<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____________ TO _______________
COMMISSION FILE NO. 001-13037
SERVICE EXPERTS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 62-1639453
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
SIX CADILLAC DRIVE - SUITE 400, BRENTWOOD, TENNESSEE 37027
(Address of principal executive offices) (zip code)
Registrant's telephone number, including area code: (615) 371-9990
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 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 the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date.
CLASS OUTSTANDING AT NOVEMBER 5, 1998
COMMON STOCK, $.01 PAR VALUE 17,416,679
<PAGE> 2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SERVICE EXPERTS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1997 1998
----------- -----------
(UNAUDITED)
(IN THOUSANDS)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 11,297 $ 6,024
Accounts receivable:
Trade, net of allowance for doubtful accounts
of $1,625 in 1997 and $1,966 in 1998 30,258 46,454
Related party 243 340
Employee 366 533
Other 2,117 4,999
--------- ---------
32,984 52,326
Inventories 11,949 25,594
Costs and estimated earnings in excess of billings 2,352 4,885
Prepaid expenses and other current assets 2,458 5,675
Current portion of notes receivable - related parties 14 14
Current portion of notes receivable - other 284 177
Deferred income taxes 3,984 3,972
--------- ---------
Total current assets 65,322 98,667
Property, buildings and equipment:
Land 1,709 1,904
Buildings 3,290 3,811
Furniture and fixtures 6,157 12,014
Machinery and equipment 6,192 6,974
Vehicles 15,920 20,897
Leasehold improvements 2,561 3,928
--------- ---------
35,829 49,528
Less accumulated depreciation and amortization (10,278) (14,588)
--------- ---------
25,551 34,940
Notes receivable - related parties, net of
current portion 338 334
Notes receivable - other, net of current portion 591 567
Goodwill 105,158 169,766
Other assets 1,248 6,889
--------- ---------
Total assets $ 198,208 $ 311,163
========= =========
</TABLE>
See accompanying notes.
2
<PAGE> 3
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1997 1998
----------- -----------
(UNAUDITED)
(IN THOUSANDS,
EXCEPT SHARE DATA)
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable and accrued liabilities $ 18,344 $ 16,292
Accrued compensation 6,215 8,287
Accrued warranties 2,287 3,260
Income taxes payable 787 1,118
Deferred revenue 6,837 10,295
Deferred income taxes -- 80
Billings in excess of costs and estimated earnings 1,547 1,663
Current portion of long-term debt and capital
lease obligations 446 274
--------- ---------
Total current liabilities 36,463 41,269
Long-term debt and capital lease obligations, net
of current portion 16,133 73,302
Deferred income taxes 1,805 1,875
Commitments and contingencies (see note 9)
Stockholders' equity:
Preferred stock, $.01 par value; 10,000,000
shares authorized, no shares issued and
outstanding -- --
Common stock, $.01 par value; 30,000,000
shares authorized, 15,890,859 shares
issued and outstanding at December 31, 1997
and 17,246,093 shares issued and outstanding
at September 30, 1998 159 171
Additional paid-in-capital 122,671 155,424
Retained earnings 20,977 39,122
--------- ---------
Total stockholders' equity 143,807 194,717
--------- ---------
Total liabilities and stockholders' equity $ 198,208 $ 311,163
========= =========
</TABLE>
See accompanying notes.
3
<PAGE> 4
SERVICE EXPERTS, INC.
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1997 1998 1997 1998
---- ---- ---- ----
(UNAUDITED) (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Net revenue $ 67,676 $ 120,048 $ 174,873 $ 293,604
Cost of goods sold 42,738 76,834 113,513 188,083
-------- --------- --------- ---------
Gross margin 24,938 43,214 61,360 105,521
Selling, general and
administrative expenses 17,344 29,382 42,899 73,660
-------- --------- --------- ---------
Income from operations 7,594 13,832 18,461 31,861
Other income (expense):
Interest expense (145) (1,188) (595) (2,395)
Interest income 169 64 633 355
Other income 181 194 403 483
-------- --------- --------- ---------
205 (930) 441 (1,557)
Income before income taxes 7,799 12,902 18,902 30,304
Provision (benefit) for income taxes:
Current 3,301 4,935 7,833 11,637
Deferred (493) 237 (994) 504
-------- --------- --------- ---------
2,808 5,172 6,839 12,141
-------- --------- --------- ---------
Net income $ 4,991 $ 7,730 $ 12,063 $ 18,163
======== ========= ========= =========
Net income per common share:
Basic $ 0.33 $ 0.45 $ 0.83 $ 1.09
======== ========= ========= =========
Diluted $ 0.32 $ 0.45 $ 0.82 $ 1.07
======== ========= ========= =========
Weighted average shares outstanding:
Basic 15,228 17,103 14,484 16,684
======== ========= ========= =========
Diluted 15,401 17,303 14,647 16,922
======== ========= ========= =========
</TABLE>
See accompanying notes.
4
<PAGE> 5
SERVICE EXPERTS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
1997 1998
---- ----
(UNAUDITED)
(IN THOUSANDS)
<S> <C> <C>
NET CASH FLOW PROVIDED BY (USED IN)
OPERATING ACTIVITIES $ 7,442 $ (6,807)
INVESTING ACTIVITIES:
Payments on notes receivable 96 135
Purchase of property, buildings, and equipment (7,873) (9,541)
Cash acquired through purchase of business 2,848 3,333
Payment of cash for acquired companies (38,377) (42,581)
Decrease (increase) in other assets 419 (5,580)
--------- ---------
Net cash used in
investing activities (42,887) (54,234)
FINANCING ACTIVITIES:
Issuance of stock, net of issuance costs 38,220 --
Proceeds of long-term debt 5,726 118,160
Payments of long-term debt and capital leases (3,152) (62,392)
Payments on notes payable to related parties (1,509) --
--------- ---------
Net cash provided by
financing activities 39,285 55,768
Increase (decrease) in cash and cash equivalents 3,840 (5,273)
Cash and cash equivalents at beginning of period 10,841 11,297
--------- ---------
Cash and cash equivalents at end of period $ 14,681 $ 6,024
========= =========
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid $ 611 $ 2,555
========= =========
Income taxes paid $ 6,056 $ 12,087
========= =========
</TABLE>
See accompanying notes.
5
<PAGE> 6
SERVICE EXPERTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 1998 (UNAUDITED)
1 - BASIS OF PRESENTATION
OVERVIEW
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form 10-Q and
Article 10 of Regulation S-X. Accordingly, they do not include all of the
information and footnotes required by generally accepted accounting principles
for complete financial statements. In the opinion of management, all adjustments
(consisting of normal recurring accruals) considered necessary for a fair
presentation have been included. Operating results for the nine months ended
September 30, 1998 are not necessarily indicative of the results that may be
expected for the year ended December 31, 1998.
2 - BUSINESS COMBINATIONS
On September 24, 1998, the Company completed a business combination
with Dodge Heating and Air Conditioning, Inc. and DH&A, Inc. (collectively,
"Dodge") that was accounted for as a pooling of interests. Dodge merged with and
into a wholly-owned subsidiary of the Company in exchange for 468,590 shares of
the Company's Common Stock. Because this business combination has been accounted
for as a pooling of interests, the consolidated financial statements for the
periods presented have been restated to include the accounts of Dodge. The
following is a summary of the results of operations of Dodge for the period
prior to the business combination:
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
1997 1998
------ ------
(unaudited)
(In thousands)
<S> <C> <C>
Net Revenue
Service Experts $167,573 $284,365
Dodge 7,300 9,239
-------- --------
Combined $174,873 $293,604
======== ========
Net Income
Service Experts $ 11,515 $ 16,548
Dodge 548 1,615
-------- --------
Combined $ 12,063 $ 18,163
======== ========
</TABLE>
3 - SECONDARY STOCK OFFERING
On March 18, 1997, the Company completed a secondary public stock
offering whereby 1,850,000 shares of Common Stock were sold at $22.00 per share,
which resulted in net proceeds of $38.0 million to the Company. A portion of the
net proceeds was used to pay the cash portion of the consideration for certain
pending acquisitions and to repay certain indebtedness arising from such
acquisitions. The remaining proceeds were used to fund the Company's capital
expenditures, future acquisitions and for general corporate purposes.
4 - ACQUISITIONS
The following table sets forth certain information regarding
acquisitions in 1997 and 1998:
<TABLE>
<CAPTION>
Service Total Total
Centers Companies Shares Cash Convertible Total
Acquired Acquired Issued Consideration Debt Consideration
-------- -------- ------ ------------- ------------ -------------
(In thousands, except number of acquisitions)
<S> <C> <C> <C> <C> <C> <C>
1997
First Quarter 7 13 772 $15,126 $ 0 $28,287
Second Quarter 9 18 470 10,788 0 21,625
Third Quarter 10 20 717 10,252 0 30,254
Fourth Quarter 12 20 540 6,949 0 22,612
1998
First Quarter 10 19 389 8,626 0 19,242
Second Quarter 12 34 485 25,375 0 40,996
Third Quarter 9 30 681 11,679 667 29,073
</TABLE>
6
<PAGE> 7
OTHER INFORMATION REGARDING ACQUISITIONS
All of the foregoing acquisitions (the "Acquired Companies") were
accounted for using the purchase method of accounting, except for five
acquisitions in 1997 and one acquisition in 1998 which were accounted for as
poolings of interests. 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. In computing the purchase price for
accounting purposes, the value of shares is determined using the value of shares
set forth in the acquisition agreement, less a discount ranging from 0% to 20%
(as determined by an independent investment banking firm), as a result of
restrictions on the transferability of the shares issued. The discount to the
purchase price on acquisitions from January 1, 1998 through September 30, 1998
is $3.9 million. Asset and equity balances have been reduced accordingly, with
no effect on net income. This reduction in goodwill will affect amortization
expense in future periods. The operating results of the acquisitions, except for
the six pooled 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 these
entities as if the respective transactions had occurred as of the beginning of
the periods presented. The pro forma results of operations have been adjusted
for additional income tax provisions for state and federal taxes as certain of
the Acquired Companies previously were taxed as subchapter S corporations. The
pro forma results of operations neither purport to represent what the Company's
results of operations would have been had such transactions in fact occurred at
the beginning of the periods presented nor purport to project the Company's
results of operations in any future period.
PRO FORMA RESULTS OF OPERATIONS
<TABLE>
<CAPTION>
NINE MONTHS
ENDED
SEPTEMBER 30,
1997 1998
---- ----
(IN THOUSANDS,
EXCEPT PER
SHARE DATA)
<S> <C> <C>
Net revenue $279,914 $315,884
Net income 18,307 19,514
Net income per common share:
Basic $ 1.12 $ 1.14
Diluted $ 1.10 $ 1.13
</TABLE>
5 - CONVERTIBLE DEBT
On September 30, 1998, the Company issued 5.62% convertible
subordinated notes in an aggregate principal amount of $667,445 in connection
with certain acquisitions (the "Convertible Notes"). Each Convertible Note is
convertible at the option of either the Company or the holder into shares of
Common Stock at a conversion price of $31.56 per share. The Convertible Notes
are due in full in September 2002 and provide for quarterly interest payments.
6 - INCOME TAXES
The income tax provisions recorded for the three months and the nine
months ended September 30, 1997 and 1998 differ from the income tax provision
computed at the federal statutory tax rate of 35% primarily due to goodwill
amortization, a portion of which is not deductible for federal income tax
purposes, state income taxes, and pooled income of S corporations not subject to
federal income tax.
7
<PAGE> 8
7 - NET INCOME PER SHARE
The following table sets forth the computation of basic and diluted
income per share:
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------
1997 1998
---- ----
(IN THOUSANDS,
EXCEPT PER
SHARE DATA)
<S> <C> <C>
Numerator:
Net income $12,063 $18,163
------- -------
Numerator for basic income per share - income available
to common stockholders 12,063 18,163
------- -------
Numerator for diluted income per share - income available
to common stockholders after assumed conversions 12,063 18,163
------- -------
Denominator:
Denominator for basic income per share - weighted average
shares 14,484 16,684
Effect of dilutive securities:
Employee stock options 123 144
Warrants 40 55
Contingent shares -- 39
------- -------
Dilutive potential common shares 163 238
Denominator for diluted income per share - adjusted
weighted-average shares and assumed conversions 14,647 16,922
======= =======
Basic income per share $ 0.83 $ 1.09
======= =======
Diluted income per share $ 0.82 $ 1.07
======= =======
</TABLE>
8 - COMMITMENTS AND CONTINGENCIES
The Company currently, and from time to time, is expected to be subject
to claims and suits arising in the ordinary course of business. Management
continually evaluates contingencies based on the best available evidence and
believes that adequate provision for losses has been provided to the extent
necessary.
9 - RECLASSIFICATIONS
Certain reclassifications have been made to the accompanying financial
statements to conform to the September 30, 1998 presentation.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OVERVIEW
In 1997, the Company acquired 71 heating, ventilating and air
conditioning ("HVAC") service and replacement businesses and one consulting
business (the "1997 Acquired Companies"), of which 38 are Service Centers. The
consideration paid by the Company for the 1997 Acquired Companies was
approximately $102.8 million, consisting of approximately 2.5 million shares of
Common Stock, warrants to purchase 200,000 shares of Common Stock and
approximately $43.1 million in cash. Five of the transactions were accounted for
using the pooling of interests method of accounting, and the remainder were
accounted for using the purchase method. Approximately $73.9 million of the
consideration paid by the Company was allocated to intangible assets which are
amortized over a 40-year period.
From January 1, 1998 through March 31, 1998, the Company acquired
19 HVAC businesses, of which 10 are Service Centers. The consideration paid by
the Company for these businesses was approximately $19.2 million, consisting of
approximately 389,000 shares of Common Stock and approximately $8.6 million in
cash. All of these acquisitions were accounted for using the purchase method.
Approximately $15.0 million of the consideration paid by the Company was
allocated to intangible assets which are amortized over a 40-year period.
8
<PAGE> 9
From April 1, 1998 through June 30, 1998, the Company acquired 34 HVAC
businesses, of which 12 are Service Centers. The consideration paid by the
Company for these businesses was approximately $41.0 million, consisting of
approximately 485,000 shares of Common Stock, warrants to purchase 100,000
shares of Common Stock and approximately $25.4 million in cash. All of these
acquisitions were accounted for using the purchase method. Approximately $27.5
million of the consideration paid by the Company was allocated to intangible
assets which are amortized over a 40-year period.
From July 1, 1998 through September 30, 1998, the Company acquired 30
HVAC businesses (collectively, with the above businesses, the "1998 Acquired
Companies"), of which nine are Service Centers. The consideration paid by the
Company for these businesses was approximately $29.1 million, consisting of
approximately 681,000 shares of Common Stock, warrants to purchase 17,500 shares
of Common Stock, convertible subordinated notes in the aggregate principal
amount of approximately $667,000 and approximately $11.7 million in cash. One of
the transactions was accounted for using the pooling of interests method of
accounting, and the remainder were accounted for using the purchase method.
Approximately $21.6 million of the consideration paid by the Company was
allocated to intangible assets which are to be amortized over a 40-year period.
The 1997 and 1998 Acquired Companies (collectively, the "Acquired
Companies") 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 Acquired Companies have agreed to
certain reductions in their compensation in connection with the acquisitions.
COMPONENTS OF INCOME
Net revenue of the Acquired Companies has been derived primarily from
the installation, service and maintenance of central air conditioners, furnaces
and heat pumps 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,
promotion and advertising expenses and goodwill amortization.
RESULTS OF OPERATIONS
Because of the significant effect of the acquisitions of the Acquired
Companies and the anticipated effect of 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 HVAC businesses in
the future. The integration of acquired HVAC businesses 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.
THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 1997
Net Revenue. Net revenue increased $52.4 million, or 77.4%, from $67.7
million for the three months ended September 30, 1997 to $120.0 million for the
three months ended September 30, 1998. Approximately $45.7 million of the
increase is attributable to the acquisition of new Service Centers between
October 1997 and September 1998.
Cost of Goods Sold. Cost of goods sold increased $34.1 million, or
79.8%, from $42.7 million for the three months ended September 30, 1997 to $76.8
million for the three months ended September 30, 1998. Approximately $29.9
million of this increase is attributable to the acquisition of new Service
Centers between October 1997 and
9
<PAGE> 10
September 1998. As a percentage of net revenue, cost of goods sold increased
0.8% from 63.2% for the three months ended September 30, 1997 to 64.0% for the
three months ended September 30, 1998.
Gross Margin. Gross margin increased $18.3 million, or 73.3%, from
$24.9 million for the three months ended September 30, 1997 to $43.2 million for
the three months ended September 30, 1998. Approximately $15.7 million of this
increase is attributable to the acquisition of new Service Centers between
October 1997 and September 1998. As a percentage of net revenue, gross margin
decreased 0.8% from 36.8% for the three months ended September 30, 1997 to 36.0%
for the three months ended September 30, 1998.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased $12.0 million, or 69.4%, from $17.3 million
for the three months ended September 30, 1997 to $29.4 million for the three
months ended September 30, 1998. Approximately $8.9 million of this increase is
attributable to the acquisition of new Service Centers between October 1997 and
September 1998. The remaining increase is primarily attributable to the rise in
goodwill amortization from 1997 to 1998 and additional administrative expenses.
As a percentage of net revenue, selling, general and administrative expenses
decreased 1.1% from 25.6% for the three months ended September 30, 1997 to 24.5%
for the three months ended September 30, 1998.
Income from Operations. Income from operations increased $6.2 million,
or 82.1%, from $7.6 million for the three months ended September 30, 1997 to
$13.8 million for the three months ended September 30, 1998. Income from
operations as a percentage of net revenue increased 0.3% from 11.2% for the
three months ended September 30, 1997 to 11.5% for the three months ended
September 30, 1998.
Other Income (Expense). Other income decreased $1.1 million from
$205,000 for the three months ended September 30, 1997 to ($930,000) for the
three months ended September 30, 1998. Other income as a percentage revenue
decreased 1.1% from 0.3% for the three months ended September 30, 1997 to (0.8%)
for the three months ended September 30, 1998. This decrease is primarily
because of interest costs incurred on debt used to fund acquisitions.
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
1997
Net Revenue. Net revenue increased $118.7 million, or 67.9%, from
$174.9 million for the nine months ended September 30, 1997 to $293.6 million
for the nine months ended September 30, 1998. Approximately $96.3 million of the
increase is attributable to the acquisition of new Service Centers between
October 1997 and September 1998.
Cost of Goods Sold. Cost of goods sold increased $74.6 million, or
65.7%, from $113.5 million for the nine months ended September 30, 1997 to
$188.1 million for the nine months ended September 30, 1998. Approximately $63.6
million of this increase is attributable to the acquisition of new Service
Centers between October 1997 and September 1998. As a percentage of net revenue,
cost of goods sold decreased 0.8% from 64.9% for the nine months ended September
30, 1997 to 64.1% for the nine months ended September 30, 1998.
Gross Margin. Gross margin increased $44.1 million, or 72.0%, from
$61.4 million for the nine months ended September 30, 1997 to $105.5 million for
the nine months ended September 30, 1998. Approximately $32.7 million of this
increase is attributable to the acquisition of new Service Centers between
October 1997 and September 1998. As a percentage of net revenue, gross margin
increased 0.8% from 35.1% for the nine months ended September 30, 1997 to 35.9%
for the nine months ended September 30, 1998. This percentage increase is
attributable to an increased demand for higher margin products and services
during the nine months ended September 30, 1998.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased $30.8 million, or 71.7%, from $42.9 million
for the nine months ended September 30, 1997 to $73.7 million for the nine
months ended September 30, 1998. Approximately $19.2 million of this increase is
attributable to
10
<PAGE> 11
the acquisition of new Service Centers between October 1997 and September 1998.
As a percentage of net revenue, selling, general and administrative expenses
increased 0.6% from 24.5% for the nine months ended September 30, 1997 to 25.1%
for the nine months ended September 30, 1998.
Income from Operations. Income from operations increased $13.4 million,
or 72.6%, from $18.5 million for the nine months ended September 30, 1997 to
$31.9 million for the nine months ended September 30, 1998. Income from
operations as a percentage of net revenue increased 0.3% from 10.6% for the nine
months ended September 30, 1997 to 10.9% for the nine months ended September 30,
1998.
Other Income (Expense). Other income decreased $2.0 million, or 453.1%,
from $441,000 for the nine months ended September 30, 1997 to ($1,557,000) for
the nine months ended September 30, 1998. Other income as a percentage of net
revenue decreased 0.8% from 0.3% for the nine months ended September 30, 1997 to
(0.5%) for the nine months ended September 30, 1998. This decrease is primarily
because of interest costs incurred on debt used to fund acquisitions.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 1998, the Company had working capital of $57.5
million, including cash and cash equivalents of $6.0 million. The ratio of
current assets to current liabilities was 2.4 to 1.0 at September 30, 1998 and
1.8 to 1.0 at December 31, 1997.
The Company's principal capital needs arise from the acquisition of new
HVAC businesses and the costs associated with such expansion. Net cash flow
provided by (used in) operating activities decreased from $7.4 million for the
nine months ended September 30, 1997 to ($6.8) million for the nine months ended
September 30, 1998. This decrease was primarily the result of a $10.4 million
increase in inventory and a $13.5 million increase in receivables. Cash used in
investing activities was primarily attributable to the acquisition of HVAC
businesses.
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 favorable target businesses and to negotiate favorable acquisition
terms, the availability of adequate financing and other factors, many of which
are beyond the control of the Company. In addition, there can be no assurance
that the Company will be successful in identifying and acquiring Service
Centers, 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.
On March 18, 1997, the Company completed a secondary offering of
1,850,000 shares of its Common Stock at $22.00 per share. The proceeds to the
Company, net of expenses and underwriters' discounts and commissions, were
approximately $38.0 million. The Company used the proceeds for planned capital
expenditures, acquisitions and general corporate purposes.
The Company currently has a $100.0 million unsecured revolving credit
facility with a banking syndication available through April 30, 2001 (the
"Credit Facility"), of which approximately $30.2 million was outstanding on
November 9, 1998. Borrowings under the Credit Facility bear interest at either
(i) the higher of the agent's base lending rate or the federal funds rate plus
one-half of one percent per annum or (ii) a variable rate equal to the 30, 60,
90 or 180-day LIBOR, as such rate changes from time to time, plus a variable
margin of from 62.5 to 150 basis points depending on the Company's funded debt
to EBITDA ratio determined on a quarterly basis, at the election of the Company.
All of the Company's subsidiaries have guaranteed the repayment of indebtedness
under the Credit Facility. The Credit Facility contains 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 payment of dividends.
On June 23,1998, the Company issued $32.5 million of 6.97% senior
unsecured notes, due June 15, 2003, and $17.5 million of 7.13% senior unsecured
notes, due June 15, 2005 (collectively, the "Notes"), in a private placement to
a group of institutional
11
<PAGE> 12
investors. The Notes provide for interest to be paid on December 15 and June 15
of each year, with principal due at maturity. All of the Company's subsidiaries
have guaranteed the repayment of the Notes. The Note Purchase Agreement pursuant
to which the Notes were issued contains covenants with respect to the
maintenance of certain financial ratios and specified net worth and limiting the
incurrence of additional indebtedness and the sale of substantial assets,
consolidations or mergers by the Company.
On September 30, 1998, the Company issued 5.62% convertible
subordinated notes in an aggregate principal amount of $667,445 in connection
with certain acquisitions. Each Convertible Note is convertible at the option of
either the Company or the holder into shares of Common Stock at a conversion
price of $31.56 per share. The Convertible Notes are due in full in September
2002 and provide for quarterly interest payments.
The Company currently has on file with the Commission a shelf
Registration Statement on Form S-4 (Registration No. 333-12319) (the "Shelf
Registration Statement") covering securities with a collective aggregate
offering price of $50.0 million for use in acquisitions of HVAC businesses.
Under the Shelf Registration Statement, the Company may issue shares of Common
Stock, warrants to purchase Common Stock and debt securities in connection with
acquisitions.
Management believes that the Company's existing cash balances and
available lines of credit 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 debt securities or 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.
Year 2000
Many computer systems in use today were designed and developed using
two digits, rather than four, to specify the year. As a result, such systems
will recognize the Year 2000 as "00" and may assume that the year is 1900 rather
than 2000. This could cause many computer applications to fail completely or to
create erroneous results unless corrective measures are taken. The Company
recognizes the need to minimize the risk that its operations will be adversely
affected by Year 2000 software failures and is in the process of preparing for
the Year 2000.
The Company has evaluated its Year 2000 risk in three separate
categories: information technology systems ("IT"), non-IT systems ("Non-IT") and
material third party relationships. The Company has developed a plan in which
the risks in each of these categories are being reviewed and addressed by the
appropriate level of management as follows:
IT. The Company is actively engaged in developing and installing new
financial, information and operational systems which are expected to be
completed and installed by December 31, 1999. In connection with this
implementation, system programs have been designed so that the Year 2000 will be
recognized as a valid date and will not affect the processing of date-sensitive
information. Certain systems have already been installed in certain Service
Centers and at the corporate level. Systems will be installed in all Service
Centers by June 30, 1999. Through September 30, 1998, the Company has incurred
approximately $125,000 of systems and related costs that address Year 2000
compliance. The Company expects to spend an additional $475,000 to complete its
Year 2000 compliance plans. These costs include some normal system software
and equipment upgrades or replacements separate from the Year 2000 issue, which
the Company anticipated incurring and budgeted in the normal course of business.
Non-IT. Non-IT systems involve embedded technologies, such as
microcontrollers or microprocessors. Examples of Non-IT systems include
telephones, time clocks and security systems. Management believes the Company's
Non-IT risks are minimal. Most of the costs of addressing Non-IT risks are
included in normal upgrade and replacement expenditures which were planned
outside of the Company's Year 2000 review.
Third Party Risk. The Company's review of its third party risk includes
detailed reviews of material relationships with vendors and certain business
partners. The Company is monitoring and assessing the progress of its material
vendors and business partners to determine whether they will be able to
successfully interact with the Company in the Year 2000. The Company has
contacted and received oral or written responses from at least 25% of its
material vendors, all of which are in various stages of addressing the Year
2000 issue, and is currently awaiting responses from the remainder of its
material vendors.
If the steps taken by the Company and its material vendors and business
partners to be Year 2000 compliant are not successful, the Company would likely
experience various operational difficulties resulting in a material adverse
effect upon the Company's financial condition and results of operations. These
could include, among other things, processing transactions to an incorrect
accounting period, difficulties in posting general ledger entries and lapses of
service by vendors. If the Company's plan to install new systems which
effectively address the Year 2000 issue is not successfully or timely
implemented, the Company may need to devote more resources to the process and
additional costs may be incurred. The Company believes that the Year 2000 issue
is being appropriately addressed through the implementation of these new systems
and software development and by its material vendors and business partners and
does not expect the Year 2000 issue to have a material adverse effect on the
financial position, results of operations or cash flows of the Company in future
periods. The Company's forward-looking statements regarding Year 2000 issues are
dependent on many factors, including the ability of the Company's vendors to
achieve Year 2000 compliance, the proper functioning of the new IT and non-IT
systems installed by the Company, the integration of such systems and the
development of software, some of which are beyond the Company's control.
The Company currently does not have a contingency plan to address the
failure of the Company's IT or non-IT systems or the systems of material third
parties to be Year 2000 compliant. Should the remaining review of the Company's
Year 2000 risks reveal potentially non-compliant computer systems or material
third party risks, contingency plans will be developed to address the
deficiencies revealed at that time.
INFLATION
The HVAC industry is labor intensive. Wages and other expenses increase
during periods of inflation and when shortages in marketplaces occur. In
addition, suppliers pass along rising costs to the Company in the form of higher
prices. The Company has generally been able to offset increases in operating
costs by increasing charges, expanding services and implementing cost control
measures to curb such increases. The Company can not predict its ability to
offset or control future cost increases.
12
<PAGE> 13
FORWARD LOOKING STATEMENTS
This Form 10-Q and other information that is provided by the Company
contains forward-looking statements, including those relating to the acquisition
of HVAC businesses, the integration of such businesses, the adequacy of the
Company's capital resources and other statements regarding trends relating to
various revenue and expense items, including Year 2000 related issues. These
statements are subject to a number of risks and uncertainties beyond the
Company's control that could cause the Company's actual results to differ
materially from those projected in such forward-looking statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
No disclosure is required.
13
<PAGE> 14
PART II
OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
From time to time, the Company issues subordinated notes convertible
into shares of the Company's Common Stock in connection with the acquisition of
HVAC service and replacement businesses. In general, the subordinated notes are
convertible into shares of the Company's Common Stock immediately at a
conversion price equal to 140% of the market price of the Common Stock at the
time the note is issued. The Company issues convertible subordinated notes and
the shares of Common Stock issued upon conversion of notes in transactions
intended to be exempt from the registration requirements of the Securities Act
of 1933, as amended, pursuant to Sections 3(a)(11), 3(b) or 4(2) thereunder.
On September 30, 1998, the Company issued 5.62% convertible
subordinated notes in an aggregate principal amount of $667,445.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
- ------- -----------------------
<S> <C> <C>
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 -- Form of Agreement and Plan of Merger among certain of the
Registrant's subsidiaries, a wholly-owned subsidiary of the
Registrant and the Registrant(c)
10.2 -- Form of Stock Purchase Agreement between the former
stockholders of certain of the Registrant's subsidiaries and
the Registrant(d)
10.3 -- First Amendment to Second Amended and Restated Credit
Agreement, dated as of September 30, 1998, between the
Registrant and SunTrust Bank, Nashville, N.A., as agent for the
lenders
10.4 -- Form of Convertible Subordinated Note
27.1 -- Financial Data Schedule September 30, 1998 (for SEC use only)
27.2 -- Restated Financial Data Schedule September 30, 1997 (for SEC
use only)
(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
annual report on Form 10-K for the fiscal year ended December 31, 1997,
File No. 001-13037.
</TABLE>
(b) Reports on Form 8-K.
The Company filed a Current Report on Form 8-K on September 24, 1998
containing the financial statements of certain HVAC businesses acquired
and pro forma financial statements pursuant to Item 5 of Form 8-K.
14
<PAGE> 15
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
SERVICE EXPERTS, INC.
By: /s/ Anthony M. Schofield
Anthony M. Schofield
Chief Financial Officer
Date: November 10, 1998
15
<PAGE> 16
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBITS
- ------- -----------------------
<S> <C> <C>
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 -- Form of Agreement and Plan of Merger among certain of the
Registrant's subsidiaries, a wholly-owned subsidiary of the
Registrant and the Registrant(c)
10.2 -- Form of Stock Purchase Agreement between the former
stockholders of certain of the Registrant's subsidiaries and
the Registrant(d)
10.3 -- First Amendment to Second Amended and Restated Credit
Agreement, dated as of September 30, 1998, between the
Registrant and SunTrust Bank, Nashville, N.A., as agent for the
lenders
10.4 -- Form of Convertible Subordinated Note
27.1 -- Financial Data Schedule September 30, 1998 (for SEC use only)
27.2 -- Restated Financial Data Schedule September 30, 1997 (for SEC
use only)
(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
annual report on Form 10-K for the fiscal year ended December 31, 1997,
File No. 001-13037.
</TABLE>
<PAGE> 1
EXHIBIT 10.3
FIRST AMENDMENT TO SECOND AMENDED AND RESTATED
CREDIT AGREEMENT
ENTERED INTO by and between SERVICE EXPERTS, INC., a Delaware
corporation (the "Borrower"), SUNTRUST BANK, NASHVILLE, N.A., AGENT ("Agent"),
SUNTRUST BANK, NASHVILLE, N.A. ("STB"), BANK OF AMERICA, FSB ("BOA"), SOUTHTRUST
BANK, NATIONAL ASSOCIATION ("SB"), NATIONSBANK, N.A. ("Nations"), and FIRST
AMERICAN NATIONAL BANK ("FANB") (herein STB, BOA, SB, Nations, and FANB shall
collectively be referred to as "Lenders") as of this 30th day of September,
1998.
RECITALS:
1. The Borrower, the Agent, and the Lenders entered into a Second
Amended and Restated Credit Agreement dated April 28, 1998 (herein the "Credit
Agreement").
2. The Borrower, the Agent, and the Lenders desire to amend the Credit
Agreement as set forth herein.
NOW, THEREFORE, in consideration of the premises and for other good and
valuable consideration, the receipt and adequacy of which is hereby
acknowledged, the Borrower, the Agent, and the Lenders agree as follows:
1. The definition of "Applicable Margin" as set forth in Article I of
the Credit Agreement is hereby amended and restated as follows:
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------
RATIO OF TOTAL FUNDED DEBT TO EBITDA
--------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Purpose < = 1.0x >1.0x but < = >1.5x but < = >2.0x but < = >2.5x
- 1.5x - 2.0x - 2.5x -
- -----------------------------------------------------------------------------------------------------------------
Facility Fee 17.5 basis 20 basis 25 basis 37.5 basis 45 basis
Percentage points per points per points per points per annum points per
annum annum annum annum
- -----------------------------------------------------------------------------------------------------------------
Calculation of 45 basis 67.5 basis 75 basis 87.5 basis 105 basis
LIBOR points per points per points per points per points per
Option and annum annum annum annum annum
Letter of
Credit Fee
- -----------------------------------------------------------------------------------------------------------------
</TABLE>
2. The definition of "Commitment Fee" as set forth in Article I of, as
used in, the Credit Agreement is hereby amended to mean Facility Fee.
<PAGE> 2
3. Article I of the Credit Agreement is hereby amended to include the
following new definition:
"Facility Fee" has the same meaning as set forth in Section 2.16
herein.
4. Section 2.01(a) of the Credit Agreement shall be amended and
restated as follows:
(a) Availability. Subject to the conditions and pursuant to
the terms of the Loan Documents and in reliance upon the
representations, warranties, and covenants set forth in the Loan
Documents, each Lender severally agrees to make Advances (relative to
such Lender) to the Borrower under the Revolving Credit Loan equal to
such Lender's Pro Rata share of the Advance requested to be made on
such day (herein its "Revolving Credit Loan Commitment") (excluding
Advances requested under the Swing Line Loan), provided that in no
event shall any Lender be permitted to fund an amount under its
Revolving Credit Loan Commitment (including its Pro Rata Share of
outstanding Letters of Credit), plus any outstanding Competitive Bid
Loans, plus any outstanding Swing Line Loans owing to such Lender in
excess of its Pro Rata Share of the Maximum Total Amount.
5. Section 2.04(h) of the Credit Agreement shall be amended and
restated in its entirety as follows:
(h) Any Lender's Competitive Bid Rate Advance shall reduce
such Lender's obligation to lend its Pro Rata Share of the remaining
unused commitments.
6. Section 2.16 of the Credit Agreement shall be amended and restated
as follows:
Section 2.16 Facility Fee. On the first Business Day following
the end of each Fiscal Quarter thereafter (or if such day is not a
Business Day, then on the next succeeding Business Day) and on the
Maturity Date, the Borrower shall pay to the Agent on or before 1:00
p.m. (Nashville, Tennessee time) for distribution upon receipt promptly
thereafter to the Lenders based on their Pro Rata Share a Facility Fee
equal to: (a) the Maximum Total Amount (without taking into account
usage) multiplied by: (b) the Applicable Margin then in effect for the
Facility Fee calculation for the Fiscal Quarter (or portion thereof),
divided by (c) four(4).
7. Section 7.01(f) of the Credit Agreement shall be amended and
restated as follows:
(f) Seller Notes not to exceed $50,000,000 in the aggregate
outstanding principal balance at any one time;
2
<PAGE> 3
6. The introductory paragraph to Section 7.03 of the Credit Agreement
shall be amended and restated as follows:
Section 7.03 Investments, Loans, and Advances. Make or permit
to remain outstanding any loans or advances to or investments in any
Person in an aggregate amount in excess of the lesser of (i) an amount
equal to five percent (5%) of the Consolidated Net Worth of the
Consolidated Entities, or (ii) $20,000,000, except that, subject to all
other provisions of this Article, the foregoing restriction shall not
apply to:
7. Article VIII shall be amended to include new Section 7.14 to read as
follows:
Section 7.14 Prepayment of Seller Notes. Prepay Seller Notes
in the aggregate amount in excess of $1,000,000 in any twelve (12)
month period without obtaining the written consent of the Majority
Lenders.
8. The Credit Agreement is not amended in any other respect.
9. The Borrower reaffirms the provisions of the Credit Agreement, and
agrees that its obligations are valid and binding, enforceable in accordance
with its terms, subject to no defense, counterclaim, or objection.
ENTERED INTO as of this 30th day of September, 1998.
BORROWER:
SERVICE EXPERTS, INC.
By:
-------------------------------
Title:
----------------------------
3
<PAGE> 4
AGENT:
SUNTRUST BANK, NASHVILLE, N.A., Agent
By:
-----------------------------------------
Title:
-------------------------------------
Address: 201 Fourth Avenue North
Nashville, Tennessee 37219
[Signatures Continued on Next Page]
4
<PAGE> 5
LENDERS:
SUNTRUST BANK, NASHVILLE, N.A.
By:
----------------------------------------
Title:
-------------------------------------
Address: 201 Fourth Avenue North
Nashville, Tennessee 37219
[Signatures Continued on Next Page]
5
<PAGE> 6
BANK OF AMERICA, FSB
By:
----------------------------------------
Title:
-------------------------------------
Address: 1230 Peachtree Street, Suite 3600
Atlanta, Georgia 30309
[Signatures Continued on Next Page]
6
<PAGE> 7
SOUTHTRUST BANK, NATIONAL
ASSOCIATION
By:
---------------------------------
Title:
-------------------------------
Address: 230 Fourth Avenue North,
8th Floor
Nashville, Tennessee 37219
[Signatures Continued on Next Page]
7
<PAGE> 8
NATIONSBANK, N.A.
By:
------------------------------------
Title:
---------------------------------
Address: 100 N. Tyron Street, 8th Floor
Charlotte, North Carolina 28255
Pro Rata Share: 12 1/2%
[Signatures Continued on Next Page]
8
<PAGE> 9
FIRST AMERICAN NATIONAL BANK
By:
-----------------------------------
Title:
--------------------------------
Address:4th & Union Street, 3rd Floor
Nashville, Tennessee 37237-0310
9
<PAGE> 1
EXHIBIT 10.4
THIS NOTE IS NONNEGOTIABLE
____% CONVERTIBLE SUBORDINATED NOTE
DUE __________, 2002
$___________________ Nashville, Tennessee
______________, 1998
SERVICE EXPERTS, INC., a Delaware corporation (the "Company"), for
value received, hereby promises to pay ________________ ("Shareholder") the
principal amount of _______________ ($____________), together with accrued
interest thereon at the rate of ____% per annum (computed on the basis of a
365-day year) from the date hereof. Principal shall be payable in four equal
annual installments beginning one year from the date hereof. Interest shall be
payable quarterly on each January 1, April 1, July 1 and October 1 after the
date hereof. The final principal installment and all accrued and unpaid interest
shall be due and payable _____ __, 2002 (the "Maturity Date"). Payments of
principal and interest on this Note shall be made in lawful money of the United
States of America at the principal office of Shareholder, or at such other
office or agency as the holder shall have designated by written notice to the
Company. The Company shall have the right to prepay this Note in whole or in
part without penalty upon thirty (30) days prior written notice.
1. Events of Default. If any of the following conditions or events
(each an "Event of Default" and collectively, the "Events of Default") shall
occur and be continuing:
(a) if the Company shall default in the payment of any principal
on this Note when the same becomes due and payable, whether at maturity or
otherwise, and such payment shall not have been made within thirty (30) days
after written notice of default shall have been received by the Company from the
holder of this Note; or
(b) if the Company shall default in the payment of any
interest on the Note when the same becomes due and payable and such default
shall continue more than thirty (30) days after written notice of default shall
have been received by the Company from the holder of this Note; or
(c) if the Company shall make an assignment for the benefit of
creditors, or shall admit in writing its inability to pay its debts as they
become due, or shall file a voluntary petition in bankruptcy, or shall be
adjudicated as bankrupt or insolvent, or shall file any petition or answer
seeking for itself any reorganization, arrangement, composition, readjustment,
liquidation, dissolution or similar relief under any present or future statute,
law or regulation, or shall file any answer admitting or not contesting the
material allegations of a petition filed against the Company in any such
proceeding, or shall seek or consent to or acquiesce in the appointment of any
custodian, trustee, receiver or liquidator of the Company or such subsidiary or
of all or any substantial part of the properties of the Company or such
subsidiary, or if the Company or its directors or majority shareholders shall
take any action looking to the dissolution or liquidation of the Company; or
(d) if, within sixty (60) days after the commencement of an
involuntary bankruptcy proceeding or other action against the Company seeking
any reorganization, arrangement, composition, readjustment, liquidation,
dissolution or similar relief under any present or future statute, law or
regulation, such action shall not have been dismissed or all orders or
proceedings thereunder affecting the operations or the business of the Company
stayed, or if the stay of any such order or proceeding shall thereafter be set
aside, or if, within sixty (60) days after the appointment without the consent
or acquiescence of the Company or
<PAGE> 2
any custodian, trustee, receiver or liquidator of the Company or of all or any
substantial part of the properties of the Company, such appointments shall not
have been vacated;
then, and in any such Event of Default, the holder hereof may at any time
(unless all defaults shall theretofore have been remedied) at its option, by
written notice to the Company, declare this Note to be due and payable,
whereupon this Note shall forthwith mature and become due and payable, together
with interest accrued and unpaid hereon, without presentment, demand, protest or
notice, all of which are hereby waived.
2. Conversion.
2.1 Conversion Privilege
2.1.1 Conversion by Shareholder. This Note
may, at the election of the holder hereof and at any time prior to the earlier
of the Maturity Date or the prepayment in full of this Note, be converted into
the number of fully paid and nonassessable shares of Common Stock, $0.01 par
value per share, of the Company (the "Common Stock") determined by dividing (x)
the principal amount being converted by (y) the conversion price of $______
(which is 140% of the Closing Price), as adjusted from time to time in
accordance with Sections 2.4 and 2.5 hereof (such conversion price, as so
adjusted and readjusted and in effect at any time, being herein called the
"Conversion Price"). As used herein, "Closing Price" means the average closing
sales price of a share of the Common Stock as reported on the New York Stock
Exchange for the five trading days immediately preceding the date hereof.
2.1.2 Conversion by the Company. In the event
the closing sales price of a share of Common Stock as reported on the New York
Stock Exchange exceeds the Conversion Price on five (5) consecutive trading
days, the Company, at its election, may convert this Note into the number of
fully paid and nonassessable shares of Common Stock determined by dividing (x)
the principal amount outstanding by (y) the Conversion Price. Upon such
conversion and without any further action by the parties hereto, the holder
hereof will not be entitled to any additional principal or interest payments
hereunder. Upon receipt of written notice from the Company informing the holder
of the conversion of the Note, the holder shall convert the Note in accordance
with the provisions of Section 2.2 below.
2.2 Manner of Conversion, Partial Conversion, Etc.
2.2.1. Surrender of Note. This Note may be
converted by the holder hereof by surrender of this Note any time prior to the
Maturity Date, accompanied by written notice stating that such holder elects to
convert all or a portion of the principal amount thereof and stating the name or
names, together with addresses, in which the certificate or certificates for
shares of Common Stock are to be issued. Any conversion shall be deemed to have
been effected (i) with respect to a conversion under Section 2.1.1, immediately
prior to the close of business on the date on which this Note shall have been so
surrendered to the Company and (ii) with respect to a conversion under Section
2.1.2, immediately prior to the close of business on the fifth consecutive
trading day that the closing sales price of a share of Common Stock as reported
on the New York Stock Exchange exceeds the Conversion Price; and at such time
the rights of the holder as to that portion of this Note so converted shall
cease, and the person in whose name or names any certificate or certificates for
shares of Common Stock (or other securities) shall be issuable upon such
conversion shall be deemed to have become the holder or holders of record
thereof.
2.2.2. Accrued Interest, Etc. The Company will
have no obligation to pay to the holder converting this Note any accrued but
unpaid interest on the principal amount so converted up to and including the
date of conversion.
2
<PAGE> 3
2.3. Delivery of Stock Certificates; Fractional Shares. As
promptly as practicable after the conversion of this Note in whole or in part,
and in any event within ten (10) days thereafter, the Company at its expense
will issue and deliver to the holder of this Note, or as such holder (upon
payment by such holder of any applicable transfer taxes and subject to
compliance with securities laws) may direct, a certificate or certificates for
the number of full shares of Common Stock issuable upon such conversion, plus,
in lieu of any fractional share to which such holder would otherwise be
entitled, cash equal to such fraction multiplied by the market value of one full
share of Common Stock as of the close of business on the date of such
conversion, as determined by the Board of Directors. Upon issuance, such
certificates may bear a legend stating in substance:
"THE SHARES REPRESENTED BY THIS CERTIFICATE MAY ONLY BE TRANSFERRED IN
ACCORDANCE WITH THE TERMS OF THE LETTER AGREEMENT, DATED ___________,
1998, BETWEEN THE REGISTERED HOLDER HEREOF AND SERVICE EXPERTS, INC., A
COPY OF WHICH AGREEMENT IS ON FILE AT THE PRINCIPAL OFFICES OF SERVICE
EXPERTS, INC."
2.4. Adjustment of Conversion Price. The Conversion Price
shall be adjusted from time to time as follows:
2.4.1. In case the Company shall hereafter (i) pay a
dividend or make a distribution on its Common Stock in shares of Common Stock,
(ii) subdivide its outstanding shares of Common Stock into a greater number of
shares, (iii) combine its outstanding shares of Common Stock into a smaller
number of shares, or (iv) issue by reclassification of its Common Stock any
shares of capital stock of the Company, the Conversion Price in effect
immediately prior to such action shall be adjusted so that the Holder of this
Note or any portion hereof thereafter surrendered for conversion shall be
entitled to receive the number of shares of Common Stock or other capital stock
of the Company which he would have owned immediately following such action had
this Note or such portion hereof been converted immediately prior thereto. Any
adjustment made pursuant to this subsection 2.4.1 shall become effective
immediately after the record date in the case of a dividend or distribution and
shall become effective immediately after the effective date in the case of a
subdivision, combination or reclassification. If, as a result of an adjustment
made pursuant to this subsection 2.4.1, the Holder of this Note or such portion
hereof thereafter surrendered for conversion shall become entitled to receive
shares of two or more classes of capital stock or shares of Common Stock and
other capital stock of the Company, the Board of Directors (whose determination
shall be conclusive) shall reasonably determine the allocation of the adjusted
Conversion Price between or among shares of such classes of capital stock or
shares of Common Stock and other capital stock.
2.4.2. If the amount of any single adjustment of the
Conversion Price required pursuant to this subsection 2.4.2 would be less than
one cent ($0.01) at the time such adjustment is otherwise so required to be
made, such amount shall be carried forward and adjustment with respect thereto
made at the time of and together with any subsequent adjustment which, together
with such amount and any other amount or amounts so carried forward, shall
aggregate at least one cent ($0.01) when the Conversion Price is adjusted.
2.5. Adjustments for Consolidation, Merger, Sale of Assets,
Reorganization, Etc. If at any time the Company shall be a party to any
transaction (including without limitation a merger, consolidation, sale of all
or substantially all of the Company's assets or recapitalization of the Common
Stock) in which the previously outstanding Common Stock shall be changed into or
exchanged for different securities of the Company or changed into or exchanged
for common stock or other securities of another company or interests in a
noncorporate entity or other property (including cash) or any combination of any
of the foregoing (each such transaction being hereinafter referred to as the
"Transaction," the
3
<PAGE> 4
Company (in the case of a recapitalization of the Common Stock) or such other
company or entity (in each other case) being hereinafter referred to as the
"Acquiring Company," and the common stock (or equivalent equity interests) of
the Acquiring Company being hereinafter referred to as the "Acquirer's Stock"),
then as a condition to the consummation of the Transaction, lawful and adequate
provisions shall be made so that, upon the basis and the terms and in the manner
provided in this Section 2.5, the holder of this Note, upon the conversion
thereof at any time after the consummation of the Transaction, shall be entitled
to receive, in lieu of the Common Stock issuable upon such conversion prior to
such consummation the stock and other securities, cash and property to which the
holder would have been entitled upon the consummation of the Transaction if the
holder had converted this Note immediately prior thereto (subject to adjustments
from and after the date of the consummation of the Transaction (the
"Consummation Date") as nearly equivalent as possible to the adjustments
provided for in Section 2.4 and this Section 2.5).
2.6. Notices of Record Date, Etc. In the event of
(a) any action by the Company which would require an
adjustment to the Conversion Price pursuant to Section 2.4, or
(b) any capital reorganization of the Company, any
reclassification or recapitalization of the Common Stock, any consolidation or
merger involving the Company and any other person, any transfer of all or
substantially all the assets of the Company to any other person or any other
transaction described in Section 2.5 hereof, or
(c) any voluntary or involuntary dissolution, liquidation
or winding-up of the Company,
the Company will mail to the holder of this Note, at least ten (10) days prior
to the date of any action referred to in the notice referred to herein, a notice
specifying (i) the date on which any such record is to be taken for the purpose
of determining the holders of record of Common Stock entitled to receive such
dividend, distribution or right, and the amount and character of such dividend,
distribution or right, and (ii) the date or expected date on which any such
reorganization, reclassification, recapitalization, transfer, consolidation,
merger, dissolution, liquidation, winding-up or other transaction referred to in
Section 2.4 or 2.5 hereof is to take place, and the time, if any such time is to
be fixed, as of which the holders of record of Common Stock shall be entitled or
obligated to exchange their shares of Common Stock for the securities or other
property deliverable upon such reorganization, reclassification,
recapitalization, transfer, consolidation, merger, dissolution, liquidation,
winding-up or other transaction referred to in Section 2.4 or 2.5 hereof. In
addition, promptly after the occurrence of any event which results in an
adjustment of the Conversion Price, the Company shall mail to the holder of this
Note a notice of such adjustment together with a statement setting forth the
computations relating thereto. Failing to give such notice or any default
therein shall not affect the legality or validity of the proceedings described
in Subsection (a), (b) or (c) of this Section 2.6.
2.7. Reservation of Stock, Etc., Issuable on Conversion. The
Company will at all times reserve and keep available, solely for issuance and
delivery upon the conversion of this Note, the number of shares of Common Stock
(or other securities), whether authorized but unissued shares reserved by it
which are free from preemptive rights or issued shares which have been
reacquired by it, from time to time issuable upon the conversion of this Note at
the time outstanding. The Company hereby covenants that all such securities
shall be duly authorized and, when issued upon such conversion, shall be validly
issued and, in the case of shares, fully paid and nonassessable with no
liability on the part of the holders thereof.
4
<PAGE> 5
2.8. Conversion Agent. The Company may, upon ten (10) days
prior written notice to the holder of this Note, appoint a bank or trust company
as agent for the purpose of accepting this Note surrendered for conversion and
issuing Common Stock upon the conversion of this Note pursuant to Section 2.2,
and thereafter (as long as the authority of such agent shall continue in effect)
any such surrender and conversion and issuance shall be made at such office to
and by such agent.
3. Subordination.
3.1. Definition. For purposes of this Section 3.1 the term
"Senior Debt" shall mean any indebtedness for borrowed money, the payment of
which the Company is at the time of determination responsible or liable as
obligor, guarantor or otherwise, other than (a) indebtedness as to which, in the
instrument creating or evidencing the same or pursuant to which the same is
outstanding, it is expressly provided that such indebtedness is junior and
subordinate to other indebtedness and obligations of the Company, (b)
indebtedness which by its terms refers explicitly to this Note and states that
such indebtedness shall not be senior thereto and shall be equally subordinated
and equally junior, and (c) indebtedness of the Company in respect of this Note.
Senior Debt shall continue to be Senior Debt and entitled to the benefits of the
subordination provisions set forth herein irrespective of any amendment,
modification, or waiver of any term of the Senior Debt or extension or renewal
of the Senior Debt.
3.2. Note Subordinate to Senior Debt. The Company, for itself,
its successors and assigns, covenants and agrees, and each holder, by its
acceptance of this Note or any portion hereof, likewise covenants and agrees,
that this Note shall be subordinated and subject, to the extent and in the
manner herein set forth, in right of payment to the prior payment in full of all
Senior Debt. The provisions of this Section 3 are made for the benefit of all
holders of Senior Debt, and any such holder may proceed to enforce such
provisions.
3.3. Other Subordinated Indebtedness. This Note shall rank on
a parity with all other of the Company's Subordinated Convertible Notes.
3.4. Payment Over of Proceeds Upon Dissolution, Etc. No
payment on account of principal of (or premium, if any) or interest on this Note
shall be made, if any default or event of default with respect to any Senior
Debt, which permits or with the giving of notice or passage of time or both
would permit the holders thereof (or a trustee on their behalf) to accelerate
the maturity thereof, shall have occurred and be continuing.
In the event this Note is declared due and payable
before the maturity date hereof, or upon any payment or distribution of assets
of the Company of any kind or character, whether in cash, property or
securities, to creditors upon any dissolution or winding-up or total or partial
liquidation or reorganization of the Company, whether voluntary or involuntary
or in bankruptcy, insolvency, receivership or other proceedings, or upon any
assignment by the Company for the benefit of creditors or any other marshalling
of the assets of the Company, all principal of (and premium, if any) and
interest due or to become due upon all Senior Debt (including any interest
thereon occurring after the commencement of any such proceeding) shall first be
paid in full before the holder of this Note shall be entitled to retain any
assets (other than shares of stock of the Company as reorganized or readjusted
or securities of the Company or any other corporation provided for by a plan of
reorganization or readjustment, the payment of which is subordinated, at least
to the same extent as this Note, to the payment of all Senior Debt which may at
the time be outstanding, provided that the rights of the holders of the Senior
Debt are not altered by such reorganization or readjustment) so paid or
distributed in respect of this Note (for principal, premium, if any, or
interest); and upon such dissolution or winding-up or liquidation or
reorganization or assignment or marshalling of assets, any payment or
distribution of assets of the Company of any kind or character, whether in cash,
property or securities (other than
5
<PAGE> 6
shares of stock of the Company as reorganized or readjusted or securities of the
Company or any other corporation provided for by a plan or reorganization or
readjustment, the payment of which is subordinated, at least to the same extent
as this Note, to the payment of all Senior Debt which may at the time be
outstanding or committed, provided that the rights of the holders of the Senior
Debt are not altered by such reorganization or readjustment), to which the
holders of this Note would be entitled, except for the provisions of this
Section, shall be paid by the Company or by any receiver, trustee in bankruptcy,
liquidating trustee, agent or other person making such payment or distribution,
or by the holders of this Note if received by them or it, directly to the
holders of Senior Debt (pro rata to each such holder as their interests may
appear on the basis of the respective amounts of Senior Debt held by such
holder, including any interest thereon accruing after the commencement of any
such proceedings) or their representatives, to the extent necessary to pay all
Senior Debt in full, after giving effect to any concurrent payment or
distribution to or for the holders of Senior Debt, before any payment or
distribution is made to the holders of this Note.
Should any payment, distribution, security or proceeds
thereof, the receipt of which is prohibited by this Agreement, be received by
the Shareholder prior to the satisfaction of all Senior Debt, the Shareholder
will forthwith deliver the same to the holders of the Senior Debt in precisely
the form received (except for the endorsement or assignment of the Shareholder
where necessary), for application on any indebtedness, due or not due, of the
Company to the Shareholder, and, until so delivered, the same shall be held in
trust by the Shareholder as property of the holders of the Senior Debt. In the
event of the failure of the Shareholder to make any such endorsement or
assignment, the holders of the Senior Debt, or any of their officers or
employees, are hereby irrevocably authorized to make the same.
No holder of Senior Debt shall be prejudiced in his
right to enforce subordination of this Note by any act or failure to act on the
part of the Company.
Subject to the payment in full of all Senior Debt, the
holder of this Note shall be subrogated (equally and ratably with the holders of
all indebtedness of the Company which, by its express terms, ranks on a parity
with this Note and is entitled to like rights of subrogation) to the rights of
the holders of Senior Debt to receive payments or distributions of assets of the
Company applicable to the Senior Debt until this Note shall be paid in full. For
purposes of such subrogation, no payments or distributions on the Senior Debt
pursuant to this Section shall, as between the Company, its creditors other than
the holders of Senior Debt, and the holder of this Note, be deemed to be a
payment by the Company to or on account of the Senior Debt, and no payments or
distributions to the holders of this Note of assets by virtue of the subrogation
herein provided for shall, as between the Company, its creditors other than the
holder of Senior Debt, and the holders of this Note, be deemed to be a payment
to or on account of this Note. The provisions of this Section are and are
intended solely for the purpose of defining the relative rights of the holder of
this Note, on the one hand, and the holders of Senior Debt, on the other hand,
and nothing contained in this Section or in this Note is intended to or shall
impair the obligation of the Company, which is unconditional and absolute, to
pay the principal of (and premium, if any) and interest on this Note as and when
the same shall become due and payable in accordance with its terms, or to affect
the relative rights of the holders of this Note and creditors of the Company
other than the holders of Senior Debt, nor shall anything herein prevent the
holders of this Note from exercising all remedies otherwise permitted by
applicable law upon default under this Note, subject to the rights, if any,
under this Section, of the holders of Senior Debt in respect of cash, property
or securities of the Company otherwise payable or delivered to the holders of
this Note upon the exercise of any such remedy.
Nothing contained in this Section 3.4 shall prevent
conversion of this Note.
6
<PAGE> 7
4. Miscellaneous.
4.1. Governing Law. This Note shall be governed by the laws of
the State of Tennessee.
4.2. Notices. All notices delivered pursuant to the terms
hereof shall be deemed effective upon receipt thereof.
IN WITNESS WHEREOF, the undersigned has caused this Note to be executed
by its duly authorized officer on the date first above written.
SERVICE EXPERTS, INC.
By:
------------------------------
Title:
---------------------------
7
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF SERVICE EXPERTS, INC. FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 6,024
<SECURITIES> 0
<RECEIVABLES> 52,326
<ALLOWANCES> 1,966
<INVENTORY> 25,594
<CURRENT-ASSETS> 98,667
<PP&E> 49,528
<DEPRECIATION> 14,588
<TOTAL-ASSETS> 311,163
<CURRENT-LIABILITIES> 41,269
<BONDS> 73,302
0
0
<COMMON> 171
<OTHER-SE> 194,546
<TOTAL-LIABILITY-AND-EQUITY> 311,163
<SALES> 293,604
<TOTAL-REVENUES> 293,604
<CGS> 188,083
<TOTAL-COSTS> 188,083
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 2,395
<INCOME-PRETAX> 30,304
<INCOME-TAX> 12,141
<INCOME-CONTINUING> 18,163
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 18,163
<EPS-PRIMARY> 1.09
<EPS-DILUTED> 1.07
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF SERVICE EXPERTS, INC. FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 14,681
<SECURITIES> 0
<RECEIVABLES> 29,392
<ALLOWANCES> 1,625
<INVENTORY> 9,833
<CURRENT-ASSETS> 61,693
<PP&E> 31,279
<DEPRECIATION> 8,606
<TOTAL-ASSETS> 170,709
<CURRENT-LIABILITIES> 31,716
<BONDS> 11,974
0
0
<COMMON> 149
<OTHER-SE> 125,733
<TOTAL-LIABILITY-AND-EQUITY> 170,709
<SALES> 174,873
<TOTAL-REVENUES> 174,873
<CGS> 113,513
<TOTAL-COSTS> 113,513
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 595
<INCOME-PRETAX> 18,902
<INCOME-TAX> 6,839
<INCOME-CONTINUING> 12,063
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 12,063
<EPS-PRIMARY> .83
<EPS-DILUTED> .82
</TABLE>
