<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 MARCH 31, 1999
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 MAY 13, 1999
COMMON STOCK, $.01 PAR VALUE 17,474,223
<PAGE> 2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SERVICE EXPERTS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31, MARCH 31,
1998 1999
---- ----
(UNAUDITED)
(IN THOUSANDS)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 8,408 $ 11,702
Accounts receivable:
Trade, net of allowance for doubtful accounts
of $2,050 in 1998 and $2,459 in 1999 50,211 57,971
Related party 312 290
Employee 581 1,001
Other 6,351 4,035
-------- --------
57,455 63,297
Refundable income taxes 2,836 723
Inventories 29,715 33,982
Costs and estimated earnings in excess of billings 5,911 7,244
Prepaid expenses and other current assets 6,558 7,886
Current portion of notes receivable - related parties 14 14
Current portion of notes receivable - other 140 146
Deferred income taxes 4,008 4,057
-------- --------
Total current assets 115,045 129,051
Property, buildings and equipment:
Land 1,904 1,923
Buildings 5,001 5,131
Furniture and fixtures 13,801 15,380
Machinery and equipment 8,150 9,058
Vehicles 23,197 25,924
Leasehold improvements 3,850 4,815
-------- --------
55,903 62,231
Less accumulated depreciation and amortization (17,283) (19,865)
-------- --------
38,620 42,366
Notes receivable - related parties, net of
current portion 324 305
Notes receivable - other, net of current portion 508 511
Goodwill, net of accumulated amortization of
$5,379 in 1998 and $6,497 in 1999 191,016 220,475
Unallocated purchase price 8,738 --
Other assets 2,304 1,901
-------- --------
Total assets $356,555 $394,609
======== ========
</TABLE>
See accompanying notes.
2
<PAGE> 3
<TABLE>
<CAPTION>
DECEMBER 31, MARCH 31,
1998 1999
---- ----
(UNAUDITED)
(IN THOUSANDS;
EXCEPT PER SHARE DATA)
<S> <C> <C>
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Short-term note payable $ 2,418 $ --
Trade accounts payable and accrued liabilities 17,677 18,776
Accrued compensation 5,523 6,452
Accrued warranties 2,847 3,321
Billings in excess of costs and estimated earnings 1,268 1,414
Current portion of long-term debt and capital
lease obligations 2,275 4,819
-------- --------
Total current liabilities 32,008 34,782
Long-term debt and capital lease obligations, net
of current portion 104,479 134,033
Deferred revenue 9,883 11,229
Deferred income taxes 3,682 3,727
Commitments and contingencies (see note 8)
Minority interest 121 121
Stockholders' equity:
Common stock, $.01 par value; 30,000,000
shares authorized, 17,450,664 shares
issued and outstanding at December 31, 1998
and 17,466,901 shares issued and outstanding
at March 31, 1999 175 175
Preferred stock, $.01 par value; 10,000,000 shares
authorized, no shares issued and outstanding -- --
Additional paid-in-capital 163,302 163,247
Deferred compensation (941) (541)
Retained earnings 43,865 47,836
Accumulated other comprehensive income (loss) (19) --
-------- --------
Total stockholders' equity 206,382 210,717
-------- --------
Total liabilities and stockholders' equity $356,555 $394,609
======== ========
</TABLE>
See accompanying notes.
3
<PAGE> 4
SERVICE EXPERTS, INC.
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
1998 1999
---- ----
(UNAUDITED)
(IN THOUSANDS,
EXCEPT PER SHARE DATA)
<S> <C> <C>
Net revenue ............................................................... $ 70,662 $ 116,166
Cost of goods sold ........................................................ 46,145 75,704
----------- -----------
Gross margin .............................................................. 24,517 40,462
Selling, general and administrative expenses .............................. 19,147 32,967
----------- -----------
Income from operations .................................................... 5,370 7,495
Other income (expense):
Interest expense ........................................................ (274) (1,794)
Interest income ......................................................... 100 45
Other income ............................................................ 120 874
----------- -----------
(54) (875)
----------- -----------
Income before income taxes ................................................ 5,316 6,620
Provision for income taxes:
Current ................................................................. 2,174 2,592
Deferred ................................................................ 107 57
----------- -----------
2,281 2,649
----------- -----------
Net income ................................................................ $ 3,035 $ 3,971
=========== ===========
Net income per common share:
Basic ................................................................. $ 0.19 $ 0.23
=========== ===========
Diluted ............................................................... $ 0.19 $ 0.23
=========== ===========
Weighted average shares outstanding:
Basic ................................................................. 16,202 7,463
=========== ===========
Diluted ............................................................... 16,372 17,550
=========== ===========
Pro forma net income data (unaudited), reflecting
Pro forma tax provision on income of a
pooled company previously taxed as a
Subchapter S corporation:
Historical net income applicable to common stock .......................... $ 3,035 $ 3,971
Pro forma adjustment to provision for income taxes ........................ 22 --
----------- -----------
Pro forma net income applicable to Common Stock ........................... $ 3,057 $ 3,971
=========== ===========
Pro forma net income per common share:
Basic ................................................................... $ 0.19 $ 0.23
=========== ===========
Diluted ................................................................. $ 0.19 $ 0.23
=========== ===========
</TABLE>
See accompanying notes.
4
<PAGE> 5
SERVICE EXPERTS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
1998 1999
---- ----
(UNAUDITED)
(IN THOUSANDS)
<S> <C> <C>
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES..................................... $(11,318) $ 2,092
INVESTING ACTIVITIES
Payments on notes receivable............................................................ 44 10
Purchase of property, building and equipment............................................ (2,401) (2,840)
Proceeds from sale of property, buildings and equipment................................. -- 156
Proceeds from sale of investment........................................................ -- 1,594
Cash acquired through acquisitions...................................................... 1,010 2,017
Payment of cash for acquired companies.................................................. (7,142) (22,121)
Decrease in other assets................................................................ (264) (294)
-------- -------
Net cash used in investing activities.......................................... (8,753) (21,478)
-------- -------
FINANCING ACTIVITIES
Decrease in short-term debt............................................................. -- (2,418)
Issuance of stock pursuant to options exercised......................................... -- 304
Net increase in line of credit.......................................................... 30,772 24,794
-------- -------
Net cash provided by financing activities...................................... 30,772 22,680
-------- -------
Increase in cash and cash equivalents................................................... 10,701 3,294
Cash and cash equivalents at beginning of year.......................................... 11,298 8,408
-------- -------
Cash and cash equivalents at end of period.............................................. $ 21,999 $11,702
======== =======
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid........................................................................... $ 274 $ 1,783
======== =======
Income taxes paid....................................................................... $ 224 $ 967
======== =======
</TABLE>
See accompanying notes.
5
<PAGE> 6
SERVICE EXPERTS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE MONTHS ENDED
MARCH 31, 1999 (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 three months ended March 31, 1999 are
not necessarily indicative of the results that may be expected for the year
ended December 31, 1999.
2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The condensed consolidated financial statements of the Company include the
accounts of the Company and its subsidiaries. All intercompany transactions have
been eliminated in consolidation.
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.
NEWLY ISSUED ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 is
required to be adopted by the Company in 2000. Management does not anticipate
that the adoption of SFAS No. 133 will have a significant effect on the
financial position or results of operations of the Company.
3 - MARKETABLE SECURITIES
At December 31, 1998, the Company's investments in marketable equity securities
totaled approximately $994,000. During the three months ended March 31, 1999,
the Company sold the securities for a gain of approximately $619,000.
6
<PAGE> 7
4 - ACQUISITIONS
From January 1, 1999 through March 31, 1999, the Company acquired 31 heating,
ventilating and air conditioning businesses. The following displays pertinent
information regarding acquisitions accounted for under the purchase method:
<TABLE>
<CAPTION>
Service Total Total Total
Centers Companies Shares Cash Convertible Total
Acquired Acquired Issued Consideration Debt Consideration
-------- --------- ------ ------------- -------------- -------------
(in thousands)
1998
<S> <C> <C> <C> <C> <C> <C>
First Quarter......... 10 19 389,000 $ 8,585 $ - $19,243
Second Quarter........ 12 34 593,000 25,077 - 43,504
Third Quarter......... 8 29 222,000 11,710 667 19,314
Fourth Quarter........ 12 23 232,000 11,681 5,497 22,034
1999
First Quarter......... 12 31 -0- 20,620 7,304 27,924
</TABLE>
OTHER INFORMATION REGARDING ACQUISITIONS
All of the foregoing acquisitions were accounted for using the purchase method
of accounting. 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 acquisitions
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 Service Centers, as well as
Service Centers acquired during 1999, 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 federal
and state taxes as certain of the Service Centers 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>
THREE MONTHS
ENDED
MARCH 31,
----------
1998 1999
---- ----
(IN THOUSANDS,
EXCEPT PER
SHARE DATA)
<S> <C> <C>
Net revenue $103,448 $123,223
Net income 4,233 3,911
Net income per common share:
Basic $ 0.24 $ 0.22
Diluted $ 0.24 $ 0.22
</TABLE>
7
<PAGE> 8
5 - NET INCOME PER COMMON SHARE
The following table sets forth the computation of basic and diluted net income
per share:
<TABLE>
<CAPTION>
THREE MONTHS
ENDED
MARCH 31,
---------
1998 1999
---- ----
(IN THOUSANDS,
EXCEPT PER
SHARE DATA)
<S> <C> <C>
Numerator:
Net income $ 3,035 $ 3,971
----------- -----------
Numerator for basic income per share - income available
to common stockholders after assumed conversations 3,035 3,971
----------- -----------
Numerator for diluted income per share - income available
to common stockholders after assumed conversations 3,035 3,971
=========== ===========
Denominator:
Denominator for basic income per share - weighted
Average shares 16,202 17,463
Effect of dilutive securities:
Employee stock options 118 71
Warrants 52 16
----------- -----------
Dilutive potential common shares 170 87
Denominator for diluted income per share - adjusted
Weighted-average shares and assumed conversions 16,372 17,550
=========== ===========
Basic net income per share $ 0.19 $ 0.23
=========== ===========
Diluted net income per share $ 0.19 $ 0.23
=========== ===========
</TABLE>
6 - INCOME TAXES
The income tax provision recorded for the three months ended March 31, 1998 and
1999 differs from the expected income tax provision due primarily to goodwill
amortization, a portion of which is not deductible for federal income tax
purposes, and the provision for state income taxes.
7 - FINANCING ARRANGEMENTS
From January 1, 1999 through March 31, 1999, the Company issued convertible
subordinated notes ("Notes") totaling approximately $7,304,000 as consideration
in certain acquisitions. Principal is payable in four equal annual installments
beginning one year from the date of issuance. Interest at an average rate of
4.85% (ranging from 4.71% to 5.12%) is payable quarterly. The Notes are
convertible, at the option of the holder, into the Company's Common Stock at any
time, at an average conversion price of $18.85 per share (ranging from $14.93 to
$32.15), subject to adjustment in certain events. If the closing sales price of
a share of Common Stock exceeds the conversion price for periods ranging from
five to ten consecutive trading days, the Company may elect to convert the Notes
into shares of Common Stock at the conversion price.
Subsequent to March 31, 1999, the Company entered into a short-term revolving
line of credit with SunTrust Bank, Nashville, N.A. in the maximum amount of $20
million, and bearing interest at a per annum rate equal to the one month LIBOR
plus 75 basis points. This line of credit matures on June 30, 1999.
8
<PAGE> 9
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 an adequate provision for losses has been provided to the extent
necessary.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OVERVIEW
In 1998, the Company acquired 106 HVAC businesses (the "1998 Acquired
Companies"), of which 43 are Service Centers. The consideration paid by the
Company for the 1998 Acquired Companies was approximately $110.1 million,
consisting of approximately 1.8 million shares of Common Stock, $6.2 million in
notes convertible into shares of Common Stock, and approximately $56.3 million
in cash. One of the Acquired Companies was accounted for using the pooling of
interests method and the remainder were accounted for using the purchase method.
Approximately $85.5 million of the consideration paid by the Company was
allocated to intangible assets which are being amortized over a 40-year period.
From January 1, 1999 through March 31, 1999, the Company acquired 31 HVAC
businesses (the "1999 Acquired Companies"), of which 12 are Service Centers. The
consideration paid by the Company for the 1999 Acquired Companies was
approximately $27.9 million, consisting of approximately $7.3 million in notes
convertible into shares of Common Stock and approximately $20.6 million in
cash. Approximately $19.5 million of the consideration paid by the Company was
allocated to intangible assets which are being amortized over a 40-year period.
The 1998 and 1999 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 has been derived primarily from the installation, service and
maintenance of central air conditioners, furnaces and heat pumps in existing
homes and commercial businesses. 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, legal and professional
fees, insurance expense and promotion and advertising expenses.
9
<PAGE> 10
RESULTS OF OPERATIONS
Because of the significant effect and timing of 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 MARCH 31, 1999 COMPARED TO THREE MONTHS ENDED MARCH 31, 1998
Net Revenue. Net revenue increased $45.5 million, or 64.4%, from $70.7
million for the three months ended March 31, 1998 to $116.2 million for the
three months ended March 31, 1999. Approximately $12.8 million of the increase
is attributable to reported revenue from Service Centers for three months in
both periods and spoke acquisitions acquired during these periods, approximately
$2.3 million of the increase is attributable to Service Centers acquired in 1998
reporting results for a full three months in 1999 and approximately $30.4
million of the increase is attributable to the acquisition of new Service
Centers between April 1998 and March 1999.
Cost of Goods Sold. Cost of goods sold increased $29.6 million, or
64.1%, from $46.1 million for the three months ended March 31, 1998 to $75.7
million for the three months ended March 31, 1999. Approximately $20.4 million
of this increase is attributable to the acquisition of new Service Centers
between April 1998 and March 1999. As a percentage of net revenue, cost of goods
sold decreased 0.1% from 65.3% for the three months ended March 31, 1998 to
65.2% for the three months ended March 31, 1999.
Gross Margin. Gross margin increased $16.0 million, or 65.0%, from
$24.5 million for the three months ended March 31, 1998 to $40.5 million for the
three months ended March 31, 1999. Approximately $11.5 million of this increase
is attributable to the acquisition of new Service Centers between April 1998 and
March 1999. As a percentage of net revenue, gross margin increased 0.1% from
34.7% for the three months ended March 31, 1998 to 34.8% for the three months
ended March 31, 1999.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased $13.8 million, or 72.2%, from $19.1 million
for the three months ended March 31, 1998 to $32.9 million for the three months
ended March 31, 1999. As a percentage of net revenue, selling, general and
administrative expenses increased from 27.1% for the three months ended March
31, 1998 to 28.4% for the three months ended March 31, 1999. This increase is
primarily attributable to an increase of approximately $656,000 of goodwill
amortization and an increase of approximately $1.9 million of administrative
overhead.
Income from Operations. Income from operations increased $2.1 million,
or 39.6%, from $5.4 million for the three months ended March 31, 1998 to $7.5
million for the three months ended March 31, 1999. This increase is primarily
attributable to the acquisition of new Service Centers between April 1998 and
March 1999. Income from operations as a percentage of net revenue decreased 1.1%
from 7.6% for the three months ended March 31, 1998 to 6.5% for the three months
ended March 31, 1999.
Other Income (Expense). Other income (expense) increased $821,000, or
1520.4%, from ($54,000) for the three months ended March 31, 1998 to ($875,000)
for the three months ended March 31, 1999. Other expense as a percentage of net
revenue increased from (0.1%) for the three months ended March 31, 1998 to
(0.8%) for the three months ended March 31, 1999. This increase is primarily a
result of approximately $1.5 million of increased interest costs incurred on
debt used to fund acquisitions, offset by a $619,000 gain realized on the sale
of marketable equity securities.
Provision for Income Taxes. The Company's effective tax rate of 40.0%
for the three months ended March 31, 1999 differed from the federal statutory
rate of 35.0% primarily as a result of goodwill amortization, portions of which
are not deductible for federal income tax purposes, and state income taxes. The
effective tax rate of 42.9% for the three months ended March 31, 1998 differed
from the federal statutory rate of 35.0% primarily as a result of goodwill
amortization, portions of which
10
<PAGE> 11
are not deductible for federal income tax purposes, and state income taxes, and
offset by income of a Subchapter S corporation accounted for using the pooling
of interests method which is not subject to federal income tax.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 1999, the Company had working capital of $94.3 million, including
cash and cash equivalents of $11.7 million. The ratio of current assets to
current liabilities was 3.7 to 1.0 at March 31, 1999 and 3.6 to 1.0 at December
31, 1998.
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 and
capital expenditures.
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 HVAC businesses, that
the Company can integrate such new HVAC businesses into the Company's operations
or that the Company's new HVAC businesses will generate sales revenue or profit
margins consistent with those of the Company's existing HVAC businesses.
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 $75.1 million was outstanding at March 31, 1999. At March
31, 1999, $24.9 million was available under the Credit Facility. 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
rates change 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 (i) the
maintenance of certain financial ratios and specified net worth, (ii) the
limitation of (A) the aggregate outstanding principal balance of the Senior
Notes (as defined below) to $75.0 million and (B) the aggregate outstanding
principal balance of any debt issued by the Company directly to sellers of
acquired HVAC businesses to $50.0 million, (iii) the sale of substantial assets,
consolidations or mergers by the Company and (iv) the payment of dividends.
Subsequent to March 31, 1999, the Company entered into a short-term revolving
line of credit with SunTrust Bank, Nashville, N.A. in the maximum amount of
$20.0 million, and bearing interest at a per annum rate equal to the one month
LIBOR plus 75 basis points. This line of credit matures on June 30, 1999.
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 "Senior Notes"), in a private placement to a
group of institutional investors. The Senior 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 Senior
Notes. The Note Purchase Agreement, pursuant to which the Senior Notes were
issued, contains covenants with respect to maintaining 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.
During 1998, the Company issued convertible subordinated notes ("Notes")
totaling approximately $6,164,000 as consideration in certain acquisitions.
Principal is payable in four equal annual installments beginning one year from
the date of issuance. Interest, at an average rate of 4.85% (ranging from 4.51%
to 5.54%), is payable quarterly. The Notes are convertible, at the option of the
holder, into the Company's Common Stock at any time, at an average conversion
price of $36.70 per share (ranging from $31.56 to $42.09), subject to adjustment
in certain events. If
11
<PAGE> 12
the closing sales price of a share of Common Stock exceeds the conversion price
for five consecutive trading days, the Company may elect to convert the Notes
into shares of Common Stock at the conversion price.
From January 1, 1999 through March 31, 1999, the Company issued Notes totaling
approximately $7,304,000 as consideration in certain acquisitions. Principal is
payable in four equal annual installments beginning one year from the date of
issuance. Interest at an average rate of 4.85% (ranging from 4.71% to 5.12%), is
payable quarterly. The Notes are convertible, at the option of the holder, into
the Company's Common Stock at any time, at an average conversion price of $18.85
per share (ranging from $14.93 to $32.15), subject to adjustment in certain
events. If the closing sales price of a share of Common Stock exceeds the
conversion price for periods ranging from five to ten consecutive trading days,
the Company may elect to convert the Notes into shares of Common Stock at the
conversion price.
The conversion of all Notes issued through March 31, 1999 into shares of the
Company's Common Stock would result in the issuance of approximately 563,000
shares of Common Stock. Subsequent to March 31, 1999, the trading price of the
Company's Common Stock has resulted in the Company having the option to convert
$4.8 million of these notes into 291,000 shares of Common Stock. As of May 17,
1999, the Company has not elected to exercise the option to convert any of the
Notes.
For the three months ended March 31, 1999, net cash provided by operations was
$2.1 million compared to cash used in operations of $11.3 million during the
three month period ended March 31, 1998.
For the three months ended March 31, 1999, net cash used in investing activities
totaled $21.5 million as compared to $8.8 million for the three month period
ended March 31, 1998. Cash used by investing activities during the three month
period ended March 31, 1999 is primarily attributed to the approximate $22.1
million of cash used to purchase HVAC businesses.
For the three months ended March 31, 1999, net cash provided by financing
activities was $22.7 million as compared to $30.8 million for the three month
period ended March 31, 1998. Cash provided by financing activities during the
three month period ended March 31, 1999 is primarily attributed to an increase
in borrowing against the Credit Facility.
The Company currently has on file with the Securities and Exchange 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 future 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
convertible into shares of Common Stock in connection with acquisitions.
Management believes that 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. Prior to
September 1998, such acquisitions were predominantly funded by issuing shares of
Common Stock and cash. Since September 1998, the Company has used convertible
subordinated notes and cash to fund its acquisitions. Future acquisitions could
be effected using Common Stock, warrants, 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.
IMPACT OF YEAR 2000
The following disclosure is designated as Year 2000 readiness disclosure for
purposes of the Year 2000 Information and Readiness Disclosure Act.
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 in all Service Centers. The Company's new financial, information and
operational systems have been installed at the SEI Management Company support
center and at 48 locations. Two modules of the Company's new financial system
currently being installed are not Year 2000 compliant. Modifications are being
made on these modules and management expects that these modifications will be
completed by July 1999. The Company is prioritizing the installation of its new
systems at Service
12
<PAGE> 13
Centers which are not Year 2000 compliant to minimize its IT risk. 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. Current systems in place at various Service Centers
that have not installed the Company's new financial, information and operational
systems are being evaluated for Year 2000 compliance, and the assessment efforts
are 98% complete. In certain situations, current systems may need to be upgraded
to Year 2000 compliant versions or replaced with the new financial, information
and operational systems. Management believes that all upgrades and replacements
necessary to ensure Year 2000 readiness of IT systems for currently owned
Service Centers will be 75% complete by September 1999 and 100% complete by
December 1999.
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. The Company is in the process of performing an inventory and assessment
of the embedded systems at the Service Centers and SEI Management Company
support center. The assessment effort is scheduled to be completed by September
1999, and the Company expects to complete any required upgrade or replacement of
Non-IT systems by October 1999. This actual completion date may be affected by
the number of non-Year 2000 ready embedded systems identified during the
assessment. The Company is not able to reasonably estimate the costs to be
incurred for the review and modification of the Company's Non-IT systems as it
has not completed its inventory and assessment.
The Company plans to acquire additional HVAC businesses during the remainder of
1999. Each new HVAC business will be assessed for Year 2000 readiness, and the
Company expects that any required IT or Non-IT systems upgrades or replacements
will be made before January 1, 2000.
Third Party Risk. The Company's review of its third party risk includes detailed
review of material relationships with vendors and certain business partners. To
operate its business, the Company relies upon government agencies, utility
companies, providers of telecommunication services, suppliers and other third
party service providers ("Material Relationships"), over which it can assert
little control. The Company's ability to conduct its core business is dependent
upon the ability of these Material Relationships to fix their Year 2000 issues
to the extent they affect the Company. The Company is monitoring and assessing
the progress of its Material Relationships 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 approximately 70% of its
Material Relationships and is currently awaiting responses from the remainder of
its Material Relationships. The majority of the responses received indicate that
the vendors are Year 2000 compliant. The Company expects to complete its Year
2000 readiness assessment of its Material Relationships by June 1999.
If the steps taken by the Company and its Material Relationships 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, inability to service customers
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. Management believes that the Year 2000 issue
is being appropriately addressed through the implementation of these new systems
and software development or the upgrade of current systems in place and by its
Material Relationships. Management 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.
13
<PAGE> 14
Through March 31, 1999, the Company has incurred approximately $475,000 of
systems and related costs that address Year 2000 compliance plans. The Company
expects to spend an additional $765,000 to complete its Year 2000 compliance
plans. The Company expenses costs associated with Year 2000 system changes as
the costs are incurred.
The costs of Year 2000 compliance and the date on which the Company believes it
will complete the project are based on management's best estimates, which were
derived utilizing numerous assumptions of future events, including the continued
availability of certain resources, third party modification plans and other
factors. However, there can be no guarantee that these estimates will be
achieved and actual results could differ materially from those anticipated.
Specific factors that might cause such material differences include, but are not
limited to, the availability and cost of personnel trained in this area,
supplier compliance and contingency actions and similar uncertainties. The
Company's total Year 2000 project costs do not include the estimated costs and
time associated with anticipated third party Year 2000 issues based on presently
available information.
The Company's Year 2000 contingency plan, although still in development,
addresses recovery solutions for Year 2000 related issues which may be
encountered by the Company. The contingency plan will mitigate the effects
arising from the most likely Year 2000 scenarios, based on current information
available to the Company. These scenarios could include the Company's failure to
complete all of its remediation plans in a timely manner or any third parties'
failure to deliver goods and services essential to the Company's business.
Management expects development of the contingency plan to conclude during the
second quarter.
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 cannot predict its ability to offset or control
future cost increases.
FORWARD LOOKING STATEMENTS
This discussion contains certain forward-looking statements, including those
relating to the acquisition of additional HVAC service and replacement
businesses, each of which is accompanied by specific, cautionary language that
could cause different results than expected by the Company.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
During the three months ended March 31, 1999, the Company sold its investment in
marketable equity securities. There were no other material changes to the
quantitative and qualitative disclosures about market risks presented in the
Company's Annual Report on Form 10-K for the year ended December 31, 1998.
14
<PAGE> 15
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. The subordinated notes are convertible into shares
of the Company's Common Stock at conversion prices ranging from 140% to 200% of
the average market price of the Common Stock for a period ranging from five to
ten trading days preceding the date the note is issued. The Company has issued
convertible subordinated notes and the shares of Common Stock issued upon
conversion of notes, pursuant to the Shelf Registration Statement and 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. In the future, the Company intends to issue convertible subordinated
notes and the shares of Common Stock issued upon conversion primarily pursuant
to the Shelf Registration Statement.
For the three months ended March 31, 1999, the Company issued convertible
subordinated notes bearing interest at rates ranging from 4.83% to 5.12% in an
aggregate principal amount of approximately $2.4 million 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.
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)
27.1 -- Restated Financial Data Schedule for the Three Months Ended
March 31, 1998 (for SEC use only)
27.2 -- Financial Data Schedule for the Three Months Ended March 31,
1999 (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 Annual Report on Form 10-K for the year ended
December 31, 1998, File No. 001-13037.
(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 year ended
December 31, 1997, File No. 001-13037.
15
<PAGE> 16
(b) Reports on Form 8-K.
The Company filed a Current Report on Form 8-K on January 28, 1999 containing
financial statements of Gulf Coast Cooling, Inc., Matz Sheet Metal Works, Inc.
and Right Way Heating and Air Conditioning Service, Inc., Climate Control, Inc.,
Epperson, Inc., and pro forma financial statements pursuant to Item 5 of Form
8-K. The Company filed a Current Report on Form 8-K on February 5, 1999
containing an indenture and related documents in connection with the issuance of
convertible subordinated notes pursuant to Item 5 of Form 8-K. The Company filed
a Current Report on Form 8-K on February 24, 1999 announcing the Company's
earning for the fourth quarter and year ending December 31, 1998 pursuant to
Item 5 of Form 8-K. The Company also filed a Current Report on Form 8-K on March
9, 1999 containing financial statements of Fras-Air Contracting, Inc., Triton
Mechanical, Inc., and Bill's Commercial Air Conditioning, Inc., and pro forma
financial statements pursuant to Item 5 of Form 8-K.
16
<PAGE> 17
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: May 17, 1999
17
<PAGE> 18
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)
27.1 -- Restated Financial Data Schedule for the Three Months Ended
March 31, 1998 (for SEC use only)
27.2 -- Financial Data Schedule for the Three Months Ended March 31,
1999 (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 Annual Report on Form 10-K for the year ended
December 31, 1998, File No. 001-13037.
(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 year ended
December 31, 1997, File No. 001-13037.
18
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF SERVICE EXPERTS, INC. FOR THE THREE MONTHS ENDED MARCH
31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<CASH> 21,999
<SECURITIES> 0
<RECEIVABLES> 36,148
<ALLOWANCES> 1,658
<INVENTORY> 20,669
<CURRENT-ASSETS> 84,353
<PP&E> 40,176
<DEPRECIATION> 12,048
<TOTAL-ASSETS> 239,038
<CURRENT-LIABILITIES> 23,268
<BONDS> 47,665
0
0
<COMMON> 159
<OTHER-SE> 158,838
<TOTAL-LIABILITY-AND-EQUITY> 239,038
<SALES> 0
<TOTAL-REVENUES> 70,662
<CGS> 46,145
<TOTAL-COSTS> 46,145
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 274
<INCOME-PRETAX> 5,316
<INCOME-TAX> 2,281
<INCOME-CONTINUING> 3,035
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,035
<EPS-PRIMARY> .19
<EPS-DILUTED> .19
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF SERVICE EXPERTS, INC. FOR THE THREE MONTHS ENDED MARCH
31, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<CASH> 11,702
<SECURITIES> 0
<RECEIVABLES> 65,756
<ALLOWANCES> 2,459
<INVENTORY> 33,982
<CURRENT-ASSETS> 129,051
<PP&E> 62,231
<DEPRECIATION> 19,865
<TOTAL-ASSETS> 394,609
<CURRENT-LIABILITIES> 34,782
<BONDS> 134,033
0
0
<COMMON> 175
<OTHER-SE> 210,542
<TOTAL-LIABILITY-AND-EQUITY> 394,609
<SALES> 0
<TOTAL-REVENUES> 116,166
<CGS> 75,704
<TOTAL-COSTS> 75,704
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,794
<INCOME-PRETAX> 6,620
<INCOME-TAX> 2,649
<INCOME-CONTINUING> 3,971
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,971
<EPS-PRIMARY> .23
<EPS-DILUTED> .23
</TABLE>
