO expanded the geographic coverage
of the Company by providing entry to the Florida, Illinois, Maryland,
Mississippi, New York, Oklahoma, South Carolina and Texas markets and increasing
the Company's market presence in Arkansas, California, Indiana, Louisiana and
Tennessee. The Company now operates 32 Service Centers (the operations of three
HVAC businesses included among the Acquired Companies were consolidated
following acquisition) in 31 market areas in 17 states.
The following table sets forth certain information with respect to the
Company's existing Service Centers and the Pending Acquisitions:
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COMPANY MARKET EFFECTIVE DATE
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PREDECESSOR COMPANIES
Norrell Heating and Air Conditioning
Company, Inc.............................. Birmingham, AL August 21, 1996
Hardwick Air Masters, Inc................... Little Rock, AR August 21, 1996
Service Experts of Palm Springs, Inc........ Palm Springs, CA August 21, 1996
Comerford's Heating and Air Conditioning,
Inc....................................... Pleasanton, CA August 21, 1996
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COMPANY MARKET EFFECTIVE DATE
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PREDECESSOR COMPANIES -- (CONTINUED)
Coastal Air Conditioning Service, Inc....... Savannah, GA August 21, 1996
Rolf Coal and Fuel Corp..................... Fort Wayne, IN August 21, 1996
Brand Heating & Air Conditioning, Inc....... Lafayette, IN August 21, 1996
Gilley's Heating & Cooling, Inc............. Monroe, LA August 21, 1996
Vision Holding Company, Inc................. Kansas City, MO August 21, 1996
Air Experts, a United Services Co., Inc..... St. Louis, MO August 21, 1996
AC Service & Installation Co., Inc./
Donelson Air Conditioning Company, Inc.... Nashville, TN August 21, 1996
Arrow Heating & Air Conditioning, Inc....... Racine, WI August 21, 1996
ACQUIRED COMPANIES
AirCon Air Conditioning, Inc. .............. Little Rock, AR January 2, 1997
Freschi Air Systems, Inc.................... Antioch, CA December 1, 1996
Dial One Raymond's Plumbing, Heating &
Cooling, Inc. ............................ Auburn, CA January 2, 1997
Gaddis Co................................... El Centro, CA January 2, 1997
Custom Air Conditioning, Inc................ Jupiter, FL December 1, 1996
Automated Air, Inc. ........................ Champaign, IL January 2, 1997
Bauer Heating & Air Conditioning, Inc....... Decatur, IL January 2, 1997
Sylvester's Corp............................ Anderson, IN January 2, 1997
Bryant-Allen, Inc........................... Indianapolis, IN January 2, 1997
Paul E. Smith Co., Inc...................... Indianapolis, IN December 1, 1996
B. W. Heating & Cooling, Inc................ Mishawaka, IN January 2, 1997
Quality Air Conditioning & Heating of West
Monroe, Inc............................... Monroe, LA December 1, 1996
Frees Service Experts, Inc.................. Shreveport, LA December 1, 1996
Parker Heating & Air Conditioning,
Incorporated.............................. Gaithersburg, MD January 2, 1997
Comfortech, Inc............................. Jackson, MS December 1, 1996
Sunbeam Service Experts, Inc................ Buffalo, NY December 1, 1996
Falso Service Experts, Inc.................. East Syracuse, NY December 17, 1996
Gordon's Specialty Company, Inc............. Norman, OK December 1, 1996
Pardee Refrigeration Company Incorporated... Charleston, SC December 1, 1996
Sanders Indoor Comfort, Inc................. Greeneville, SC December 1, 1996
Island Air Conditioning, Inc................ Isle of Palms, SC December 1, 1996
Air-Conditioning and Heating Unlimited,
Inc....................................... Memphis, TN December 1, 1996
B & B Air Conditioning, Inc................. Dallas, TX December 1, 1996
Eisenbach Enterprises, Inc.................. Tyler, TX December 1, 1996
PENDING ACQUISITIONS
C. Iapaluccio Co., Inc...................... Danbury, CT
Claire's Air Conditioning and Refrigeration,
Inc....................................... Midland, TX
Claire & Sanders, Inc....................... Midland, TX
Royden, Inc................................. Provo, UT
Piedmont Air Conditioning, Inc.............. Raleigh, NC
Roland Down, Inc............................ Albany, NY
Stark Services Company, Inc................. Dallas, TX
Lewis & Guymon, Inc. ....................... Orem, UT
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OPERATING STRATEGY
Management believes that successful implementation of the Company's
operating strategy will enable it to establish a national reputation for
superior, high quality service. By developing a national reputation, management
believes the Company will appeal to a large number of customers who are familiar
with and rely upon a large, national company. The Company's operating strategy
incorporates the successful methods developed by CSG and capitalizes on the
operating efficiencies resulting from the integration of the operations of its
Service Centers. The key elements of the Company's operating strategy are as
follows:
Providing Superior, High Quality Service in a Professional Manner. The
Service Centers provide high quality service at a competitive price and in a
friendly, professional manner. In order to provide such service, service
technicians, maintenance technicians and installers employed by the Company
complete comprehensive training programs designed to teach employees the
Company's operating procedures. These procedures are described in CSG's training
manuals which provide detailed instructions in areas such as residential
replacement sales, residential installation, preventive maintenance agreements,
service and routine maintenance. The Company has standardized policies and
operating procedures intended to result in a uniform level of professional, high
quality service, including installation and maintenance procedures, random
drug-testing of employees, the technician's appearance and the use of "Carpet
Saver" shoe coverings when inside a customer's home. The Service Centers utilize
a flat rate billing system that advises the customer of the cost of service
before work begins and charges the quoted price regardless of the actual time
necessary to repair the system. The Service Centers are generally open for
business from 8:00 a.m. to 8:00 p.m. on weekdays, and most are open on Saturday
from 8:00 a.m. to 4:00 p.m. Management believes that by providing evening and
Saturday service, in addition to 24 hour emergency service, the Service Centers
are able to better accommodate customers than most of its competitors. In
addition, the Company guarantees complete customer satisfaction and plans to
establish a toll-free "Customer Can't Lose" phone line during the second quarter
of 1997 to address customer complaints and questions.
Increasing Revenue at Service Centers. The Company actively promotes its
maintenance agreements to both new and existing customers. See "Service
Centers -- Maintenance and Service Agreements." The sale of maintenance
agreements not only generates recurring revenue through the payment of fees, but
also helps the Company develop a committed, loyal customer base and provides the
opportunity for cross-marketing of the Company's other services and products.
The Company offers a wide assortment of financing packages designed to enable
customers to purchase equipment and services from the Company in the most
convenient and cost-effective manner possible. Certain Service Centers also
offer their customers a Professional Courtesy(TM) credit card solely for use in
purchasing equipment and services from the Company. This financing, including
the Professional Courtesy credit card, is offered through a number of third
party lenders. Pursuant to its arrangements with such financing companies, the
Company receives an origination fee based on the amount financed, but does not
bear any credit risk from such financing.
The Service Centers utilize a variety of local print advertising and
targeted marketing promotions designed by CSG, including maintenance technician
referrals, service technician referrals, yellow page advertising and direct mail
campaigns followed up by telemarketing. During the off-peak spring and fall
months, the Service Centers aggressively market products and services which
generate revenue during such months and help to offset increased demand
historically experienced in the summer and winter months. Management believes
that these marketing efforts will result in increased business for its Service
Centers. In 1996, advertising and marketing expenditures (net of marketing
expenditures by manufacturers) were 3.4% as a percentage of the Company's net
revenue.
The Company's Service Centers offer a number of services and products that
are not available from most HVAC contractors. Indoor air quality ("IAQ") has
become an increasingly popular and profitable segment of the industry. According
to industry sources, the market for IAQ products and services in the United
States was estimated to be $1.8 billion in 1994 and is expected to double by the
year 2000 as public awareness of indoor air pollution, which the U.S.
Environmental Protection Agency now ranks as one of the top five environmental
health threats, continues to grow. As technology has improved, HVAC businesses
have begun to utilize equipment that monitors the levels of certain harmful
substances in the air of a customer's home.
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The Company offers and actively promotes a variety of IAQ services designed to
detect and correct unhealthy air quality. Among these services are duct
cleaning, fresh air ventilation and heat recovery systems, ultraviolet light
processes and the sale and installation of ozonators.
Achieving Operating Efficiencies. Manufacturers of HVAC equipment have
historically offered more favorable prices and rebates to high volume
purchasers. Management is currently discussing purchase terms for HVAC equipment
with certain manufacturers on a national basis. Management believes that the
Company will be able to increase the discounts and rebates previously available
to the individual Service Centers. Since the IPO, the Company has achieved
increased operating efficiencies by consolidating certain functions at the
corporate level, including the purchase of insurance, the provision of legal
support and the utilization of corporate trainers in the areas of marketing and
IAQ. The Company intends to review the desirability of consolidating other
functions at the corporate level, including the purchasing and leasing of
service vehicles and national marketing. A portion of any operating efficiencies
will be offset by increased general and administrative expenses at the Company's
corporate headquarters.
Since the IPO, the Company has implemented a uniform system of budgets,
forecasts, reports and financial controls, including a uniform general ledger
system and electronic mail system, for its Service Centers. In addition, each of
the Service Centers generates and provides to the Company a daily management
report of revenue and expense information and certain billing and collection
data. The Company uses this information to prepare and provide to each Service
Center monthly and quarterly comparative financial data, which enable each
Service Center to track and compare its performance with the other Service
Centers.
Attracting and Retaining Quality Employees. Management believes the
Service Centers attract and retain quality employees by providing (i) an
environment that emphasizes professionalism and customer satisfaction, (ii)
extensive training that allows employees to advance to higher-earning positions
and (iii) stability of income because the Service Centers do not experience the
cyclical lay-offs typically found in the HVAC industry. The Company has a cash
bonus program for each Service Center pursuant to which managers may earn
bonuses based on the performance of the Service Center and the Company relative
to established goals set by the Service Center's president and the Company. The
Service Centers generally are operated by managers who are trained in the CSG
operating methods and procedures and who management believes are better educated
than a typical HVAC service business operator.
Potential employees must pass extensive interviews and background checks,
where permitted, as well as technical tests prior to being hired. Service
technicians, maintenance technicians and installers employed by the Company are
required to complete training programs designed to teach employees the Company's
operating procedures. These training programs are conducted both at the Service
Centers and at CSG sponsored seminars. Since the IPO, the Company has
implemented training programs relating to marketing and IAQ products that are
conducted at Service Centers by the Company's corporate trainers. Management
believes that these policies have resulted in a low rate of employee turnover.
See "Contractor Success Group."
CONTRACTOR SUCCESS GROUP
CSG, a wholly-owned subsidiary of the Company, was formed in 1991 to offer
HVAC companies proprietary products and marketing, management, educational and
advisory services not available from industry trade associations. Currently,
there are over 270 members of CSG serving distinct market areas in the United
States and Canada defined primarily by zip codes. CSG offers its members a
competitive edge over other contractors in the market by providing useful
management and technical skills, training programs and proprietary products. In
exchange, CSG members pay an initial fee upon joining CSG and a quarterly fee
thereafter. In 1996, CSG collected fees totaling approximately $3.2 million. CSG
members are granted exclusive rights to the territory in which they operate.
Although the Company has acquired 32 CSG members since its formation, other HVAC
companies have joined CSG. The Company intends to continue to build and expand
the membership of CSG.
CSG licenses to its members copyrighted training manuals that cover in
specific detail the aspects of owning and operating an HVAC service and
replacement company, including residential replacement sales, residential
maintenance, service contracts, residential installation, business planning and
service dispatch. In
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addition, CSG members receive materials containing, and attend conferences
discussing, methods and procedures to operate an efficient, profitable company,
including (i) daily report forms designed to provide accurate and timely sales
and cost information essential to determining the performance of an HVAC
business, (ii) "Scorecard," a monthly report distributed to CSG members
comparing top producers among members, (iii) contracts and forms, including
non-competition agreements for employees, sales and service contracts, (iv)
marketing promotions that are tested and proven with specific instructions on
how to tailor advertising for the member's market and (v) quarterly projects
introducing to CSG members new products and services designed to increase
productivity.
Seminars and Services
Potential CSG subscribers are invited to attend an informational seminar at
CSG's facility in St. Louis, Missouri where they are introduced to the CSG
concept and are invited to join the organization. Upon paying the initial fee,
CSG subscribers attend "Boot Camp" which is an intensive four-day workshop
conducted by CSG three times each year. At Boot Camp, HVAC contractors are
educated on all aspects of operating an HVAC service and replacement business.
Attendees receive presentations and materials that explain in specific detail
the methods and procedures successfully utilized by CSG members. Topics covered
include administration, sales, service, advertising, direct marketing,
maintenance, service contracts, acquisitions and accounting. CSG members may
also attend "Success Convention," which is a quarterly two-day convention of CSG
members designed to allow the members to compare ideas and projects and at which
quarterly projects are presented, and "Sales Extravaganza," which is an annual
convention designed to encourage and motivate a member's salespeople, selling
technicians and telemarketers.
Future University
In connection with the acquisition of its Service Centers, the Company has
acquired approximately 37% of the issued and outstanding Common Stock of Future
University, Inc. ("Future University(R)"). The remaining shares of Future
University's Common Stock are held by a number of CSG members and their
shareholders. Future University is a corporation formed in 1991 that offers to
CSG members for an additional enrollment fee technical and operational
educational programs designed to improve the profitability of the CSG member's
business. The technical programs offer installers and technicians a combination
of classroom and on-the-job-training during one and two week sessions.
Technicians receive skills training that will enable them to effectively analyze
customer problems and offer efficient solutions. In the maintenance training
classes, for example, technicians are trained to maximize the operating
efficiency of HVAC systems, assure safe operation of systems and reduce the
chances of future breakdowns. In the sales training classes, technicians are
trained to deal with customer expectations, use and promote various products and
services, develop leads, explain financing programs and improve on various
customer relations skills. In sending technicians to the Future University
program, CSG members are able to develop a high level of commitment in their
employees. The technical programs are held in Little Rock, Arkansas under an
exclusive licensing arrangement with Hardwick Air Masters, Inc., one of the
Company's Service Centers. Pursuant to the current licensing arrangement,
Hardwick Air Masters, Inc. receives 70% of the revenue from the technical
programs and Future University receives 30% of such revenue. The operational
programs offer to general managers and salespeople a variety of classes covering
residential sales training, replacement sales, marketing and promotions,
telemarketing and general operations. These programs are held in Houston, Texas.
Management believes that Future University is the only comprehensive
training school for management, salespeople, installers and technicians in the
residential HVAC industry. Since 1994, over 1,000 students per year have
completed Future University's technical and operational training programs.
SERVICE CENTERS
General
Management estimates that during 1996 the Service Centers' service and
maintenance technicians responded to over 350,000 maintenance, repair and
service calls. The services offered by each Service Center
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include (i) the sale of replacement central air conditioners, furnaces and heat
pumps, (ii) the maintenance and repair of HVAC units, (iii) diagnostic analysis
of the condition of existing unit and (iv) the sale of ancillary products such
as IAQ devices and monitors. Most of the Service Centers employ an in-house
sales force that sells replacement units, installation technicians who install
replacement equipment in existing homes, service technicians who service and
maintain the equipment, and an administrative staff to perform dispatching,
purchasing and other administrative functions. In addition, some of the Service
Centers offer plumbing services. Management believes that in 1996 the
installation and servicing of plumbing systems represented less than 1% of the
Company's pro forma net revenue. The Company anticipates that these Service
Centers will continue to offer, and that Service Centers acquired in the future
may offer, plumbing services, but currently does not intend to expand this
business.
All of the Service Centers' technicians are trained to promote the
Company's preventive maintenance agreements and to cross-market IAQ equipment
and other ancillary services and products offered by the Company. Service
technicians are trained to perform service and maintenance in a professional
manner, to identify problems with existing HVAC systems and to offer customers
the most practical, cost-effective solution to their problem, whether that
involves repairing the existing system or suggesting a replacement system or
part. Often this involves providing customers with information on products to
upgrade their system and improve efficiency as well as informing them about the
advantages and disadvantages of a particular product or service. Maintenance
technicians perform routine maintenance examinations of HVAC systems in an
effort to keep the systems in working order and to identify potential problems
before they become too costly to correct.
Management believes that most HVAC contractors charge the cost of the
materials and the hourly rate for the actual time it takes to install or repair
the system. In contrast, the Company utilizes a flat rate pricing system that
advises the customer of the cost of service for the particular job before work
begins and charges the quoted price regardless of the time necessary to repair
the system. While this may result in parts, labor and other costs incurred in
repairing a customer's system exceeding the quoted price from time to time, the
Company is able to alter its pricing on a per job basis. The Company's
experience is that customers generally prefer this pricing method because it
eliminates surprise or hidden costs. This pricing method also creates an
incentive for the Company to hire quality technicians and to provide them with
the training necessary to service customer needs efficiently.
Sale of Replacement Units
The replacement market for residential HVAC equipment is dependent upon the
base of installed units, the mechanical life and usage of the equipment and
technological advances in the efficiency of newer units. Management believes the
replacement market for HVAC units offers the potential for high growth and
profitability in the future given the potential number of HVAC systems that will
need replacement in the coming years and the Company's ability to effectively
service that need. The market for replacement units is highly fragmented, with
no single manufacturer dominating the market. In order to service the
replacement market, the Company maintains relationships with several national,
regional and local manufacturers of replacement units in order to offer a wide
variety of products to its customers. The Company is not dependent on any
manufacturers or distributors of replacement units, but rather has access to
products from all over the country allowing the Company to offer products that
its competition may be unable to provide.
At the time of sale, a customer is offered a wide assortment of financing
packages by the Service Center. A Service Center's installers and technicians,
in addition to the salespeople, are trained to educate customers as to the
financing options available, assist the customer in completing the credit
application forms and determine whether the customer's financing is approved.
The Company also offers its customers a Professional Courtesy credit card solely
for use in purchasing equipment and services from the Company. Such financing,
including the Professional Courtesy credit card, is offered through a number of
third party lenders. Pursuant to its arrangements with such financing companies,
the Company receives an origination fee based on the amount financed, but does
not bear any credit risk from such financing.
9
<PAGE> 10
Maintenance and Service Agreements
The Company currently has approximately 64,000 maintenance agreements with
customers. These agreements are for a term of one to three years and generally
provide for two diagnostic and precision maintenance visits during the year at
an average cost to the customer of approximately $135 per year. The sale of
maintenance agreements not only generates recurring revenue through the payment
of fees, but also helps the Company develop a committed, loyal customer base and
provides the opportunity for cross-marketing of the Company's other services and
products. Management believes that customers with maintenance agreements are the
Company's most satisfied customers because of the many benefits offered by these
agreements, including (i) energy savings resulting from a more efficient HVAC
system, (ii) fewer and less costly emergency repairs, (iii) longer useful life
for the HVAC system, (iv) discounted rates for service and (v) guaranteed
same-day service in the event of an emergency repair. Maintenance agreements
also allow the Company to more fully utilize its technicians during the
historically slower spring and fall months by scheduling maintenance
appointments during such time. Because systems under maintenance agreements are
less likely to require emergency repairs, the Service Centers are able to
provide more prompt service to emergency and new service calls.
The Company's service agreements are generally for a term of one year and
provide for the repair of any problem with the customer's system at no
additional cost to the customer. Pursuant to the terms of the service
agreements, if the cost of repair exceeds the value of the customer's HVAC
system, the Company is not required to repair the system and the customer
receives a $300 discount if he purchases a replacement unit from the Company. In
some states, warranties provided for in the Company's service agreements may be
deemed insurance contracts by applicable state insurance regulatory agencies
thereby subjecting the Company and the service agreements to the insurance laws
and regulations of any such state. In such states, the Company insures its
service agreements through licensed insurers. Management believes that the
Company has made adequate provision for potential claims under these agreements.
See "Regulation."
Commercial Service and Replacement
Some of the Service Centers offer HVAC services to small and medium-sized
businesses. In 1996, revenues generated from the provision of services and sale
of products to commercial customers represented less than 20% of the Company's
pro forma net revenue. The Service Centers target restaurants, small office
buildings, warehouses and theaters as potential prospects for its commercial
services. The Company's commercial sales representatives receive extensive
training designed to enable the representatives to promote the Company's
services and products effectively. The services offered to commercial customers
are generally the same as services offered to residential customers, including
the analysis, maintenance and repair of existing HVAC systems, the sale of
replacement systems and the sale of ancillary products, including IAQ devices
and services. While management does not plan to further develop its commercial
HVAC business beyond existing operations given the potential for growth in the
residential service and replacement market, the Company intends to continue to
provide, and may acquire Service Centers that provide, commercial HVAC services.
SERVICES AND OPERATIONS
The Company provides management, financial and accounting services for all
of the Service Centers' operations, as well as insurance and certain marketing
and legal support. Management provides certain financial control support,
including budgets, forecasts and reports, while allowing each general manager of
a Service Center to manage its day-to-day operations.
Since the IPO, the Company has added various corporate management and staff
personnel including three regional vice presidents, a controller, a human
resources manager, a management information systems director, a general counsel,
a regional accountant, a staff accountant and two corporate trainers.
In order to better organize its corporate support structure, the Company
has divided its Service Centers into three regions. Each Service Center in a
region reports directly to a regional vice president. In addition, the Company
intends to appoint area presidents who will coordinate various functions among
groups of Service
10
<PAGE> 11
Centers located in the same geographic area while continuing to operate as
president of a Service Center. These individuals will report to their respective
regional vice presidents.
The Company provides the following services:
Purchasing
Each Service Center generally purchases the HVAC units, parts and supplies
it uses from distributors. Because of the number of Service Centers operated by
the Company, management believes that it will be able to negotiate at a lower
cost the purchase of these items. The principal manufacturers of the products
sold by the Company include The Trane Company, Carrier Air Conditioning, Inc.,
Lennox Industries, Inc. and Rheem Manufacturing Company. The Service Centers
generally order equipment only upon receipt of a contract for purchase from a
customer, enabling them to maintain low inventory.
Management Information Systems
The Service Centers currently utilize various compatible management and
financial information systems. The Company intends to convert the Service
Centers' current systems to an integrated system within the next 12 months. The
Company has recently implemented a general ledger system utilizing SuccessWare
software at each of its Service Centers. The implementation of an integrated
system will allow the Company to maintain greater control over the operations of
its Service Centers. The Company tracks important data related to the Service
Centers' operations and financial performance and monitors all advertising
expenditures. In addition, the Service Centers generate and provide to the
Company a daily management report of revenue and expense information and certain
billing and collection data. The Company uses such information to prepare and
provide to each Service Center monthly and quarterly comparative financial data,
which enable each Service Center to track and compare its performance with the
other Service Centers.
Employee Screening and Training
Prior to employment, potential employees of the Company are tested to
determine their technical expertise. In addition, as permitted by local law,
employees of the Company are required to pass a drug test prior to employment
and are thereafter subject to random drug testing. Failure to take or pass a
drug test results in immediate termination of employment. Once hired, employees
of the Company generally complete various training programs covering technical
skills and communication and sales techniques. In addition, employees
periodically attend educational seminars and conventions conducted by CSG. See
"Contractor Success Group." The Company has recently established training
programs relating to marketing and IAQ products that are conducted at the
Company's Service Centers by two corporate trainers.
Advertising and Marketing
The Company's advertising and marketing programs are designed to attract
new customers and to stimulate increased demand from existing customers. Each
Service Center, utilizing materials produced by CSG, develops customized
marketing programs tailored to meet the needs of its local customer base.
Emphasizing superior, high quality service, the Service Centers market directly
to prospective and existing customers through various means, including local
print advertising, yellow page advertising and direct mail campaigns followed up
by telemarketing. In 1996, advertising and marketing expenditures (net of
marketing expenditures by manufacturers) were 3.4% as a percentage of the
Company's net revenue. The Company intends, over time, to develop the Service
Experts name as a key element of its marketing strategy. As a part of this
strategy, management intends gradually to integrate the Company's name and logo
in advertising while continuing to utilize established local brand names.
REGULATION
HVAC systems are subject to various environmental statutes and regulations,
including, but not limited to, laws and regulations implementing the Clean Air
Act, relating to minimum energy efficiency standards of
11
<PAGE> 12
HVAC systems and the production, servicing and disposal of certain ozone
depleting refrigerants used in such systems. In connection with the entry into
new markets, the Company may become subject to compliance with additional
regulations. Although, there can be no assurance that the regulatory environment
in which the Company operates will not change significantly in the future,
compliance with existing regulatory requirements has not had a material effect
on the Company.
Various local, state and federal laws and regulations, including, but not
limited to, laws and regulations implementing the Clean Air Act, impose
licensing standards on technicians who service heating and air conditioning
units. While the installers and technicians employed by the Service Centers are
duly certified by applicable local, state and federal agencies and have been
able to meet or exceed such standards to date, there can be no assurance that
they will be able to meet stricter future standards. In addition, installers
must comply with local building codes when installing HVAC units in residences
and commercial buildings.
In some states, warranties provided for in the Company's service agreements
may be deemed insurance contracts by applicable state insurance regulatory
agencies thereby subjecting the Company and the service agreements to the
insurance laws and regulations of any such state.
TRADEMARKS
"Service Experts" is registered as a federal trademark with the United
States Patent and Trademark Office. The Company currently licenses the Service
Experts name and logo to two companies that are members of CSG. The Company owns
and licenses numerous proprietary products used by the Service Centers and other
CSG members. See "Contractor Success Group." In addition, the Company owns
approximately 37% of the issued and outstanding common stock of "Future
University," which is registered as a federal trademark with the United States
Patent and Trademark Office. See "Contractor Success Group -- Future
University." The Company regards its trademarks as having significant value and
being an important factor in the development and marketing of its operations.
The Company's policy is to pursue registration of its trademarks whenever
possible and to oppose vigorously any infringement of its trademarks.
COMPETITION
The HVAC service and replacement industry is highly competitive in each of
the markets in which the Company operates. The Company's Service Centers compete
with utility companies and other full-service HVAC businesses primarily on the
basis of quality, reliability, customer service and price. Some of these
companies have access to capital, personnel, marketing and technological
resources that are equal to or greater than those of the Company. Because of the
fragmented nature of the industry and relative low barriers to entry, additional
competitors, including companies that offer other home improvement services in
addition to HVAC services, may emerge that have greater access than the Company
to capital, personnel and technological resources. Certain of these companies
are pursuing a consolidation strategy in the industry and compete with the
Company for potential acquisitions as well as for customers.
EMPLOYEES
Management estimates that the Company has approximately 1,250 employees,
all but approximately 20 of which are employed at Service Centers. None of the
Company's employees is represented by a collective bargaining agreement.
INSURANCE
The Company maintains general liability, workers compensation and property
insurance. The costs of insurance coverage varies, and the availability of
certain coverage has fluctuated in recent years. As of February 1, 1997, the
Company consolidated the purchase of insurance for its operations under a single
policy, excluding major medical insurance which will continue to be provided by
existing plans until a consolidated plan can be negotiated. This coverage will
result in savings from the amounts previously paid by the Subsidiaries. While
management believes, based upon its claims experience, that the Company's
present
12
<PAGE> 13
insurance coverage is adequate for its current operations, there can be no
assurance that the coverage is sufficient for all future claims or will continue
to be available in adequate amounts or at reasonable rates.
ITEM 2. PROPERTIES
The Company currently occupies the building and underlying real estate on
which all of its Service Centers are located pursuant to leases with terms
generally ranging from five to ten years on terms the Company believes to be
commercially reasonable. Total rental expense for the Company's leased centers
in 1996 was approximately $295,000. The Company generally plans to continue to
lease rather than purchase space for the Service Centers to maximize the
Company's available capital.
The Company's corporate headquarters are located in approximately 6,580
square feet of space in Nashville, Tennessee. The remaining term of the lease on
this office space is approximately five years, and the Company pays annual rent
of $115,200. The Company also maintains an office in approximately 3,600 square
feet of office space leased in Chesterfield, Missouri. The remaining term of the
lease on this office space is approximately eight months, and the Company pays
annual rent of approximately $60,000.
ITEM 3. LEGAL PROCEEDINGS
The Company does not have pending any litigation that, separately or in the
aggregate, if adversely determined, would have a material adverse effect on the
Company. The Company and its Service Centers may, from time to time, be parties
to litigation or administrative proceedings which arise in the normal course of
their businesses.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the stockholders during the fourth
quarter ended December 31, 1996.
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<PAGE> 14
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The following table sets forth the reported high and low sales prices of
the Common Stock for the quarters indicated as reported on the Nasdaq National
Market. The Company completed its IPO on August 16, 1996 at a price per share of
$13.00. The Common Stock is traded on the Nasdaq National Market under the
symbol "SERX."
<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
1996
Third Quarter (beginning August 16, 1996)................. $20.25 $15.50
Fourth Quarter............................................ 28.50 19.00
1997
First Quarter (through February 14, 1997)................. $28.25 $25.00
</TABLE>
On February 14, 1997, the last reported sale price of the Common Stock was
$27.88 per share. As of February 14, 1997, there were approximately 168 holders
of record of the Company's Common Stock.
The Company has never declared or paid dividends on its Common Stock. The
Company expects that future earnings will be retained to finance the growth and
development of the Company's business and, accordingly, does not intend to
declare or pay any dividends on the Common Stock for the foreseeable future. The
declaration, payment and amount of future dividends, if any, will be subject to
the discretion of the Company's Board of Directors and will depend upon the
future earnings, results of operations, financial condition and capital
requirements of the Company, among other factors. Under Delaware law, the
Company is prohibited from paying any dividends unless it has capital surplus or
net profits available for this purpose. In addition, the Company's credit
facilities impose restrictions on the ability of the Company to pay dividends.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected financial data of the Company. The
Company was incorporated on March 27, 1996. On August 21, 1996, and
simultaneously with the closing of the IPO, the Company acquired 12 HVAC
companies and CSG (collectively, the "Predecessor Companies") in exchange for
shares of Common Stock and cash (the "Combination"). The acquisitions of the
Predecessor Companies have been accounted for using the historical cost basis of
the Predecessor Companies in accordance with the Securities and Exchange
Commission (the "Commission") Staff Accounting Bulletin No. 48 ("SAB 48"). In
accordance with the provisions of the Commission's Staff Accounting Bulletin No.
97 ("SAB 97"), the historical financial statements of the Company for periods
prior to August 21, 1996 are the combined financial statements of the AC Service
& Installation Co., Inc. and Donelson Air Conditioning Company, Inc.
(collectively, the "Acquiring Company"). In addition, the historical financial
statements of the Company for all periods presented include the financial
statements of the Pooled Companies which were acquired effective December 1,
1996 in business combinations accounted for as poolings of interests, and the
operations of all other Service Centers are included from their respective
effective dates of acquisition. The following should be read with the historical
financial statements and notes thereto appearing elsewhere herein.
The selected financial data for the fiscal years ended December 31, 1993,
1994, 1995 and 1996 (except for pro forma amounts) have been derived from the
financial statements of the Acquiring Company and the Pooled Companies. The
selected financial data of the Company for the fiscal year ended December 31,
1992 have been derived from unaudited financial statements not included
elsewhere herein. The unaudited financial statements have been prepared on the
same basis as the audited financial statements and, in the opinion of
management, contain all adjustments, consisting only of normal recurring
accruals, necessary for a fair presentation of the combined financial position
and combined results of operations for the periods presented.
14
<PAGE> 15
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------------
1992 1993 1994 1995 1996
------- ------- ------- ------- -------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
INCOME STATEMENT DATA:
Net revenue...................................... $14,507 $16,339 $22,193 $24,876 $46,856
Cost of goods sold............................... 10,095 11,716 15,999 16,916 30,198
------- ------- ------- ------- -------
Gross margin..................................... 4,412 4,623 6,194 7,960 16,658
Selling, general and administrative expenses..... 4,241 4,584 5,723 7,162 12,837
------- ------- ------- ------- -------
Income from operations........................... 171 39 471 798 3,821
Other income (expense)........................... (32) (75) (64) (56) 485
Income before tax................................ 193 63 424 790 4,306
Provision for income taxes....................... 76 (18) 41 82 1,196
------- ------- ------- ------- -------
Net income....................................... $ 117 $ 75 $ 383 $ 708 $ 3,110
======= ======= ======= ======= =======
Net income per share............................. $ .70
Weighted average shares outstanding.............. 4,451
=======
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------------------------
1992 1993 1994 1995 1996
------ ------ ------ ------ --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital................................... $1,231 $1,226 $ 850 $1,336 $ 12,387
Total assets...................................... 3,935 4,605 5,431 6,020 68,504
Total debt........................................ 1,390 1,374 1,317 1,530 275
Stockholders' equity.............................. 1,524 1,452 1,550 2,064 53,071
</TABLE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the information
contained in the Company's Consolidated Financial Statements, including the
Notes thereto, and the other financial information appearing elsewhere in this
report.
OVERVIEW
Simultaneous with the IPO in August 1996, the Company acquired the
Predecessor Companies in the Combination. Prior to the Combination, the Company
had no operations. The consideration paid by the Company for the Predecessor
Companies was approximately $77.5 million, consisting of 4.5 million shares of
Common Stock and $18.7 million in cash. No intangible assets were recorded as a
result of the Combination due to the accounting treatment in accordance with SAB
48. On a pro forma basis, these companies, together with the Pooled Companies,
generated revenue in 1996 of approximately $77.0 million and contributed
operating income of approximately $8.7 million.
Since the IPO, the Company has acquired 23 HVAC businesses. The
consideration paid by the Company for the Acquired Companies was approximately
$58.6 million, consisting of 3.2 million shares of Common Stock and $5.6 million
in cash. Two of the transactions were accounted for using the pooling of
interests method of accounting, and the remainder were accounted for using the
purchase method. Of the purchase price, $45.1 million was allocated to
intangible assets which are to be amortized over a 40-year period. On a pro
forma basis, the Acquired Companies (excluding the Pooled Companies) generated
revenue in 1996 of approximately $63.7 million and contributed operating income
of approximately $4.6 million.
The Company currently has agreements in principle to acquire eight HVAC
businesses. The Pending Acquisitions are expected to close during the first six
months of 1997. The consideration to be paid by the Company for these businesses
is approximately $21.7 million, consisting of 225,406 shares of Common Stock and
$15.4 million in cash. All of the Pending Acquisitions are expected to be
accounted for using the purchase method. Of the purchase price, $16.0 million is
expected to be allocated to intangible assets which are to be amortized over a
40-year period. On a pro forma basis, these companies generated revenue in 1996
of approximately $31.3 million and contributed operating income of approximately
$3.1 million. The Pending
15
<PAGE> 16
Acquisitions are subject to the execution of definitive agreements containing
customary conditions, and there can be no assurance that the Company will be
able to consummate all of the acquisitions or to successfully integrate the
businesses of the acquired companies.
FINANCIAL STATEMENT PRESENTATION
Since the IPO, the financial presentation of the Company has changed. The
Combination was accounted for using the historical cost basis of the Predecessor
Companies in accordance with SAB 48. On July 31, 1996, SAB 97 was adopted to
replace SAB 48 for certain combination transactions. In accordance with the
provisions of SAB 97, the presentation of financial information for the Company
reflects the Acquiring Company as the acquiror of the other Predecessor
Companies. Prior financial statements of the combined Predecessor Companies are
not included in the Company's historical financial presentation. The operation
of the Predecessor Companies and other acquired companies (except for those
companies acquired under the pooling of interests method) have been included in
the Company's financial statements from their respective effective dates of
acquisition.
The Service Centers historically have been managed as independent private
companies and, as such, their results of operations reflect different tax
structures which have influenced, among other things, their historical levels of
owner's compensation. Owners and certain key employees of the Service Centers
have agreed to certain reductions in their compensation in connection with the
acquisitions. These reductions equaled approximately $8.1 million based upon
1996 actual compensation expense.
COMPONENTS OF INCOME
Net revenue of the Service Centers has been derived primarily from the
following sources (i) the installation of central air conditioners, furnaces and
heat pumps primarily in existing homes and (ii) the service and maintenance of
central air conditioners, furnaces and heat pumps primarily in existing homes.
Net revenue and associated income from operations are subject to seasonal
fluctuations resulting from increased demand for the Company's services during
warmer weather in the summer months and during colder weather in winter months,
particularly in the beginning of each season. Cost of goods sold primarily
consists of purchased materials such as replacement air conditioning units and
heat pumps and the labor associated with both installations and repair orders.
The main components of selling, general and administrative expenses include
administrative salaries, insurance expense and promotion and advertising
expenses.
RESULTS OF OPERATIONS
Because of the significant effect of the Combination, the acquisitions of
the Acquired Companies and the anticipated effect of the Pending Acquisitions on
the Company's results of operations, the Company's historical results of
operations and period-to-period comparisons will not be indicative of future
results and may not be meaningful. The Company plans to continue acquiring
Service Centers in the future. The integration of acquired Service Centers and
the addition of management personnel to support existing and future acquisitions
may positively or negatively affect the Company's results of operations during
the period immediately following acquisition.
The following table sets forth certain selected financial data as a
percentage of net revenue for the periods indicated:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------
1994 1995 1996
----- ----- -----
<S> <C> <C> <C>
Net revenue................................................. 100.0% 100.0% 100.0%
Cost of goods sold.......................................... 72.1 68.0 64.4
----- ----- -----
Gross margin................................................ 27.9 32.0 35.6
Selling, general and administrative expenses................ 25.8 28.8 27.4
----- ----- -----
Income from operations...................................... 2.1% 3.2% 8.2%
===== ===== =====
</TABLE>
16
<PAGE> 17
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
Net Revenue. Net revenue increased $22.0 million, or 88.4%, from $24.9
million for the year ended December 31, 1995 to $46.9 million for the year ended
December 31, 1996. This increase is primarily attributable to the acquisitions
completed during 1996.
Cost of Goods Sold. Cost of goods sold increased $13.3 million, or 78.5%,
from $16.9 million for the year ended December 31, 1995 to $30.2 million for the
year ended December 31, 1996. As a percentage of net revenue, cost of goods sold
decreased from 68.0% for the year ended December 31, 1995 to 64.4% for the year
ended December 31, 1996.
Gross Margin. Gross margin increased $8.7 million, or 109.3%, from $8.0
million for the year ended December 31, 1995 to $16.7 million for the year ended
December 31, 1996. As a percentage of net revenue, gross margin increased from
32.0% for the year ended December 31, 1995 to 35.6% for the year ended December
31, 1996. The increase in gross margin as a percentage of net revenue is
attributable to the inclusion of Acquired Companies that operated at a higher
margin.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased $5.7 million, or 79.2%, from $7.2 million for
the year ended December 31, 1995 to $12.8 million for the year ended December
31, 1996. This increase is attributable to the inclusion of the Acquired
Companies and an increase in management personnel since the IPO. As a percentage
of net revenue, general and administrative expenses decreased from 28.8% for the
year ended December 31, 1995 to 27.4% for the year ended December 31, 1996.
Income from Operations. Income from operations increased $3.0 million, or
378.8%, from $798,000 for the year ended December 31, 1995 to $3.8 million for
the year ended December 31, 1996. Income from operations as a percent of net
revenue increased from 3.2% in the 1995 period to 8.2% in the 1996 period.
Year Ended December 31, 1995 Compared to Year Ended December 31, 1994
Net Revenue. Net revenue increased $2.7 million, or 12.1%, from $22.2
million in 1994 to $24.9 million in 1995. The increase in net revenue was
primarily attributable to promotion of service contracts and increased
advertising.
Cost of Goods Sold. Cost of goods sold increased $917,000, or 5.7%, from
$16.0 million in 1994 to $16.9 million in 1995. As a percentage of net revenue,
cost of goods sold decreased from 72.1% in 1994 to 68.0% in 1995. The decrease
as a percentage of net revenue was primarily attributable to an emphasis on more
profitable products, improved employee training and volume purchasing discounts.
Gross Margin. Gross margin increased $1.8 million, or 28.5%, from $6.2
million for the twelve months ended December 31, 1994 to $8.0 million for the
twelve months ended December 31, 1995. As a percentage of net revenue, gross
margin increased 4.1% from 27.9% for the twelve months ended December 31, 1994
to 32.0% for the twelve months ended December 31, 1995. The increase as a
percentage of net revenue was primarily attributable to the emphasis on more
profitable products, improved employee training and volume purchasing discounts.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased $1.4 million, or 25.1%, from $5.7 million in
1994 to $7.2 million in 1995. As a percentage of net revenue, selling, general
and administrative expenses increased from 25.8% in 1994 to 28.8% in 1995. The
increase as a percentage of net revenue was primarily attributable to increased
management personnel added to support recent growth.
Income from Operations. Income from operations increased $327,000, or
69.4%, from $471,000 in 1994 to $798,000 in 1995. As a percentage of net
revenue, income from operations increased from 2.1% in 1994 to 3.2% in 1995.
17
<PAGE> 18
LIQUIDITY AND CAPITAL RESOURCES
The Company's principal capital needs arise from the acquisition of new
HVAC businesses and the costs associated with such expansion. Cash used in
investing activities was primarily attributable to the acquisition of HVAC
businesses. Cash provided by financing activities consisted primarily of
proceeds from the IPO.
On August 21, 1996, the Company completed the IPO at $13.00 per share. The
proceeds to the Company, net of expenses and underwriting discounts and
commissions, were approximately $28.1 million. Of the net proceeds, $18.7
million was used to pay the cash portion of the consideration for the
Predecessor Companies, including $1.0 million which was used to repay certain
indebtedness arising from the Combination. The Company has used the remaining
proceeds for working capital and capital expenditures, including the acquisition
of additional Service Centers.
The Company's ability to acquire new HVAC businesses will depend on a
number of factors, including the ability of management of the Company to
identify target businesses and to negotiate acceptable acquisition terms, the
availability of adequate financing and other factors, many of which are beyond
the control of the Company. Since the IPO, the Company has acquired 23 HVAC
businesses for an aggregate of approximately $5.6 million cash and approximately
3.2 million shares of Common Stock. In addition, the Company currently has
agreements in principle to acquire eight HVAC businesses for an aggregate of
approximately $15.4 million cash and approximately 225,406 shares of Common
Stock. There can be no assurance that the Company will be successful in
identifying and acquiring new HVAC businesses, that the Company can integrate
such new Service Centers into the Company's operations or that the Company's new
Service Centers will generate sales revenue or profit margins consistent with
those of the Company's existing Service Centers.
The Company has a $10 million unsecured revolving credit facility and an
additional $10 million unsecured discretionary revolving credit facility with
SunTrust Bank, Nashville, N.A. available through September 10, 1998 (together,
the "Credit Facilities"). Borrowings under the Credit Facilities bear interest
at a variable rate equal to the 30-day LIBOR, as such rate changes from time to
time, plus a variable margin of from 125 to 250 basis points depending on the
Company's funded debt to EBITDA ratio determined on a quarterly basis. Certain
of the Company's subsidiaries have guaranteed the repayment of indebtedness
under the Credit Facilities. At December 31, 1996, there were no amounts
outstanding on the above lines of credit. The Credit Facilities contain
covenants with respect to the maintenance of certain financial ratios and
specified net worth and limiting the incurrence of additional indebtedness, the
sale of substantial assets, consolidations or mergers by the Company and the
payments of dividends.
The Company currently has on file with the Commission a Registration
Statement on Form S-4 (the "Shelf Registration Statement") covering securities
with a collective aggregate offering price of $50.0 million for use in future
acquisitions of HVAC businesses. Under the Shelf Registration Statement, as
proposed to be amended by the Company, the Company may issue shares of Common
Stock, warrants to purchase Common Stock and debt securities in connection with
acquisitions.
Management believes that the proceeds of the Company's proposed public
offering of 1,850,000 shares of Common Stock expected to be completed in March
1997, the Company's existing cash balances, cash generated from operations and
additional borrowings will be sufficient to fund the Company's operating needs,
planned capital expenditures and debt service requirements for the next 12
months. Management continually evaluates potential strategic acquisitions as
part of the Company's growth strategy. To date, such acquisitions have been
predominantly funded by issuing shares of Common Stock, although future
acquisitions could be effected using greater amounts of cash. Although the
Company believes that its financial resources will enable it to consider
potential acquisitions, should the Company's actual results of operations fall
short of, or its rate of expansion significantly exceed, its plans, or should
its costs or capital expenditures exceed expectations, the Company may need to
seek additional financing in the future. In negotiating such financing, there
can be no assurance that the Company will be able to raise additional capital on
terms satisfactory to the Company. Failure to obtain additional financing on
reasonable terms could have a negative effect on the Company's plans to acquire
additional HVAC businesses.
18
<PAGE> 19
Newly Issued Accounting Standards
The Company has considered the impact of newly issued financial accounting
pronouncements, principally Statement of Financial Accounting Standards No. 121
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," and does not believe that adoption of this or any other newly
issued pronouncements would have a significant impact on the Company's financial
statements.
The Company has elected to adopt the pro forma provisions of the Statement
of Financial Accounting Standard No. 123 "Accounting for Stock-Based
Compensation."
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Appendix A.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
19
<PAGE> 20
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
EXECUTIVE OFFICERS AND KEY EMPLOYEES
Information with respect to the executive officers of the Company is
incorporated by reference to the information contained under the caption
"Executive Compensation-Executive Officers of the Company" included in the
Company's Proxy Statement relating to its Annual Meeting of Stockholders to be
held on May 2, 1997.
DIRECTORS
Information with respect to the Company's directors is incorporated by
reference to the information contained under the caption "Election of Directors"
included in the Company's Proxy Statement relating to its Annual Meeting of
Stockholders to be held on May 2, 1997.
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT.
Information with respect to compliance with Section 16(a) of the Securities
Exchange Act of 1934 is incorporated by reference to the information contained
under the heading "Compliance with Reporting Requirements of the Exchange Act"
included in the Company's Proxy Statement relating to its Annual Meeting of
Stockholders to be held on May 2, 1997.
ITEM 11. EXECUTIVE COMPENSATION
This information is incorporated by reference to the information contained
under the heading "Executive Compensation" included in the Company's Proxy
Statement relating to its Annual Meeting of Stockholders to be held on May 2,
1997, except that the Comparative Performance Graph and the Compensation
Committee Report on Executive Compensation included in the Proxy Statement are
expressly not incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
This information is incorporated by reference to the information contained
under the caption "Voting Securities and Principal Holders Thereof" included in
the Company's Proxy Statement relating to its Annual Meeting of Stockholders to
be held on May 2, 1997.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
This information is incorporated by reference to the information contained
under the caption "Certain Relationships and Related Transactions" included in
the Company's Proxy Statement relating to its Annual Meeting of Stockholders to
be held on May 2, 1997.
20
<PAGE> 21
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Index to Consolidated Financial Statements, Financial Statement
Schedules and Exhibits
(1) CONSOLIDATED FINANCIAL STATEMENTS: See Item 8 herein.
The Consolidated Financial Statements of the Company required to be
included in Part II, Item 8, are indexed on Page A-1 and submitted as
a separate section of this report.
(2) CONSOLIDATED FINANCIAL STATEMENT SCHEDULES:
All schedules are omitted, because they are not applicable or not
required, or because the required information is included in the
consolidated financial statements or notes thereto.
(3) EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
- ------- -----------------------
<C> <C> <S>
3.1 -- Restated Certificate of Incorporation of the Registrant(a)
3.2 -- Bylaws of the Registrant(a)
4 -- Form of Common Stock Certificate(b)
10.1 -- Registrant's 1996 Incentive Stock Plan(a)
10.2 -- Registrant's 1996 Non-Employee Director Stock Option Plan(a)
10.3 -- Registrant's 1996 Employee Stock Purchase Plan(a)
10.4 -- Form of Combination Agreement by and among each of the
Predecessor Companies, each of its respective stockholders
and the Registrant(a)
10.5 -- Employment Agreement, dated June 26, 1996, between the
Registrant and Alan R. Sielbeck(a)
10.6 -- Employment Agreement, dated June 26, 1996, between the
Registrant and James D. Abrams(a)
10.7 -- Employment Agreement, dated June 26, 1996, between the
Registrant and Anthony M. Schofield(a)
10.8 -- Form of Employment Agreement between the Registrant and
certain of its employees(a)
10.9 -- Form of Escrow Agreement between the Registrant, each of the
stockholders of the Subsidiaries and the escrow agent(a)
10.10 -- Form of Equitable Securities Corporation Stock Purchase
Warrant(a)
10.11 -- Loan Agreement, dated September 10, 1996, between the
Registrant and SunTrust Bank, Nashville, N.A.(c)
10.12 -- Form of Agreement and Plan of Merger among certain of the
Subsidiaries, a wholly-owned subsidiary of the Registrant
and the Registrant(c)
10.13 -- Form of Combination Agreement between certain of the
Subsidiaries and the Registrant(c)
11 -- Statement re Computation of Per Share Earnings
21 -- List of subsidiaries of the Registrant(d)
23.1 -- Consent of Ernst & Young LLP
</TABLE>
- ---------------
(a) Incorporated by reference to the exhibits filed with the Registrant's
Registration Statement on Form S-1, Registration No. 333-07037.
(b) Incorporated by reference to the exhibits filed with the Registrant's
Registration Statement on Form 8-A, File No. 000-21173.
(c) Incorporated by reference to the exhibits filed with the Registrant's
Registration Statement on Form S-4, File No. 333-12319.
(d) Incorporated by reference to the exhibits filed with the Registrant's
Registration Statement on Form S-1, Registration No. 333-21971.
21
<PAGE> 22
EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS
The following is a list of all executive compensation plans and
arrangements filed as exhibits to this Annual Report on Form 10-K:
1. Registrant's 1996 Incentive Stock Plan (filed as Exhibit 10.1)
2. Registrant's 1996 Non-Employee Director Stock Option Plan (filed as
Exhibit 10.2)
3. Registrant's 1996 Employee Stock Purchase Plan (filed as Exhibit 10.3)
4. Employment Agreement, dated June 26, 1996, between the Company and Alan
R. Sielbeck (filed as Exhibit 10.5)
5. Employment Agreement, dated June 26, 1996, between the Company and James
D. Abrams (filed as Exhibit 10.6)
6. Employment Agreement, dated June 26, 1996, between the Company and
Anthony M. Schofield (filed as Exhibit 10.7)
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the reporting
period.
22
<PAGE> 23
SIGNATURES
Pursuant to the requirements of 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.
SERVICE EXPERTS, INC.
By: /s/ ALAN R. SIELBECK
------------------------------------
Alan R. Sielbeck
Chairman and
Chief Executive Officer
Date: February 17, 1997
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed by the following persons on behalf of the Registrant in
the capacities and on the date indicated.
<TABLE>
<CAPTION>
NAME TITLE(S) DATE
---- -------- ----
<C> <S> <C>
/s/ ALAN R. SIELBECK Chairman of the Board and February 17, 1997
- ----------------------------------------------------- Chief Executive Officer
Alan R. Sielbeck (principal executive
officer)
/s/ JAMES D. ABRAMS President, Chief Operating February 17, 1997
- ----------------------------------------------------- Officer and Director
James D. Abrams
/s/ ANTHONY M. SCHOFIELD Chief Financial Officer February 17, 1997
- ----------------------------------------------------- (principal financial and
Anthony M. Schofield accounting officer)
/s/ RAYMOND J. DE RIGGI Director February 17, 1997
- -----------------------------------------------------
Raymond J. De Riggi
/s/ NORMAN T. ROLF Director February 17, 1997
- -----------------------------------------------------
Norman T. Rolf
/s/ WILLIAM G. ROTH Director February 17, 1997
- -----------------------------------------------------
William G. Roth
/s/ TIMOTHY G. WALLACE Director February 17, 1997
- -----------------------------------------------------
Timothy G. Wallace
</TABLE>
23
<PAGE> 24
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
- ------- -----------------------
<C> <C> <S>
3.1 -- Restated Certificate of Incorporation of the Registrant(a)
3.2 -- Bylaws of the Registrant(a)
4 -- Form of Common Stock Certificate(b)
10.1 -- Registrant's 1996 Incentive Stock Plan(a)
10.2 -- Registrant's 1996 Non-Employee Director Stock Option Plan(a)
10.3 -- Registrant's 1996 Employee Stock Purchase Plan(a)
10.4 -- Form of Combination Agreement by and among each of the
Predecessor Companies, each of its respective stockholders
and the Registrant(a)
10.5 -- Employment Agreement, dated June 26, 1996, between the
Registrant and Alan R. Sielbeck(a)
10.6 -- Employment Agreement, dated June 26, 1996, between the
Registrant and James D. Abrams(a)
10.7 -- Employment Agreement, dated June 26, 1996, between the
Registrant and Anthony M. Schofield(a)
10.8 -- Form of Employment Agreement between the Registrant and
certain of its employees(a)
10.9 -- Form of Escrow Agreement between the Registrant, each of the
stockholders of the Subsidiaries and the escrow agent(a)
10.10 -- Form of Equitable Securities Corporation Stock Purchase
Warrant(a)
10.11 -- Loan Agreement, dated September 10, 1996, between the
Registrant and SunTrust Bank, Nashville, N.A.(c)
10.12 -- Form of Agreement and Plan of Merger among certain of the
Subsidiaries, a wholly-owned subsidiary of the Registrant
and the Registrant(c)
10.13 -- Form of Combination Agreement between certain of the
Subsidiaries and the Registrant(c)
11 -- Statement re Computation of Per Share Earnings
21 -- List of subsidiaries of the Registrant
23.1 -- Consent of Ernst & Young LLP
27 -- Financial Data Schedule (for SEC use only)
</TABLE>
- ---------------
(a) Incorporated by reference to the exhibits filed with the Registrant's
Registration Statement on Form S-1, Registration No. 333-07037.
(b) Incorporated by reference to the exhibits filed with the Registrant's
Registration Statement on Form 8-A, File No. 000-21173.
(c) Incorporated by reference to the exhibits filed with the Registrant's
Registration Statement on Form S-4, File No. 333-12319.
<PAGE> 25
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
SERVICE EXPERTS, INC. -- AUDITED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
Report of Independent Auditors.............................. A-2
Consolidated Balance Sheets................................. A-3
Consolidated Statements of Income........................... A-5
Consolidated Statements of Stockholders' Equity............. A-6
Consolidated Statements of Cash Flows....................... A-7
Notes to Consolidated Financial Statements.................. A-8
</TABLE>
A-1
<PAGE> 26
REPORT OF INDEPENDENT AUDITORS
The Stockholders
Service Experts, Inc.
We have audited the accompanying consolidated balance sheets of Service
Experts, Inc. (formerly AC Service & Installation Co., Inc. and Donelson Air
Conditioning Company -- see Note 1) as of December 31, 1995 and 1996, and the
related consolidated statements of income, stockholders' equity, and cash flows
for each of the three years in the period ended December 31, 1996. 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 generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free from
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
Service Experts, Inc. (formerly AC Service & Installation Co., Inc. and Donelson
Air Conditioning Company -- see Note 1) at December 31, 1995 and 1996, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1996, in conformity with generally
accepted accounting principles.
/s/ Ernst & Young LLP
Nashville, Tennessee
February 12, 1997
A-2
<PAGE> 27
SERVICE EXPERTS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
------- -------
(IN THOUSANDS)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 445 $10,726
Accounts Receivables:
Trade, net of allowance for doubtful accounts of
$135,000 in 1995 and $620,000 in 1996................. 2,334 9,048
Related party.......................................... 298 129
Employee............................................... 66 113
Other.................................................. 77 208
------- -------
2,775 9,498
Inventories............................................... 472 3,923
Costs and estimated earnings in excess of billings........ 31 283
Prepaid expenses and other current assets................. 265 697
Current portion of notes receivable -- related parties.... -- 14
Current portion of notes receivable -- other.............. -- 286
Deferred income taxes..................................... 17 1,893
------- -------
Total current assets.............................. 4,005 27,320
Property, buildings and equipment:
Land...................................................... 105 10
Buildings................................................. 767 67
Furniture and fixtures.................................... 472 841
Machinery and equipment................................... 364 1,913
Vehicles.................................................. 2,149 5,339
Leasehold improvements.................................... 80 620
------- -------
3,937 8,790
Less accumulated depreciation and amortization.............. (2,002) (2,461)
------- -------
1,935 6,329
Notes receivable -- related parties, net of current
portion................................................... -- 352
Notes receivable -- other, net of current portion........... -- 500
Investment in affiliate..................................... -- 674
Goodwill.................................................... -- 33,032
Other assets................................................ 80 297
------- -------
Total assets...................................... $ 6,020 $68,504
======= =======
</TABLE>
A-3
<PAGE> 28
SERVICE EXPERTS, INC.
CONSOLIDATED BALANCE SHEETS -- (CONTINUED)
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1995 1996
------- -------
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable and accrued liabilities............ $ 740 $ 5,174
Cash consideration payable................................ -- 1,495
Accrued compensation...................................... 743 1,601
Accrued warranties........................................ 169 963
Income taxes payable...................................... 67 1,723
Deferred revenue.......................................... 471 3,502
Billings in excess of costs and estimated earnings........ 228 340
Current portion related party notes....................... 7 --
Current portion of long-term debt and capital lease
obligations............................................ 244 135
------- -------
Total current liabilities......................... 2,669 14,933
Long-term debt and capital lease obligations, net of current
portion................................................... 610 140
Related party notes, net of current portion................. 669 --
Deferred income taxes....................................... 8 360
Commitments (Note 10).......................................
Stockholders' equity:
Common stock $.01 par value; 50,000,000 shares authorized;
1,560,912 and 11,050,326 shares issued and outstanding
at December 31, 1995 and 1996, respectively............ 16 111
Preferred stock, $.01 par value; 10,000,000 shares
authorized, no shares issued and outstanding........... -- --
Additional paid-in capital................................ 241 48,566
Retained earnings......................................... 1,807 4,409
Equity notes receivable................................... -- (15)
------- -------
Total stockholders' equity........................ 2,064 53,071
------- -------
Total liabilities and stockholders' equity........ $ 6,020 $68,504
======= =======
</TABLE>
See accompanying notes.
A-4
<PAGE> 29
SERVICE EXPERTS, INC.
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------
1994 1995 1996
------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE
DATA)
<S> <C> <C> <C>
Net revenues.............................................. $22,193 $24,876 $46,856
Cost of goods sold........................................ 15,999 16,916 30,198
------- ------- -------
Gross margin.............................................. 6,194 7,960 16,658
Selling, general and administrative expenses.............. 5,723 7,162 12,837
------- ------- -------
Income from operations.................................... 471 798 3,821
Other income (expense):
Interest expense........................................ (90) (100) (63)
Interest income......................................... 26 44 334
Other income............................................ 17 48 214
------- ------- -------
(47) (8) 485
Income before federal and state income taxes.............. 424 790 4,306
Provision (benefit) for income taxes:
Current................................................. 48 105 2,675
Deferred................................................ (7) (23) (1,479)
------- ------- -------
41 82 1,196
------- ------- -------
Net income.............................................. $ 383 $ 708 $ 3,110
======= ======= =======
Net income per common share............................... $ .25 $ .45 $ .70
======= ======= =======
Weighted average shares used in earnings per share
computation............................................. 1,561 1,561 4,451
======= ======= =======
</TABLE>
See accompanying notes.
A-5
<PAGE> 30
SERVICE EXPERTS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL EQUITY
--------------- PAID-IN RETAINED NOTES
SHARES AMOUNT CAPITAL EARNINGS RECEIVABLE TOTAL
------ ------ ---------- --------- ---------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Balance at January 1, 1994................... 1,561 $ 16 $ 241 $ 1,193 -- $ 1,450
Capital distributions...................... -- -- -- (284) -- (284)
Net income................................. -- -- -- 383 -- 383
------ ---- ------- --------- --------- ---------
Balance at December 31, 1994................. 1,561 16 241 1,292 -- 1,549
Capital distributions...................... -- -- -- (193) -- (193)
Net income................................. -- -- -- 708 -- 708
------ ---- ------- --------- --------- ---------
Balance at December 31, 1995................. 1,561 16 241 1,807 -- 2,064
Issuance of stock at initial public
offering................................. 2,588 26 28,087 -- -- 28,113
Predecessor Companies (see Note 3)
Issuance of stock........................ 4,832 48 6,462 -- (15) 6,495
Cash distributions....................... -- -- (18,699) -- -- (18,699)
Issuance of stock for Acquired Companies
(see Note 4)............................. 2,069 21 32,475 -- -- 32,496
Capital distributions...................... -- -- -- (508) -- (508)
Net income................................. -- -- -- 3,110 -- 3,110
------ ---- ------- --------- --------- ---------
Balance at December 31, 1996................. 11,050 $111 $48,566 $ 4,409 $ (15) $ 53,071
====== ==== ======= ========= ========= =========
</TABLE>
See accompanying notes.
A-6
<PAGE> 31
SERVICE EXPERTS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1994 1995 1996
------ ------ --------
(IN THOUSANDS)
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income.................................................. $ 383 $ 708 $ 3,110
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization............................. 449 572 650
Equity in affiliate earnings.............................. -- -- (30)
Benefit for deferred income taxes......................... (7) (23) (1,479)
(Loss) gain on asset disposals............................ 8 (13) (40)
Changes in assets and liabilities:
Receivables............................................. (752) (232) 115
Inventories............................................. (76) (2) (203)
Prepaid expenses and other current assets............... 28 (7) (336)
Trade accounts payable and accrued liabilities.......... 227 (227) (1,745)
Accrued compensation.................................... 156 50 (910)
Accrued warranties...................................... 15 56 148
Deferred revenue........................................ 225 (44) 404
Income taxes payable.................................... 4 41 363
Costs and estimated earnings in excess of billings and
billings in excess of costs and estimated earnings.... 59 18 (128)
------ ------ --------
Net cash flow provided by operating activities..... 719 897 (81)
INVESTING ACTIVITIES
Advances on notes receivable................................ -- -- (250)
Purchase of property, buildings, and equipment.............. (630) (766) (638)
Proceeds from sale of property, buildings, and equipment.... 9 30 225
Cash acquired through acquisitions.......................... -- -- 3,961
Payment of cash portion of consideration to Predecessor
Companies................................................. -- -- (18,699)
(Increase) decrease in other assets......................... (96) (96) (304)
------ ------ --------
Net cash used in investing activities.............. (717) (832) (15,705)
FINANCING ACTIVITIES
Proceeds from notes payable to shareholders and related
parties................................................... -- -- 59
Payments on notes payable to shareholders and related
parties................................................... -- -- (886)
Issuance of stock, net of issuance costs.................... -- -- 28,113
Proceeds of long-term debt and capital leases............... 423 648 104
Payments of long-term debt and capital leases............... (365) (437) (815)
Distributions paid.......................................... (284) (193) (508)
------ ------ --------
Net cash (used in) provided by financing activities......... (226) 18 26,067
------ ------ --------
Increase (decrease) in cash and cash equivalents............ (224) 83 10,281
Cash and cash equivalents at beginning of period............ 586 362 445
------ ------ --------
Cash and cash equivalents at end of period.................. $ 362 $ 445 $ 10,726
====== ====== ========
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid............................................... $ 103 $ 100 $ 63
====== ====== ========
Income tax paid............................................. $ 49 $ 67 $ 1,880
====== ====== ========
ACQUISITION OF COMPANIES:
Fair value of assets acquired............................. $ -- $ -- $ 42,333
Cash paid................................................. 1,478
Common stock issued....................................... 34,068
------ ------ --------
Liabilities assumed....................................... $ -- $ -- $ 6,787
====== ====== ========
DISTRIBUTION OF ASSETS TO STOCKHOLDERS
Book value of assets distributed............................ $ -- $ -- $ 1,324
====== ====== ========
Long-term debt assumed by stockholders...................... $ -- $ -- $ 488
====== ====== ========
Notes payable to stockholders retired....................... $ -- $ -- $ 343
====== ====== ========
</TABLE>
See accompanying notes.
A-7
<PAGE> 32
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
REPORTING ENTITY
Service Experts, Inc. was incorporated on March 27, 1996. As a result of
the adoption of Securities and Exchange Commission Staff Accounting Bulletin No.
97 ("SAB 97") on July 31, 1996, the historical financial statements of Service
Experts, Inc. ("the Company") for periods prior to August 21, 1996 are the
combined financial statements of AC Service & Installation Co., Inc. and
Donelson Air Conditioning, Inc. ("the Acquiring Company") and subsequent
acquisitions accounted for under pooling of interests. (See Note 2). AC Service
& Installation Co., Inc. and Donelson Air Conditioning, Inc. were under common
control. On August 21, 1996 and simultaneous with the closing of its initial
public offering, the Company acquired in separate transactions, 12 heating,
ventilating and air conditioning ("HVAC") replacement and service businesses and
Contractor Success Group, Inc. (collectively, the "Predecessor Companies") in
exchange for shares of the Company's Common Stock and cash (the "Combination").
The Acquiring Company was treated as the acquiror entity in this transaction in
accordance with SAB 97. The operations of the acquired companies have been
included in the Company's financial statements from the date of acquisition. The
above-mentioned acquisitions have been accounted for using the historical cost
basis of the acquired companies in accordance with Securities and Exchange
Commission Staff Accounting Bulletin No. 48 ("SAB 48"). The Company operates in
one industry segment and is primarily engaged in the replacement and servicing
of HVAC for residential and commercial customers. The Company has Service
Centers located in cities across the United States.
PRINCIPALS OF CONSOLIDATION
The consolidated financial statements of Service Experts, Inc. include the
accounts of the Company and its subsidiaries. All intercompany transactions have
been eliminated in consolidation. Investments in affiliates less than 50 percent
owned are generally recorded on the equity method.
RECOGNITION OF INCOME
Revenues on all of the Company's heating and air conditioning installation
contracts ("Contracts") for commercial buildings are recognized on the
percentage of completion method in the ratio that total incurred costs bear to
total estimated costs. Revenues on all of the Company's residential heating and
air conditioning installation, service and maintenance jobs are recognized upon
completion of the services which is usually within one to two days.
Earnings and estimated costs on Contracts are reviewed throughout the terms
of the Contracts, and any required adjustments are reflected in the periods in
which they first become known. When estimates indicate a probable loss on a
contract, the full amount thereof is accrued in the period in which it is first
determined. Most Contracts are completed within six to 18 months.
Nonidentifiable selling, general, and administrative expenses are charged to
income as incurred and are not allocated to Contract costs.
Trade accounts receivable includes billings and billed retainage on
Contracts. Also included in trade accounts receivable are unbilled retainage
amounts of $76,000 and $359,000 at December 31, 1995 and 1996, respectively. The
Company classifies these amounts as current assets because all balances are
expected to be collected in the current year. Concentrations of credit risk with
respect to trade receivables are limited due to the large number of customers
comprising the Company's customer base, and their dispersions across many
different industries and geographies.
The asset, "costs and estimated earnings in excess of billings" represents
revenue recognized in excess of amounts billed on in-progress contracts. The
liability, "billings in excess of costs and estimated earnings," represents
billings in excess of revenue recognized on in-progress contracts.
A-8
<PAGE> 33
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
FAIR VALUE OF FINANCIAL INSTRUMENTS
Cash
The carrying amounts reported in the balance sheets for cash and cash
equivalents approximate fair value.
Accounts Receivable and Accounts Payable
The carrying amounts reported in the balance sheets for accounts receivable
and accounts payable approximate fair value. Accounts receivable are usually
unsecured.
Long-Term Debt
Based upon the borrowing rates currently available to the Company, the
carrying amounts reported in the balance sheets for long-term debt approximate
fair value.
CASH EQUIVALENTS
The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
During the years ended December 31, 1994, 1995 and 1996 amounts charged to
bad debts expense totaled $95,000, $42,000 and $98,000, respectively and
accounts written off, net of recoveries were $11,000, $13,000 and $3,000,
respectively.
INVENTORIES
Inventories are stated at cost, which is not in excess of market. Cost is
determined principally by the first-in, first-out (FIFO) method for all
inventories.
PROPERTY, BUILDING AND EQUIPMENT
Property, building and equipment are stated on the basis of cost.
Depreciation and amortization are provided on the straight-line and
declining-balance methods over the following useful lives:
<TABLE>
<CAPTION>
YEARS
-----
<S> <C>
Buildings................................................... 31.5
Furniture and fixtures...................................... 5-10
Machinery and equipment..................................... 5-10
Vehicles.................................................... 5-10
Leasehold improvements...................................... 7-30
</TABLE>
DEFERRED REVENUE
The Company pre-sells maintenance contracts in the form of extended service
agreements ("ESA"). ESA revenue is recorded as deferred revenue and recognized
as income when service is performed.
WARRANTIES
The Company provides the retail customer with a warranty ranging from one
to ten years on parts and labor from the date of installation of the heating and
air conditioning unit. This warranty generally runs concurrent with the
manufacturer's warranty on parts and for the first year on labor. The Company
provides an
A-9
<PAGE> 34
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
accrual for future warranty costs based upon the relationship of prior years'
sales to actual warranty costs. It is the Company's practice to classify the
entire warranty accrual as a current liability.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
INCOME TAXES
Donelson Air Conditioning Company, Inc. used the liability method of
accounting for federal and state income taxes as provided by SFAS No. 109,
"Accounting for Income Taxes." Under the liability method, the deferred tax
liability or asset is based on temporary differences between the financial
statement and income tax bases of assets and liabilities, measured at tax rates
that will be in effect when the differences reverse.
The former stockholders of AC Service & Installation Co., Inc., Custom Air
Conditioning, Inc. and Freschi Air Systems, Inc. (See Note 2) elected under
Subchapter S of the Internal Revenue Code to include the Company's income in
their own income for federal income tax purposes. Accordingly, AC Service &
Installation Co., Inc., Custom Air Conditioning, Inc. and Freschi Air Systems,
Inc. are not subject to federal income taxes. This election is not available for
Tennessee state income tax reporting; accordingly, AC Service & Installation
Co., Inc. used the liability method of accounting for Tennessee state income
taxes.
ADVERTISING COSTS
The Company expenses advertising costs as incurred. During 1994, 1995 and
1996, the Company expensed $530,000, $524,000, and $1,584,000, respectively.
GOODWILL
Goodwill consists of the excess of purchase price over the fair value of
acquired tangible and identifiable intangible assets. Excess cost over the fair
value of net assets acquired (or goodwill) is amortized on a straight-line basis
over 40 years. The carrying value of goodwill is reviewed if the facts and
circumstances suggest that it may be impaired. If this review indicates that
goodwill will not be recoverable, as determined based on the undiscounted cash
flows of the entity acquired over the remaining amortization period, the
Company's carrying value of the goodwill will be reduced by the estimated
shortfall of cash flow. Accumulated amortization of goodwill was $87,000 at
December 31, 1996.
INCOME PER COMMON SHARE
Income per common share is based on the weighted average number of shares
of common stock outstanding and common stock equivalents consisting of dilutive
stock options and warrants. Fully diluted earnings per share for 1994, 1995, and
1996 are not materially different from primary earnings per share and,
therefore, are not presented.
RECLASSIFICATIONS
Certain reclassifications have been made in 1994 and 1995 financial
statements to conform to the 1996 presentation. These reclassifications had no
effect on the results of operations previously reported.
A-10
<PAGE> 35
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. MERGERS
In December 1996, the Company completed a merger with Custom Air
Conditioning, Inc. ("Custom") and Freschi Air Systems, Inc. ("Freschi") through
the exchange of 230,049 and 177,765 shares, respectively, of the Company's
Common Stock.
These mergers have been accounted for as poolings of interests and,
accordingly, the consolidated financial statements for the periods presented
have been restated to include the accounts of Custom and Freschi. The following
is a summary of results of operations of the separate entities for periods prior
to the mergers.
<TABLE>
<CAPTION>
YEAR ENDED ELEVEN MONTHS
DECEMBER 31, ENDED
------------------ NOVEMBER 30,
1994 1995 1996
------- ------- --------------
(IN THOUSANDS) (UNAUDITED)
(IN THOUSANDS)
<S> <C> <C> <C>
Net Revenues
Service Experts......................................... $14,299 $16,453 $29,167
Custom.................................................. 4,638 5,169 5,068
Freschi................................................. 3,256 3,254 4,116
------- ------- -------
Combined................................................ $22,193 $24,876 $38,351
======= ======= =======
Net Income (loss)
Service Experts......................................... $ 179 $ 629 $ 1,751
Custom.................................................. 245 173 213
Freschi................................................. (41) (94) 406
------- ------- -------
Combined................................................ $ 383 $ 708 $ 2,370
======= ======= =======
</TABLE>
3. RECAPITALIZATION AND INITIAL PUBLIC OFFERING
On August 21, 1996, the Company completed an initial public offering
("IPO") of 2,587,500 shares of Common Stock at $13.00 per share. Simultaneously,
the Company exchanged 1,462,100 shares of Common Stock to the promoters of the
IPO and 3,369,448 shares of Common Stock and a distribution of $18,699,000 in
cash for the stock of Hardwick Air Masters, Inc., Air Experts, a United Services
Co., Inc., Arrow Heating & Air Conditioning, Inc., Brand Heating and Air
Conditioning, Inc., Coastal Air Conditioning Service, Inc., Contractor Success
Group, Inc., Comerford's Heating and Air Conditioning Inc., Gilley's Heating &
Cooling, Inc., Norrell Heating & Air Conditioning, Inc., Rolf Coal and Fuel
Corp., Service Experts of Palm Springs, Inc. and Vision Holding Company, Inc.
The exchange is being accounted for utilizing the historical cost basis in
accordance with SAB 48 with the stock being valued at the historical cost of the
net assets exchanged. Cash consideration given in these acquisitions is treated
for accounting purposes as a dividend from the Company.
The Company's stock is currently traded on the Nasdaq Stock Market's
National Market under the symbol SERX.
4. ACQUISITIONS
On November 18, 1996, the Company filed a Registration Statement on Form
S-4 (the "Shelf Registration Statement") for the acquisition of 23 unrelated
HVAC replacement and service businesses. Of the 23 companies to be acquired, the
Company had completed the acquisition of 15 of these companies as of December
31, 1996. Two of these acquisitions completed by December 31, 1996 were
accounted for as poolings of interests as discussed in Note 2. In connection
with the 13 acquisitions accounted for using the purchase method of accounting,
the Company issued 2,069,000 shares at a fair market value of $34,068,000
excluding stock issuance costs of $1,572,000, and cash of $1,499,000. The
Company established an escrow account equal to 10% of the purchase price for
each acquisition subject to final closing adjustments. The
A-11
<PAGE> 36
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
purchase price was allocated to the acquired assets based on the fair values of
those assets as determined by the Company as set forth below (in thousands):
<TABLE>
<CAPTION>
<S> <C>
Current Assets.............................................. $ 7,032
Property, Buildings and Equipment........................... 2,593
Other Assets................................................ 392
Goodwill.................................................... 32,337
Liabilities Assumed......................................... (6,787)
-------
Purchase Price............................... $35,567
=======
</TABLE>
OTHER INFORMATION REGARDING ACQUISITIONS
All of the foregoing acquisitions were accounted for using the purchase
method of accounting except as indicated in Note 3. The allocation of the
purchase price associated with the acquisitions has been determined by the
Company based upon available information and is subject to further refinement.
The operating results of the acquired companies have been included in the
accompanying consolidated statements of income from the respective dates of
acquisition. The following unaudited pro forma results of operations give effect
to the operations of the entities acquired as if the respective transactions had
occurred as of the first day of the fiscal year immediately preceding the year
of the transactions. The pro forma results of operations do not purport to
represent what the Company's results of operations would have been had such
transactions in fact occurred at the beginning of the years presented or to
project the Company's results of operations in any future period.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------
1995 1996
---------- ----------
(IN THOUSANDS)
<S> <C> <C>
Net revenues........................................... $112,056 $120,083
Net income............................................. 5,227 6,043
Income per common share................................ $ .47 $ .55
</TABLE>
Subsequent to December 31, 1996, the Company completed the acquisition of
the remaining eight companies included in the previously mentioned Shelf
Registration Statement by issuing 680,758 shares of stock and paying cash
consideration of $2.0 million. The following unaudited pro forma results of
operations give effect to the operations of the entities acquired during 1996
and subsequent to December 31, 1996 as if the respective transactions had
occurred as of the first day of the fiscal year immediately preceding the year
of the transactions. The pro forma results of operations do not purport to
represent what the Company's results of operations would have been had such
transactions in fact occurred at the beginning of the years presented or to
project the Company's results of operations in any future period.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------
1995 1996
---------- ----------
(IN THOUSANDS)
<S> <C> <C>
Net revenues........................................... $131,788 $140,654
Net income............................................. 5,727 8,490
Income per common share................................ $ .52 $ .71
</TABLE>
A-12
<PAGE> 37
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. CONTRACTS IN PROCESS
Information relative to contracts in process is as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1995 1996
------ ------
<S> <C> <C>
Contracts on the percentage-of-completion method:
Expenditures on uncompleted contacts..................... $ 911 $2,903
Estimated earnings....................................... 487 1,147
------ ------
$1,398 $4,050
Less applicable billings................................... $1,595 $4,107
------ ------
$ (197) $ (57)
====== ======
Included in the accompanying balance sheets under the
following captions:
Costs and estimated earnings in excess of billings on
uncompleted contracts................................. $ 31 $ 283
Billings in excess of costs and estimated earnings on
uncompleted contracts................................. (228) (340)
------ ------
$ (197) $ (57)
====== ======
</TABLE>
Progress billings on contracts bear a relation to costs incurred, but are
not indicative of the ultimate profit or loss on a contract.
6. LEASES
Total rental expense for all operating leases was $174,000, $191,000 and
$490,000 for 1994, 1995 and 1996, respectively. The Company leases office and
warehouse space from various shareholders of the Company. These lease agreements
expire at various dates through 2000. Related party rental expense for 1994,
1995 and 1996 was $151,000, $161,000, and $295,000, respectively. The Company
leases certain vehicles and office and warehouse facilities under terms of
noncancelable operating lease agreements which expire at various dates through
2006. Minimum rental commitments at December 31, 1996 under operating leases
having an initial noncancelable term of one year or more are as follows (in
thousands):
<TABLE>
<CAPTION>
CAPITAL OPERATING RELATED
LEASES LEASES PARTY TOTAL
------- --------- ------- ------
<S> <C> <C> <C> <C>
1997................................... $ 60 $ 421 $1,485 $1,966
1998................................... 55 308 1,483 1,846
1999................................... 47 239 1,432 1,718
2000................................... 23 151 1,432 1,606
2001................................... -- 105 1,112 1,217
Thereafter............................. -- -- 1,171 1,171
---- ------ ------ ------
185 $1,224 $8,115 $9,524
====== ====== ======
Amounts representing interest.......... 32
----
Present value of net minimum
rentals (including $45 classified as
current)............................. $153
====
</TABLE>
The carrying values of assets under capital leases, which are included with
owned assets in the accompanying balance sheets are $154,000.
Amortization of the assets under capital leases is included in depreciation
expense.
A-13
<PAGE> 38
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. LONG-TERM DEBT
Long-term debt consists of the following (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
--------------
1995 1996
---- ----
<S> <C> <C>
Mortgage note payable....................................... $516 $ --
Installment and equipment notes............................. 314 94
Other....................................................... 24 28
---- ----
854 122
Less current portion........................................ 244 90
---- ----
$610 $ 32
==== ====
</TABLE>
On September 10, 1996, the Company entered into a Revolving Line of Credit
agreement with a Nashville, Tennessee bank for up to $10,000,000 to be used for
working capital purposes and acquisitions. On the same date, the Company also
entered into a Discretionary Line of Credit agreement with a Nashville,
Tennessee bank for up to $10,000,000 to be used for acquisitions or such other
purposes as may be approved by the bank. Any principal amounts outstanding on
the Line of Credit are due on September 10, 1998. On December 31, 1996, there
were no amounts outstanding under the above lines of credit.
Interest on any outstanding portion of the lines of credit is the LIBOR
rate plus applicable rate margin ranging from 125 basis points per annum to 250
basis points per annum (8.5% at December 31, 1996) dependent upon the funded
debt to EBDITA ratio. The Company pays an annual fee of 0.25% of the unused
portion of the available borrowings.
As long as any indebtedness is outstanding, the Lines of Credit require,
among other things, that the Company maintain various financial ratios at
specified levels including minimum levels for stockholders' equity. The Lines of
Credit also limit consolidations and mergers, incurrence of indebtedness or
liens and prohibit dividends and distributions. At December 31, 1996, the
Company was in compliance with all covenants.
The Company had a mortgage note payable to Free Will Baptist, Inc. that was
secured by the Company's office building and related land. The loan required
monthly installments of $8,400, including fixed principal and imputed interest
(6.1% at December 31, 1995). The mortgage was transferred to the former
shareholders of AC Service & Installation Co., Inc. and Donelson Air
Conditioning Company, Inc. on June 30, 1996 (see Note 14).
The Company has various installment and equipment loans to various lenders
which are secured by vehicles and equipment. These loans bear interest at
various fixed rates ranging from 4.8% to 13% per annum with maturity dates
through 1999.
As of December 31, 1996, the aggregate amounts of annual principal
maturities of long-term debt are as follows (in thousands):
<TABLE>
<S> <C>
1997........................................................ $ 90
1998........................................................ 29
1999........................................................ 3
----
$122
====
</TABLE>
A-14
<PAGE> 39
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. STOCK PLANS
INCENTIVE STOCK OPTION PLAN
The Company has reserved 700,000 shares of common stock under an incentive
stock option plan. A summary of the status of the plan follows:
<TABLE>
<CAPTION>
YEAR ENDED WEIGHTED
DECEMBER 31, AVERAGE
1996 EXERCISE PRICE
-------------- --------------
<S> <C> <C>
Granted...................................... 517,811 $16.92
Exercised.................................... -- --
Canceled..................................... -- --
-------------- ------
Outstanding at end of year................... 517,811 $16.92
============== ======
Option price range per share at end of
year....................................... $13.00 - $17.25 $16.92
============== ======
Options exercisable at end of year........... --
==============
</TABLE>
Stock options are exercisable over a period determined by the Board of
Directors, but no longer than ten years after the date of the grant. At December
31, 1996, options to purchase 182,189 shares were available for grant.
The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" (APB 25) and related
interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation" (FAS 123), requires
use of option valuation models that were not developed for use in valuing
employee stock options. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying stock
on the date of grant, no compensation expense is recognized.
Pro Forma information regarding net income and earnings per share is
required by FAS 123, and has been determined as if the Company had accounted for
its employee stock options under the fair value method of that Statement. The
fair value of these options was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted-average
assumptions for 1996, respectively; risk-free interest rates of 5.97% to 6.34%;
dividends yields of 0.0%; volatility factors of the expected market price of the
Company's common stock of .55 and .25; and a weighted-average expected life of
the options of three years.
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of options
is amortized to expense over the options' vesting period. The Company's pro
forma information follows (in thousands except for earnings per share
information):
<TABLE>
<CAPTION>
1996
--------
<S> <C>
Net income.................................................. $ 3,110
Pro forma compensation expense from stock options, net of
taxes..................................................... (121)
--------
Pro forma net income........................................ $ 2,989
========
Pro forma earnings per common and common equivalent share... $ .67
========
</TABLE>
A-15
<PAGE> 40
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Under FAS 123, disclosure of exercise prices is required for the year ended
December 31, 1996 only. The weighted-average fair value of options granted
during 1996 was $4.27. The weighted-average remaining contractual life of those
options is 9.7 years.
NONEMPLOYEE DIRECTOR STOCK OPTION PLAN
The Company has a Director Stock Option Plan that provides for a maximum of
issuance 100,000 shares of Common Stock for grant to non-management members of
the Board of Directors.
Options to purchase a total of 15,000 shares of Common Stock with exercise
price of $13.00 per share were outstanding at December 31, 1996. Each option is
exercisable in full upon receipt and shall expire ten years after the Grant
Date.
EMPLOYEE STOCK PURCHASE PLAN
The Company has an Employee Stock Purchase Plan under which the sale of
100,000 shares of Common Stock have been authorized. Employees may designate up
to 10% of their base compensation, at a price equal to 85% of the lessor fair
market value of the Common Stock January 1 or December 31. Employees are
eligible to participate in the Purchase Plan if they are employed by the Company
or a participating subsidiary for at least 20 hours a week and more than five
months in any calendar year and have been employed for at least six months since
their date of hire. At December 31, 1996 no shares had been issued under this
plan.
WARRANTS
In connection with the Company's IPO, Equitable Securities Corporation
received warrants to purchase 82,391 shares of the Company's Common Stock at an
exercise price of $13.00 per share. The warrants are exercisable for a period of
five years.
9. EMPLOYEE BENEFIT PLANS
The Company has defined-contribution employee benefit plans incorporating
provisions of section 401(k) of the Internal Revenue Code. Generally, employees
of the Company must have one year of service and work 500 hours during the plan
year to be eligible. Under the plans' provisions, a plan member may make
contributions, on a tax-deferred basis, from 1% to 20% of total compensation not
to exceed the maximum established annually by the Internal Revenue Service.
Under the plans matching contributions are made by the Company in amounts
ranging from 1% to 50% of total contributions by a plan member, to a maximum of
between 2% and 6% of the employee's total calendar year compensation. The
Company's matching contributions totaled $126,000, $201,000 and $206,000 as of
December 31, 1994, 1995 and 1996, respectively.
10. COMMITMENTS AND CONTINGENT LIABILITIES
The Company is a party to a number of legal proceedings arising in the
ordinary course of its business. In the opinion of management, the resolution of
these proceedings will not have a material adverse effect on the financial
position or results of operations of the Company.
The Company maintains general liability insurance coverage and an umbrella
policy to ensure itself against any liabilities occurring in the normal course
of business. The Company believes that its insurance coverage is adequate.
A-16
<PAGE> 41
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
11. INCOME TAXES
Income tax expense consists of the following:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
1994 1995 1996
----- ----- -------
(IN THOUSANDS)
<S> <C> <C> <C>
Current:
Federal................................................... $40 $ 65 $2,214
State..................................................... 8 40 461
Deferred.................................................... (7) (23) (1,479)
--- ---- ------
$41 $ 82 $1,196
=== ==== ======
</TABLE>
Significant components of the deferred tax assets and liabilities are as
follows:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1995 1996
------ ------
(IN THOUSANDS)
<S> <C> <C>
Deferred tax liabilities:
Contract billings......................................... $ 22 $ 136
Depreciation and amortization............................. -- 360
Other-net................................................. -- 63
------ ------
Deferred tax liabilities.................................... 22 559
Deferred tax assets:
Depreciation and amortization............................. 2 --
Bad debts................................................. 18 256
Warranty reserves......................................... 11 330
Deferred revenue.......................................... -- 1,045
Accrued expenses.......................................... -- 365
Other-net................................................. -- 96
------ ------
Total gross deferred tax assets............................. 31 2,092
------ ------
Net deferred tax assets..................................... $ 9 $1,533
====== ======
</TABLE>
Management has evaluated the need for a valuation allowance for all or a
portion of the deferred tax assets and believes that the deferred tax assets
will be more likely than not realized. Accordingly, no valuation allowance has
been recognized.
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1994 1995 1996
---- ------ ------
(IN THOUSANDS)
<S> <C> <C> <C>
Tax provision at statutory rate.................... $ 75 $ 241 $1,464
State income tax less applicable federal tax
benefit.......................................... 5 27 147
Less benefit of graduated tax rates and adjustments
to eliminate S corporation....................... (39) (186) (218)
Less benefit recognized upon termination of
Subchapter S election for AC Service &
Installation Co., Inc. .......................... -- -- (236)
Other-net.......................................... -- -- 39
---- ------ ------
$ 41 $ 82 $1,196
==== ====== ======
</TABLE>
A-17
<PAGE> 42
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
PRO FORMA INCOME TAX INFORMATION (UNAUDITED)
As discussed previously, AC Service & Installation Co., Inc.; Custom Air
Conditioning, Inc.; and Freschi Air Systems, Inc. operated under Subchapter S of
the Internal Revenue Code and were not subject to corporate federal income tax.
The Subchapter S elections were terminated upon acquisition by the Company. As a
result, these Companies are subject to corporate income taxes subsequent to the
termination of S corporation status. AC Service & Installation Co., Inc.; Custom
Air Conditioning, Inc. and Freschi Air Systems, Inc. had net operating income
for income tax purposes of $133,000, $682,000 and $1,760,000 for 1994, 1995 and
1996, respectively. Had AC Service & Installation Co., Inc.; Custom Air
Conditioning, Inc. and Freschi Air Systems, Inc. filed federal and state income
tax returns as regular C corporations for 1994, 1995, and periods ended during
1996, income tax expense under the provisions of Financial Accounting Standard
No. 109 would have been, $102,000, $242,000 and $316,000, respectively.
At the date of termination of S corporation status, AC Service &
Installation Co., Inc.; Custom Air Conditioning, Inc. and Freschi Air Systems,
Inc. were required to provide deferred taxes for cumulative temporary
differences between financial reporting and tax reporting basis of assets and
liabilities. Such deferred taxes were based on the cumulative temporary
differences at the date of termination of S corporation status.
The termination of S corporation status occurred on August 21, 1996 for AC
Service & Installation Co., Inc., and a deferred tax asset of $236,000 was
recorded. The effect of recognizing the deferred tax asset was included in the
Provision for income taxes.
12. RELATED PARTY TRANSACTIONS
Notes Receivable from Related Parties
The Company has one outstanding note receivable of $366,000 from a
stockholder of the Company as of December 31, 1996. The note is payable in 180
monthly installments of $3,905 and bears annual interest of 9%.
Other Related Party Transactions
On June 30, 1996, the Company distributed land, buildings, accounts
receivable and other assets with a net book value of $1,096,000 in satisfaction
of mortgage notes payable of $488,000, shareholder notes payable of $343,000,
and accrued compensation of $365,000 to the former shareholders of AC Service &
Installation Co., Inc. and Donelson Air Conditioning, Inc.
Notes Payable to Related Parties
At December 31, 1995 the Company had notes payable to related parties,
including current and former shareholders, which bare interest ranging from 0.0%
to 12.5% and were due through 2009. These notes were repaid during 1996.
A-18
<PAGE> 43
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
13. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
Quarterly financial information for the year ended December 31, 1996 is
summarized below:
<TABLE>
<CAPTION>
QUARTER
--------------------------------------
1ST 2ND 3RD 4TH
------ ------ ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Net revenues.................................. $5,134 $7,693 $13,130 $20,899
Income before income taxes.................... 39 59 1,527 2,681
Net income.................................... 33 152 1,239 1,686
Income per common share....................... $ .02 $ .10 $ .25 $ .17
</TABLE>
14. SUBSEQUENT EVENT
Subsequent to December 31, 1996, the Company entered into letters of intent
to acquire eight HVAC businesses. Pursuant to these agreements, the Company will
merge with or acquire the stock of the eight companies for an aggregate of
approximately $15.4 million cash and approximately 225,400 shares of Common
Stock. Closing of the transactions is subject to customary conditions and is
expected to take place prior to June 30, 1997.
A-19
<PAGE> 1
SERVICE EXPERTS, INC.
EXHIBIT 11 -- COMPUTATION OF EARNINGS PER SHARE
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------
1994 1995 1996
------ ------ ------
(IN THOUSANDS, EXCEPT PER
SHARE DATA)
<S> <C> <C> <C>
PRIMARY
Average shares outstanding.................................. 1,561 1,561 4,424
Net effect of dilutive stock options based on the treasury
stock method using average market price................... -- -- 27
------ ------ ------
Totals................................................. 1,561 1,561 4,451
====== ====== ======
Net income.................................................. $ 383 $ 708 $3,110
====== ====== ======
Net income per common share................................. $ .25 $ .45 $ .70
====== ====== ======
</TABLE>
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement
(Form S-8 No. 333-11791) pertaining to the 1996 Incentive Stock Plan, 1996
Non-Employee Director Stock Option Plan and 1996 Employee Stock Purchase Plan of
Service Experts, Inc. of our report dated February 12, 1997, with respect to the
consolidated financial statements of Service Experts, Inc. included in the
Annual Report (Form 10-K) for the year ended December 31, 1996 filed with the
Securities and Exchange Commission.
Nashville, Tennessee
February 18, 1997
