10-K/A 1 d10ka.txt AMENDMENT TO FORM 10-K FOR PERIOD ENDED 12/31/2001 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ----------------- FORM 10-K/A ----------------- [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2001 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. 1-13565 ENCOMPASS SERVICES CORPORATION (Exact name of registrant as specified in its charter) Texas 76-0535259 (State or other (I.R.S. Employer jurisdiction of Identification Number) incorporation or organization) 3 Greenway Plaza, Suite 2000 Houston, Texas 77046 (Address of principal executive office) 713-860-0100 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Name of each exchange on Title of each class which registered ------------------- ------------------------ Common stock, par value $0.001 New York Stock Exchange Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [_] As of June 28, 2002, (i) there were 64,280,367 shares of common stock, par value $0.001 per share, of the registrant issued and outstanding and (ii) the aggregate market value of the common stock held by non-affiliates of the registrant (based on the closing price per share of the registrant's common stock reported on the New York Stock Exchange on that date) was $35,908,704. For purposes of the above statement only, all directors and executive officers of the registrant are assumed to be affiliates. ================================================================================ TABLE OF CONTENTS PART II Item 6. Selected Financial Data. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation. Item 8. Financial Statements and Supplementary Data. PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. * Items omitted from this Form 10-K/A are included in the Company's Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on March 14, 2002, or in the Company's Form 10-K/A, as filed with the Securities and Exchange Commission on April 30, 2002. Item included in this Form 10-K/A reflect the following changes from the corresponding items included in the Company's Annual Report on Form 10-K, as filed on March 14, 2002. During the three months ended March 31, 2002, the Company sold three business units. In accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which was adopted January 1, 2002, these business units are classified as discontinued operations. Accordingly, the amounts disclosed herein have been restated to classify these business units as discontinued operations and, therefore, to reflect the historical, after-tax results of these operations as "Income (loss) from discontinued operations, net of tax." See Note 17 herein for further discussion. Also, effective January 1, 2002, the registrant adopted the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." The accompanying audited consolidated financial statements include the transitional disclosures required by SFAS No. 142. See Note 18. No other changes to the previously filed consolidated financial statements are included herein. 1 Item 6. Selected Financial Data. Except as discussed below, the following selected financial data have been derived from the audited consolidated financial statements of the Company and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements of the Company and notes thereto, included elsewhere herein. As discussed in Notes 1 and 3 of Notes to Consolidated Financial Statements, the financial results for periods prior to the Merger on February 22, 2000 reflect the historical results of Building One. Per share results for such periods presented below have been adjusted to reflect the 1.25 exchange ratio applied in the Merger. Since Building One was formed in late 1997, the financial data for 1997 presented below reflect only the operating results of three businesses acquired by Building One in 1998 under the pooling-of-interests method of accounting.
For the Years Ended December 31, --------------------------------------------------- 2001 2000 1999 1998 1997 ---------- ---------- ---------- -------- ------- (in thousands, except per share data) INCOME STATEMENT DATA: Revenues............................................ $3,825,268 $3,902,734 $1,731,649 $787,644 $70,101 Gross profit........................................ 603,682 694,684 342,309 167,406 11,244 Selling, general and administrative expenses........ 443,432 431,019 195,215 95,939 11,771 Provision for doubtful accounts..................... 37,258 6,894 766 732 5 Amortization of goodwill and other intangible assets 36,274 32,724 15,620 7,557 -- Other operating costs............................... -- 20,000 8,020 -- -- ---------- ---------- ---------- -------- ------- Operating income (loss)............................. 86,718 204,047 122,688 63,178 (532) Income (loss) from continuing operations............ (14,413) 59,257 51,951 46,219 1,443 Income (loss) before extraordinary loss............. (51,126) 63,353 53,062 46,219 1,443 Net income (loss)................................... (51,126) 55,296 53,062 46,219 1,443 Convertible preferred stock dividends............... (20,612) (16,568) -- -- -- ---------- ---------- ---------- -------- ------- Net income (loss) available to common shareholders.. $ (71,738) $ 38,728 $ 53,062 $ 46,219 $ 1,443 ========== ========== ========== ======== ======= Income (loss) from continuing operations per share: Basic............................................ $ (0.55) $ 0.72 $ 1.25 $ 0.93 $ 0.20 Diluted.......................................... (0.55) 0.70 1.19 0.90 0.20 Net income (loss) per share: Basic............................................ $ (1.12) $ 0.65 $ 1.28 $ 0.93 $ 0.20 Diluted.......................................... (1.12) 0.63 1.21 0.90 0.20 Weighted average shares outstanding: Basic............................................ 63,845 59,234 41,538 49,885 7,104 Diluted.......................................... 63,845 61,089 46,406 51,161 7,332 ADJUSTED DATA TO EXCLUDE AMORTIZATION OF GOODWILL, NET OF TAX EFFECT (a): Income (loss) before extraordinary loss............. $ (17,441) $ 93,919 $ 67,880 Net income (loss)................................... (17,441) 85,862 67,880 Basic earnings (loss) per share..................... $ (0.60) $ 1.17 $ 1.63 Diluted earnings (loss) per share................... (0.60) 1.17 1.53
As of December 31, - ---------------------------------------------------- 2001 2000 1999 1998 1997 ---------- ---------- ---------- ---------- -------- (In thousands) BALANCE SHEET DATA: Cash and cash equivalents......................... $ 20,572 $ 10,094 $ 17,085 $ 213,096 $528,972 Working capital................................... 324,236 491,335 220,431 307,390 528,235 Total assets...................................... 2,401,326 2,697,882 1,313,754 1,043,922 539,159 Total debt........................................ 814,814 967,411 600,178 5,454 3,232 Mandatorily redeemable convertible preferred stock 289,621 269,009 -- -- -- Shareholders' equity.............................. 676,112 763,875 428,757 837,537 529,480
-------- (a) Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," which established new accounting and reporting requirements for goodwill and other intangible assets. See Note 18 to the Consolidated Financial Statements included elsewhere herein for further discussion. 2 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion should be read in conjunction with the consolidated financial statements of Encompass Services Corporation ("Encompass" or the "Company") and notes thereto, included elsewhere herein. This discussion contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the Company's current expectations and involve risks and uncertainties that could cause the Company's actual results to differ materially from those set forth in the forward-looking statements. See "Forward Looking Statements" and "Risk Factors". Introduction Encompass is one of the largest providers of facilities services in the United States. The Company provides electrical and mechanical contracting services and cleaning and maintenance management services to commercial, industrial and residential customers nationwide, including construction, installation and maintenance. On February 22, 2000, the shareholders of GroupMAC and Building One approved the merger of the two companies (the "Merger"). In connection with the Merger, GroupMAC changed its name to Encompass Services Corporation. GroupMAC was the surviving legal entity in the Merger. However, for accounting purposes, Building One was deemed to be the acquiror and, accordingly, the Merger was accounted for as a "reverse acquisition". Under this method of accounting, Encompass' historical results for periods prior to the Merger are the same as Building One's historical results. See Note 3 of Notes to Consolidated Financial Statements for further discussion of the Merger. Encompass operates in three reportable segments: Commercial/Industrial Services, Residential Services and Cleaning Systems. See Note 13 of Notes to Consolidated Financial Statements for a description of each of these reportable segments. Critical Accounting Policies The Company's significant accounting policies are described in Note 2 of Notes to Consolidated Financial Statements. Management believes that the Company's most critical accounting policy is in accounting for long-term construction contracts. Determining the points at which revenue should be recognized as earned and costs should be recognized as expenses is a major accounting issue common to all businesses engaged in the performance of long-term construction contracts. The Company uses the percentage-of-completion accounting method for construction contracts in accordance with the American Institute of Certified Public Accountants Statement of Position 81-1, "Accounting for Performance of Construction-Type and Certain Production-Type Contracts". Each of the Company's business units calculates the percentage-of-completion of each contract by dividing the costs incurred to date by the estimated total contract costs at completion (the "cost-to-cost" method). This percentage is then applied to the estimated total contract value (the total amount of revenue expected to be realized from the contract) in order to calculate the amount of revenue to be recognized to date on each contract. Provisions are recognized in the statement of operations for the full amount of estimated losses on uncompleted contracts whenever evidence indicates that the estimated total cost of a contract exceeds its estimated total contract value. Percentage-of-completion accounting requires considerable reliance on estimates in determining revenues, costs, profit margins and the extent of progress toward completion on a contract-by-contract basis. Uncertainties inherent in the performance of contracts generally include labor availability and productivity, job conditions, material cost, change order scope and pricing, final contract settlements and other factors. These uncertainties are evaluated continually for each contract, and the impact of changes in estimates of total contract costs, total contract value, and other factors are reflected in the consolidated financial statements in the period in which the revisions are determined. 3 Company business units enter into contracts primarily through competitive bids, with the final terms and prices often negotiated with the customer. Although the pricing terms and conditions of contracts vary considerably, most of these contracts are known as "fixed-price" (or "lump-sum") contracts, in which the business unit essentially agrees to perform all acts under the contract for a stated price. Company business units also enter into "cost-plus" contracts (costs incurred plus a stated mark-up percentage or a stated fee) and "time-and-materials" contracts (stated hourly labor rate plus the cost of materials). Fixed-price contracts inherently contain higher risk of loss than the other contract types, but management believes that the Company is generally able to achieve higher gross profit margins on fixed-price contracts as a result of the expertise and experience of its business units in bidding and job performance. No assurance can be given, however, that the Company will not incur significant job losses on contracts in the future. The Company recognizes maintenance, repair and replacement revenues, including cleaning and maintenance management services, as services are performed. Service contract revenue is recognized ratably over the life of the service contract. The Company accounts for revenues from fixed price installation and retrofit contracts on a percentage-of-completion basis using the cost-to-cost method. Cost of services consists primarily of salaries, wages, benefits and insurance of service and installation technicians, project managers and other field support employees; materials, components, parts and supplies; engineered equipment; subcontracted services; depreciation; fuel and other vehicle expenses and equipment rentals. Selling, general and administrative expenses consist primarily of compensation and related benefits for management, administrative salaries and benefits, advertising, office rent and utilities, communications and professional fees. Accounts receivable collectibility represents another significant accounting policy. Company business units grant credit, generally without collateral, to their customers, which primarily include general contractors, property owners and developers, governmental agencies, educational and medical institutions, and commercial and industrial companies in a variety of industries. The Company is subject to potential credit risk related to changes in business and economic factors throughout the United States. However, the Company is entitled to payment for work performed and often has certain lien rights that can be attached to the work performed. Additionally, management continually monitors the financial condition of its customers to reduce risk of loss. The Company provides an allowance for doubtful accounts when future collection is considered doubtful. Historically, receivables collectibility has not been a significant issue in the facilities services industry, particularly with respect to new construction. However, the Company recorded provisions for bad debts totaling $37.3 million from continuing operations during 2001, compared to $6.9 million in 2000. The significant increase is primarily attributable to the collapse of the telecommunications industry discussed below and, to a lesser extent, the general economic downturn which contributed to financial difficulties of certain customers outside the technology sector. Included in the Company's customer base are a number of companies involved in the telecommunications industry, including fiber-optic network companies, wireless phone companies and high-speed Internet providers. During 2001, many companies in the telecommunications sector, including some of the Company's customers, experienced a dramatic reduction in the amount of new capital available to them, upon which certain of them are reliant to successfully achieve their business plans. Consequently, the Company has experienced slower payment from certain customers, several of which have filed for protection under Chapter 11 of the U.S. Bankruptcy Code. During 2001, the Company provided allowances of $27.8 million in continuing operations and $17.7 million in the discontinued Global Technologies operations to reserve certain accounts receivable from customers in the telecommunications industry to management's best estimates of their ultimate collectibility. On September 25, 2001, the Company announced its decision to cease operations of its Global Technologies segment effective September 30, 2001. With the exception of some minor job wrap-up and receivables collection, substantially all of these operations have been terminated as of December 31, 2001. The shutdown of these operations represents the disposal of a business segment under Accounting Principles Board Opinion 4 ("APB") No. 30. Accordingly, the amounts disclosed herein have been restated to reflect the historical, after-tax results of these operations as "Income (loss) from discontinued operations, net of tax". In connection with the decision to discontinue these operations, a charge of $26.5 million, net of the related income tax benefit of $7.8 million, was recorded in 2001 to provide for the estimated costs of disposal of these operations. Such estimated costs of disposal primarily consist of the write-off of non-deductible, unamortized goodwill of $12.0 million, net facility and equipment lease obligations of $12.4 million, net asset writedowns of $3.8 million and estimated net operating losses and severance costs incurred subsequent to September 30, 2001 of $6.1 million. See Note 16 of Notes to Consolidated Financial Statements for further discussion. During the three months ended March 31, 2002, the Company sold three business units for aggregate cash proceeds of $9.6 million. In accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which was adopted effective January 1, 2002, these business units are also classified as discontinued operations. Accordingly, the amounts disclosed herein have been restated to reflect these businesses as discontinued operations. Results of Operations Year ended December 31, 2001 compared to Year ended December 31, 2000 Operating results for the years ended December 31, 2001 and 2000 are summarized as follows (in millions):
Year ended Year ended December 31, 2001 December 31, 2000 ------------------ ------------------ Operating Operating Revenues Income Revenues Income -------- --------- -------- --------- Commercial/Industrial Services..................................... $3,218.4 $ 86.3 $3,362.5 $219.2 Residential Services............................................... 331.2 30.3 287.6 30.3 Cleaning Systems................................................... 293.1 17.7 265.2 16.6 Corporate and other................................................ -- (11.3) -- (9.4) Amortization of goodwill and other intangible assets............... -- (36.3) -- (32.7) Merger and related charges and costs to exit certain activities and related costs.................................................... -- -- -- (20.0) Eliminations....................................................... (17.4) -- (12.6) -- -------- ------ -------- ------ Total.............................................................. $3,825.3 $ 86.7 $3,902.7 $204.0 ======== ====== ======== ======
Segment Results. Commercial/Industrial Services Group revenues decreased 4% to $3,218.4 million in 2001 compared to 2000, despite the inclusion for the full year of the GroupMAC operations acquired in February 2000, primarily as a result of the decline in revenues from the technology and telecommunications sector and the general economic slowdown. Commercial/Industrial Services operating income decreased 61% to $86.3 million in 2001 compared to 2000, primarily as a result of increased pricing pressures on projects as a result of deteriorating economic conditions, a greater than normal level of losses recorded on certain fixed-price projects, reduced levels of work done for customers in the higher margin technology and telecommunications sector, and significant provisions for doubtful accounts largely attributable to telecommunications customers. Residential Services Group revenues increased 15%, reflecting a full year of the GroupMAC operations acquired in the February 2000 Merger. Residential Services operating income remained flat at $30.3 million, reflecting increased price competition in certain new construction markets. Cleaning Systems Group revenues increased 11% to 293.1 million and operating income increased 7% to $17.7 million, primarily as a result of an increased volume of national service contracts. Revenues. Revenues decreased $77.5 million, or 2%, to $3,825.3 million for the year ended December 31, 2001 from $3,902.7 million for the year ended December 31, 2000. The decrease is primarily attributable to 5 decreases in revenues from technology and telecommunications customers in the West and Southwest regions of the Company's Commercial/Industrial Services Group partially offset by the inclusion of a full year of the GroupMAC businesses, which were acquired in the February 22, 2000 Merger, and an 11% increase in Cleaning Systems Group revenues. Gross profit. Gross profit decreased $91.0 million, or 13%, to $603.7 million for the year ended December 31, 2001 from $694.7 million for the year ended December 31, 2000. This decrease in gross profit is primarily due to increased pricing pressures on projects as a result of deteriorating economic conditions, a greater than normal level of losses recorded on certain fixed-price projects and reduced levels of work done for customers in the higher margin technology and telecommunications sectors. Gross profit margin decreased to 15.8% for the year ended December 31, 2001 compared to 17.8% for the year ended December 31, 2000. This decline is primarily attributable to the lower volume of technology projects in 2001 which tend to be higher margin, increased price competition as a result of general economic weakness, and the increased job losses on fixed-price projects mentioned above. Selling, general and administrative expenses. Selling, general and administrative expenses increased $12.4 million, or 3%, to $443.4 million for the year ended December 31, 2001 from $431.0 million for the year ended December 31, 2000. The increase in these expenses is primarily attributable to the inclusion of the GroupMAC operations for a full year of activity, partially offset by integration-related cost savings. As a percentage of revenues, selling, general and administrative expenses increased to 11.6% for the year ended December 31, 2001 from 11.0% for the year ended December 31, 2000. This increased percentage is primarily the result of increased costs to support the Company's branding, cross selling, training and internal growth initiatives, partially offset by integration-related cost savings. Provision for doubtful accounts. Provision for doubtful accounts increased $30.4 million to $37.3 million for the year ended December 31, 2001 from $6.9 million for the year ended December 31, 2000. This increase is primarily attributable to $27.8 million in charges recorded in 2001 to reserve certain accounts receivable from customers in the telecommunications industry to management's best estimates of their ultimate collectibility. Amortization of goodwill and other intangible assets. Amortization of goodwill and other intangible assets for the year ended December 31, 2001 increased $3.6 million, or 11%, to $36.3 million from $32.7 million for the year ended December 31, 2000. This increase primarily relates to the GroupMAC businesses that were acquired in the Merger and the impact of payments under contingent consideration agreements relating to previously acquired companies. Merger and related charges. In connection with the Merger, the Company recorded $7.8 million of costs and expenses related to severance and office closing costs in the first quarter of 2000. These costs relate to the closing of Building One's corporate headquarters in Minneapolis, Minnesota and the resulting consolidation with the GroupMAC corporate office in Houston, Texas. These costs are more fully described in Note 3 in the Notes to Consolidated Financial Statements included herein. Costs to exit certain activities and related costs. In the first quarter of 2000, the Company recorded $12.2 million of costs and expenses related to the shutdown of certain operations, the reorganization of other operations and other costs resulting from the Merger. These costs are more fully described in Note 3 in the Notes to Consolidated Financial Statements included herein. Other income (expense). Other income (expense) primarily includes net interest expense of $83.3 million for the year ended December 31, 2001, reflecting a $3.9 million decrease from the year ended December 31, 2000. Average debt balances outstanding were higher during 2001 as compared to 2000 due primarily to debt incurred in connection with the Merger in February 2000. Despite the higher average debt balance, net interest expense was lower as a result of lower prevailing interest rates during the year ended December 31, 2001 as compared to 2000. 6 Income tax provision. As a result of lower earnings before taxes, the income tax provision decreased $41.0 million to $16.0 million for the year ended December 31, 2001 from $57.0 million for the year ended December 31, 2000. The effective tax rate exceeds the statutory rate due primarily to non-deductible goodwill amortization. See Note 6 of Notes to Consolidated Financial Statements included herein. Income (loss) from discontinued operations, net of tax. The Company recorded a net loss from the discontinued Global Technologies segment and three businesses sold in 2002 of $10.2 million for the year ended December 31, 2001 compared to income from discontinued operations, net of tax, of $4.1 million for the prior year period. The loss in the year ended December 31, 2001 is due primarily to charges totaling approximately $14.0 million to reserve certain accounts receivable from customers in the telecommunications industry to management's best estimates of their ultimate collectibility and to lower volumes of work with customers in the technology and telecommunications sectors as projects were delayed or canceled due to the inability of many customers to access capital required to fund such projects. Loss on disposal of discontinued operations, net of tax. The loss on disposal of the discontinued Global Technologies segment of $26.5 million, net of related income tax benefit of $7.8 million, primarily consists of the write-off of non-deductible, unamortized goodwill of $12.0 million, net facility and equipment lease obligations of $12.4 million, net asset writedowns of $3.8 million and estimated net operating losses and severance costs incurred subsequent to September 30, 2001 of $6.1 million. Extraordinary loss, net. The net of tax extraordinary loss of $8.1 million for the year ended December 31, 2000 relates to the write-off of deferred debt issuance costs associated with Building One's revolving credit facility, term credit facility and junior subordinated notes that were repaid in connection with the Merger. Year ended December 31, 2000 compared to Year ended December 31, 1999 Operating results for the years ended December 31, 2000 and 1999 are summarized as follows (in millions):
Year ended Year ended December 31, 2000 December 31, 1999 ------------------ ------------------ Operating Operating Revenues Income Revenues Income -------- --------- -------- --------- Commercial/Industrial Services..................................... $3,362.5 $219.2 $1,491.8 $132.9 Residential Services............................................... 287.6 30.3 -- -- Cleaning Systems................................................... 265.2 16.6 245.8 18.6 Corporate and other................................................ -- (9.4) -- (5.2) Amortization of goodwill and other intangibles assets.............. -- (32.7) -- (15.6) Merger and related charges and costs to exit certain activities and related costs.................................................... -- (20.0) -- -- Restructuring and recapitalization charges......................... -- -- -- (8.0) Eliminations....................................................... (12.6) -- (6.0) -- -------- ------ -------- ------ Total.............................................................. $3,902.7 $204.0 $1,731.6 $122.7 ======== ====== ======== ======
Segment Results. Commercial/Industrial Services Group revenues increased 125% to $3,362.5 million in 2000 compared to 1999, primarily as a result of the inclusion of the GroupMAC businesses that were acquired in the Merger. For the same reason, Commercial/Industrial operating income increased 65% to $219.2 million in 2000 compared to 1999. All of the Residential Services Group was acquired from GroupMAC. Cleaning Systems Group revenues increased 8% to $265.2 million as a result of increased volume of regional and national service contracts. Operating income in the Cleaning Systems Group declined $2.0 million to $16.6 million, primarily as a result of increased bad debts and costs incurred to relocate the group headquarters in 2000. 7 Revenues. Revenues increased $2,171.1 million, or 125%, to $3,902.7 million for the year ended December 31, 2000 from $1,731.6 million for the year ended December 31, 1999. This increase in revenues is attributable to the following: . $1,712.9 million relates to the GroupMAC businesses that were acquired in the Merger. . $137.5 million relates to the incremental revenues contributed in the year ended December 31, 2000 by Commercial/Industrial Services Group companies acquired during or subsequent to the year ended December 31, 1999. . $301.3 million relates to internal growth in the Commercial/Industrial Services Group. This increase primarily relates to volume increases in the Midwest, California, Arizona, Colorado and Texas markets. . $19.4 million relates to internal growth in the Cleaning Systems Group. Gross profit. Gross profit increased $352.4 million, or 103%, to $694.7 million for the year ended December 31, 2000 from $342.3 million for the year ended December 31, 1999. This increase in gross profit is attributable to the following: . $323.7 million relates to the GroupMAC businesses that were acquired in the Merger. . $34.8 million relates to the incremental gross profit contributed in the year ended December 31, 2000 by Commercial/Industrial Services Group companies acquired during or subsequent to the year ended December 31, 1999. . Partially offsetting the above increases was a $6.1 million decrease in same store results related primarily to the negative impact of job contract losses in the California operations of the Commercial/Industrial Services Group and economic softness in the Southeastern United States. Gross profit margin decreased to 17.8% for the year ended December 31, 2000 compared to 19.8% for the year ended December 31, 1999. This decline primarily resulted from the decreased profitability of 11 eliminated business units and from a local management focus on achieving targeted growth levels that drove significant revenue growth at the expense of margin preservation. In addition, management believes that, during the first half of 2000, issues related to the Merger caused a significant amount of distraction among the operating leadership of the Company. In addition, the Merger resulted in a higher proportion of revenues for the year ended December 31, 2000 from mechanical and industrial business units, which traditionally have lower gross margins than electrical business units. Selling, general and administrative expenses. Selling, general and administrative expenses increased $235.8 million, or 121%, to $431.0 million for the year ended December 31, 2000 from $195.2 million for the year ended December 31, 1999. This increase in these expenses is attributable to the following: . $207.6 million relates to the GroupMAC businesses that were acquired in the Merger. . $18.2 million relates to the incremental selling, general and administrative expense incurred in the year ended December 31, 2000 by Commercial/Industrial Services Group companies acquired during or subsequent to the year ended December 31, 1999. . $10.0 million relates to internal growth in the Commercial/Industrial Services Group and Cleaning Systems Group. This increase primarily relates to supporting the revenue growth in the Texas, California, Arizona and Colorado markets. As a percentage of revenues, selling, general and administrative expenses decreased to 11.0% for the year ended December 31, 2000 from 11.3% for the year ended December 31, 1999. This decrease is a result of leveraging corporate, regional and operating unit overhead over a larger revenue base. Provision for doubtful accounts. Provision for doubtful accounts increased $6.1 million to $6.9 million for the year ended December 31, 2000 from $0.8 million for the year ended December 31, 1999. This increase is 8 attributable to an increase of $2.6 million related to GroupMAC companies that were acquired in the Merger and same store increases due to higher revenues. Amortization of goodwill and other intangible assets. Amortization of goodwill and other intangible assets for the year ended December 31, 2000 increased $17.1 million, or 110%, to $32.7 million from $15.6 million for the year ended December 31, 1999. This increase primarily relates to (i) the GroupMAC businesses that were acquired in the Merger and (ii) the companies acquired during or subsequent to the year ended December 31, 1999. Merger and related charges. In connection with the Merger, the Company recorded $7.8 million of costs and expenses related to severance and office closing costs. These costs relate to the closing of Building One's corporate headquarters in Minneapolis, Minnesota and the resulting consolidation with the GroupMAC corporate office in Houston, Texas. These costs are more fully described in Note 3 in the Notes to Consolidated Financial Statements included herein. Costs to exit certain activities and related costs. In the first quarter of 2000, the Company recorded $12.2 million of costs and expenses related to the shutdown of certain operations, the reorganization of other operations and other costs resulting from the Merger. These costs are more fully described in Note 3 in the Notes to Consolidated Financial Statements included herein. Restructuring and recapitalization charges. Restructuring and recapitalization charges were $8.0 million for the year ended December 31, 1999. These charges included $2.8 million relating to compensation expense for stock options exercised and the underlying shares of common stock repurchased in Building One's recapitalization plan during 1999, and $5.2 million of restructuring charges pertaining to the relocation of Building One's then existing corporate headquarters and integration of the cleaning systems operations. These costs are more fully described in Note 12 in the Notes to Consolidated Financial Statements included herein. Other income (expense). Other income (expense) primarily includes net interest expense of $87.3 million for the year ended December 31, 2000, compared to $29.9 million for the year ended December 31, 1999. This change is primarily the result of increased borrowings related to the Merger and other acquisitions. Income tax provision. The income tax provision increased $15.9 million to $57.0 million for the year ended December 31, 2000 from $41.1 million for the year ended December 31, 1999. This increase primarily relates to the increased pretax earnings. The increase in the effective tax rate from 44.2% in 1999 to 49.0% in 2000 results primarily from higher non-deductible goodwill amortization as a proportion of pre-tax income. Income from discontinued operations, net of tax. The Company recorded income from discontinued operations totaling $4.1 million, net of tax, in 2000 compared to $1.1 million in 1999. See Notes 16 and 17 in the Notes to Consolidated Financial Statements included herein for further discussion. Extraordinary loss, net. The net of tax extraordinary loss of $8.1 million for the year ended December 31, 2000 relates to the write-off of deferred debt issuance costs associated with Building One's revolving credit facility, term credit facility and junior subordinated notes that were repaid in connection with the Merger. Liquidity and Capital Resources The Company finances its operations and growth from internally generated funds and borrowings from commercial banks or other lenders. Management anticipates that the Company's cash flow from operations and borrowing capacity under its bank credit facilities, as amended effective as of June 26, 2002, will be adequate for the Company to fund its normal working capital needs, debt service requirements and planned capital expenditures for 2002. As of December 31, 2001, the Company had a $700 million Credit Facility, consisting of approximately $400 million in Term Loans and a $300 million Revolving Credit Facility, increasing to $350 million once certain debt leverage ratios are achieved. Effective as of June 26, 2002, the Company amended the Credit Facility (as amended, the "Amended Facility"). The Amended Facility consists of approximately $400 million in Term Loans and a $300 million Revolving Credit Facility, temporarily limited to $250 million until the funding of the Apollo investment discussed below. 9 Under the Amended Facility, the Company is required to maintain compliance with the following financial covenants, measured as of the end of each fiscal quarter: (1) a minimum Fixed Charge Coverage Ratio (as defined); (2) a maximum ratio of senior debt to pro forma EBITDA (as defined); (3) a maximum ratio of Funded Debt (as defined) to pro forma EBITDA (as defined); (4) a minimum amount of Consolidated Net Worth (as defined); and (5) a maximum amount of capital expenditures. In addition, the Amended Facility restricts the Company's ability to make acquisitions, pay dividends, capital expenditures and investments and requires debt prepayment with future asset sales, issuances of debt or equity, and excess cash flow (as defined in the Amended Facility). On June 27, 2002, the Company entered into a Securities Purchase Agreement with affiliates of Apollo, whereby Apollo agreed to purchase $35.0 million of equity securities of the Company (the "Apollo Investment"). In connection therewith, the Company plans to enter into a rights offering whereby holders of common stock, certain options and warrants, and the Convertible Preferred Stock will receive rights to purchase up to $50.0 million of Company equity securities, including the Apollo Investment. If the rights offering is fully subscribed, the total amount raised, including the Apollo Investment, will be $72.5 million. Pursuant to the Amended Facility, proceeds from the $35.0 million Apollo Investment, net of up to $4.0 million of certain permitted expenses, are required to be applied against the terms loans, and 50 percent of the proceeds received from the rights offering in excess of the Apollo Investment, net of certain permitted expenses, will be applied toward permanent reduction of the revolving credit facility and the term loans under the Amended Facility, on a pro rata basis. In the event the Apollo Investment is not received by October 15, 2002, the Company will be in immediate default under the Amended Facility. For the years ended December 31, 2001, 2000 and 1999, the Company generated $231.4 million, generated $49.6 million and used $3.5 million of cash from operating activities, respectively. Operating cash flow before changes in working capital and other operating accounts for the year ended December 31, 2001 totaled $104.0 million compared to $139.5 million for the year ended December 31, 2000 and $85.7 million for the year ended December 31, 1999. The decrease in 2001 compared to 2000 is primarily the result of lower profitability levels in 2001. Net changes in working capital and other operating accounts generated $127.4 million in 2001, primarily as a result of management focus on working capital management and a general business slowdown. Changes in operating accounts utilized $89.9 million for the year ended December 31, 2000 and $89.2 million in 1999, primarily to support the growth in the Company's operations in all its business segments. For the year ended December 31, 2001, the Company used $53.1 million of cash in investing activities compared to $98.9 million for the year ended December 31, 2000 and $188.0 million for the year ended December 31, 1999. This decrease is primarily the result of a reduction in cash paid for acquisitions, which primarily consisted of payments of earned contingent consideration related to businesses acquired in prior years. Capital expenditures in 2001 totaled $41.6 million, compared to $42.1 million in 2000 and $27.3 million in 1999. Capital expenditures in 2001 primarily consisted of the expansion of facilities in certain markets and the investment in information systems to support the Company's integration and growth initiatives. The Company used $167.0 million of cash for financing activities in 2001, primarily representing the repayment of amounts borrowed under the Company's Revolving Credit Facility. In the aggregate, the Company repaid $153.3 million of indebtedness during 2001. Financing activities provided cash of $35.2 million for the year ended December 31, 2000 and used cash of $6.1 million in 1999. Borrowings under the Amended Facility bear interest at variable rates, ranging from 2.0% to 4.25% over the Eurodollar Rate (as defined in the Amended Facility) and from 0.50% to 2.75% over the Alternate Base Rate (as defined in the Amended Facility), depending, in each case, on the Company's total debt-to-EBITDA ratio. The Company has entered into interest rate swap agreements, in the aggregate notional amount of $110 million as of December 31, 2001, to manage its mix of fixed and floating rate debt to partially hedge its exposure to potential fluctuations in interest rates. All such agreements are with large creditworthy financial institutions 10 and result in the Company paying a fixed rate of interest and receiving a floating rate. At December 31, 2001, the Company's ratio of fixed rate debt to total debt was 41% and the weighted average interest rate on its total debt was 8.64%, before considering the aforementioned interest rate swap agreements. After giving effect to the interest rate swap agreements in effect at December 31, 2001, the ratio of fixed rate debt was 52% and the weighted average interest rate on its total debt was 9.19%. In April 1999 and June 2001, the Company completed private offerings of $200 million and $135 million, respectively, of 10 1/2% senior subordinated notes (the "Senior Subordinated Notes"). The Senior Subordinated Notes are unsecured and guaranteed by the Company's subsidiaries, require interest to be paid semi-annually on May 1 and November 1 of each year and mature on May 1, 2009. The Company may redeem the Senior Subordinated Notes, in whole or in part, at any time on or after May 1, 2004 at specified redemption prices, plus accrued interest. At any time (which may be more than once) before May 1, 2002, the Company may redeem up to 35% of the outstanding Senior Subordinated Notes with money raised in equity offerings under certain circumstances. Upon a change of control of the Company (as defined in the indenture for the Senior Subordinated Notes), the Company will be required to offer to purchase all of the outstanding Senior Subordinated Notes at 101% of the face amount plus accrued interest. Additionally, the indenture governing the Senior Subordinated Notes contains certain covenants that restrict, among other things, the Company's ability to incur indebtedness, pay dividends or repurchase capital stock, incur liens, sell or otherwise dispose of a substantial portion of assets or merge or consolidate with another entity. Concurrent with the closing of the Merger, affiliates of Apollo exchanged approximately $106 million of Building One convertible junior subordinated debentures and $150 million of cash for 256,191 shares of the Company's Convertible Preferred Stock. The Convertible Preferred Stock, if not otherwise converted, is redeemable in 2012, and is entitled to receive an annual dividend of 7.25% payable quarterly. Under the terms of the Convertible Preferred Stock agreement, until February 22, 2003, dividends on the Convertible Preferred Stock may be paid in cash on a current basis or accumulated, at the option of the Company. However, the Amended Facility prohibits the payment of cash dividends. As a result, beginning in April 2003, the Convertible Preferred Stock will accrue dividends at an annual rate of 9.25%. However, such event does not trigger a right of acceleration of the Company's redemption obligation. The Convertible Preferred Stock is convertible into shares of the Company's common stock at any time by the holders at a conversion price of $14 per common share, subject to adjustment under certain circumstances. Pursuant to the Statement of Designation related to the Convertible Preferred Stock and the Investors' Rights Agreement between Apollo and the Company, Apollo currently has appointed three members of the Company's Board of Directors. Under the Investors' Rights Agreement, the Company is required to maintain a total debt leverage ratio (total debt to EBITDA, as defined) of 4.00 to 1. This debt leverage covenant differs from the similar covenant included in the Credit Facility and is not as clearly defined. The Company believes that it did not maintain a leverage ratio less than 4.00 to 1 during the second quarter of 2002. If such event is deemed both material and intentional, and so long as the requirements of the covenant are not met, Apollo would be entitled to appoint additional directors to the Company's Board of Directors, such that the Apollo-appointed directors would constitute a majority of the Board of Directors. Not meeting the total debt leverage covenant does not trigger a right of acceleration of the Company's obligations under any of its debt or outstanding participating preferred stock instruments. On May 11, 1999, Building One completed its recapitalization plan under a tender offer, pursuant to which Building One repurchased approximately 30.8 million shares of its common stock and 1.1 million shares of common stock underlying stock options for $564.4 million, including related expenses. This tender offer was primarily funded with proceeds from long-term debt borrowings. Other Contractual Obligations and Commercial Commitments As is common in the facilities services industry, the Company enters into certain off-balance sheet arrangements in the ordinary course of business, including non-cancelable operating leases, letters of credit and surety guarantees. The Company does not own any "special purpose" financing subsidiaries. 11 The Company enters into operating leases for many of its facility, vehicle and equipment needs. Such lease arrangements enable the Company to conserve cash by paying monthly lease rental fees for the applicable assets rather than purchasing them. At the end of the lease period, the Company has no further obligation to the lessor. If the Company decides to cancel or terminate a lease prior to the end of its term, the Company is typically obligated to pay the remaining lease payments over the term of the lease, and in certain cases may be allowed to sublet the asset to another party. The Company is occasionally required to post letters of credit generally issued by a bank as collateral under certain insurance programs or to ensure performance under contracts. A letter of credit commits the issuer to remit specified amounts to the holder, if the holder demonstrates that the Company has failed to meet its obligations under the letter of credit. If this were to occur, the Company would be obligated to reimburse the issuer for any payments the issuer was required to remit to the holder of the letter of credit. Generally, a letter of credit is released when the Company has performed the obligations that the letter of credit is securing. To date, the Company has not had a claim made against a letter of credit that resulted in a payment made by an issuer or the Company to the holder. The Company believes that it is unlikely that it will have to fund claims made under letters of credit in the foreseeable future. Particularly in connection with larger construction contracts, the Company is often required to post bid or performance bonds issued by a financial institution known as a surety. Such bonds provide a guarantee to the customer that the Company will perform under the terms of the contract and be able to pay its subcontractors and vendors. If the Company were to fail to perform its obligations under the contract, the customer would have the right to demand payment or services from the surety under the bond. The Company would then be obligated to reimburse the surety for any expenses or outlays that it incurred in the matter. The Company believes that it is unlikely that it will be required to fund any material surety claims in the foreseeable future. At December 31, 2001, the Company's contractual obligations are summarized as follows (in thousands):
Less than one year 2003 2004 2005 2006 Thereafter Total --------- ------- ------- -------- -------- ---------- ---------- Debt obligations.................. $ 4,551 $ 5,613 $ 6,500 $ 94,000 $283,000 $428,250 $ 821,914 Convertible Preferred Stock....... -- -- -- -- -- 292,799 292,799 Operating leases.................. 42,633 38,664 31,992 25,582 16,928 74,422 230,221 ------- ------- ------- -------- -------- -------- ---------- Total contractual cash obligations $47,184 $44,277 $38,492 $119,582 $299,928 $795,471 $1,344,934 ======= ======= ======= ======== ======== ======== ==========
In addition, the Company's other commercial commitments as of December 31, 2001 expire as follows (in thousands):
Less than one year 2003 2004 2005 2006 Thereafter Total --------- -------- ------- -------- -------- ---------- ---------- Letters of credit $ 1,083 $ 374 $ -- $ -- $ -- $ -- $ 1,457 ======= ======== ======= ======== ======== ======== ==========
Seasonality and Cyclicality A significant portion of the Company's business involves installation of mechanical and electrical systems in newly constructed commercial, industrial and residential facilities. The portion of the Company's business related to new construction is subject to seasonal fluctuations. Specifically, the demand for the Company's contracting services involving new construction is generally lower during the winter months, when construction activities are reduced as a result of inclement weather in many areas of the United States. In addition, the demand for mechanical maintenance, repair and replacement services tends to also be lower in the winter months due to lower air conditioning usage during these months. Accordingly, the Company expects its revenues and operating results generally will be lowest in the first fiscal quarter of the year. Historically, the construction industry has also been highly cyclical. The level of new construction in the commercial and industrial sectors is affected by, among other things, local and national economic conditions, 12 interest rates, inflationary concerns, levels of corporate and government capital spending, capital market activities and governmental activities at the regional and national levels. Factors impacting the level of new residential construction tend to be regional in nature, and include general employment and personal income levels, the availability and cost of financing for new home buyers and the general economic outlook for a given geographic region. The Company performs contracting services related to new construction in a variety of industries including, among others, automotive, heavy industrial, commercial real estate development, residential housing, retail, health care, education, government/institutional, petrochemical refining, data and telecommunications, and sports and entertainment. Consequently, management believes that a temporary slowdown in new construction related to any one of these industries would not likely have a material impact on the Company's financial condition. However, concurrent downturns in new construction in multiple industries or geographic regions, or prolonged slowdowns in specific industries or geographic regions, could have a material adverse impact on the Company's business, including its financial condition, results of operations and liquidity. Inflation Inflation did not have a significant effect on the results of operations for the years ended December 31, 2001, 2000 and 1999. New Accounting Pronouncements In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, and specifies criteria for recording intangible assets other than goodwill in business combinations, noting that values allocated to dedicated workforce may not be reported separately from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives will no longer be amortized to expense, but instead will be tested for impairment at least annually. Intangible assets with definite useful lives will continue to be amortized to expense. The Company adopted the provisions of SFAS No. 141 in July 2001 and the provisions of SFAS No. 142 effective January 1, 2002. At January 1, 2002, net goodwill balances attributable to each of the Company's reporting units were tested for impairment by comparing the fair value of each reporting unit to its carrying value. Based upon these impairment tests, the Company recognized a charge of $451.9 million, or $7.06 per share, net of tax benefit of $48.2 million, at January 1, 2002, which is shown as a cumulative effect of a change in accounting principle in the 2002 consolidated statement of operations. This non-cash impairment charge has no impact on the calculation of financial covenants under the Company's debt agreements. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supersedes both SFAS No. 121 and the accounting and reporting provisions of APB No. 30, for the disposal of a business. SFAS No. 144 provides a single accounting model for long-lived assets to be disposed of. Although retaining many of the fundamental recognition and measurement provisions of SFAS No. 121, the new rules change the criteria to be met to classify an asset as held-for-sale. The new rules also broaden the criteria regarding classification of a discontinued operation. The Company adopted the provisions of SFAS No. 144 effective January 1, 2002. During the three months ended March 31, 2002, the Company sold three business units that are classified as discontinued operations in accordance with SFAS No. 144. Accordingly, the amounts disclosed herein have been restated to reflect these businesses as discontinued operations. Risk Factors The Company has a significant amount of debt in relation to its current level of operating income, which could limit the Company's flexibility with respect to obtaining additional financing in the future to fund working capital growth, debt service requirements or other purposes. This level of debt also increases the Company's vulnerability to further adverse economic and industry conditions and higher interest rates, and may place the Company at a competitive disadvantage compared to competitors with less relative indebtedness. The Company's ability to satisfy its debt obligations and other cash needs will depend on, among other things, the Company's future operating performance and its ability to refinance or exchange debt when 13 necessary. Each of these factors is, to a large extent, dependent on economic, capital market, competitive and other factors beyond the Company's control. The Company's future operating results are difficult to project and may be affected by a number of factors, including general economic conditions, the level of new construction of commercial and industrial facilities, commercial demand for replacement of electrical, HVAC and plumbing systems, new housing starts, the availability of qualified labor and project management personnel and other factors in areas in which the Company operates. Particularly in connection with larger construction contracts, the Company is often required to post bid or performance bonds issued by a financial institution known as a surety. The surety industry has become an unsettled and volatile market in recent months, in the aftermath of certain notable corporate bankruptcies with significant surety exposure, other recent loss exposures and other factors. Collectively, these events have caused certain reinsurers and sureties to reevaluate their committed levels of underwriting and required returns. The ultimate impact of these developments, if any, on the surety market in general, or the Company specifically, cannot be determined at this time. Historically, as needed in the normal course of operations, the Company has been able to secure bid and performance bonds from its two current surety sources. The Company continues to seek opportunities to expand it surety relationships. However, given the uncertainty in the current surety market, there can be no assurance that the Company's available bonding capacity will be sufficient to satisfy its future bonding requirements. The Company has grown substantially by acquiring other companies in its industry. The Company's future success depends in part on its ability to integrate the businesses it has acquired and any future businesses it might acquire into one enterprise with a common operating plan. Most of these acquired businesses have recently changed or, in certain cases, are in the process of changing their past operating processes and systems, such as accounting, employment, purchasing, sales, estimating and project management. There can be no assurance that the Company will be able to successfully complete the integration of these businesses. As the holder of the Company's Convertible Preferred Stock and with the pending Apollo Investment, Apollo is able to exert significant influence over the election of the Company's directors and matters submitted to shareholders, as well as over the Company's business operations. So long as Apollo beneficially owns at least 25% of the Company's common stock underlying the Convertible Preferred Stock, Apollo has the right to purchase for cash any common stock equivalent that the Company offers in a private placement and the right to preclude the Company from entering into various types of transactions or making certain changes in capital structure or management without Apollo's consent. Pursuant to the Statement of Designation related to the Convertible Preferred Stock and the Investors' Rights Agreement between Apollo and the Company, Apollo currently has appointed three members of the Company's Board of Directors. Under the Investors' Rights Agreement, the Company is required to maintain a total debt leverage ratio (total debt to EBITDA, as defined) of 4.00 to 1. This debt leverage covenant differs from the similar covenant included in the Credit Facility and is not as clearly defined. The Company believes that it did not maintain a leverage ratio less than 4.00 to 1 during the second quarter of 2002. If such event is deemed both material and intentional, and so long as the requirements of the covenant are not met, Apollo would be entitled to appoint additional directors to the Company's Board of Directors, such that the Apollo-appointed directors would constitute a majority of the Board of Directors. Not meeting the total debt leverage covenant does not trigger a right of acceleration of the Company's obligations under any of its debt or outstanding participating preferred stock instruments. Because of these and other factors, past financial performance should not necessarily be considered an indicator of future performance. Investors should not rely solely on historical trends to anticipate future results and should be aware that the trading price of the Company's common stock may be subject to wide fluctuations in response to quarterly variations in operating results, general conditions in the construction industry, analyst recommendations and earnings estimates, or other events. 14 Forward Looking Statements This Annual Report may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the Company's current expectations and involve risks and uncertainties that could cause the Company's actual results to differ materially from those set forth in the statements. The Company can give no assurance that such expectations will prove to be correct. Factors that could cause the Company's results to differ materially from current expectations include: the level of demand for its services by multi-site customers; the level of interest rates, which affects demand for the Company's services and its interest expense; the potential impact of any acquisition, disposition, merger, joint venture or any other significant financial transactions that could occur in the future; working capital requirements; and general economic conditions; as well as other factors listed in this Annual Report and in the Company's most recent Form 10-Q. 15 Item 8. Financial Statements and Supplementory Data. INDEPENDENT AUDITORS' REPORT The Board of Directors Encompass Services Corporation: We have audited the accompanying consolidated balance sheets of Encompass Services Corporation and Subsidiaries as of December 31, 2001 and 2000 and the related consolidated statements of operations, shareholders' equity and other comprehensive income and cash flows for each of the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Encompass Services Corporation and Subsidiaries as of December 31, 2001 and 2000 and the results of their operations and their cash flows for each of the years then ended, in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 5 to the consolidated financial statements, the Company in 2001 changed its method of accounting for derivative instruments and hedging activities. KPMG LLP Houston, Texas February 19, 2002, except as to Note 17, which is as of June 28, 2002 16 REPORT OF INDEPENDENT ACCOUNTANTS To Board of Directors and Shareholders of Encompass Services Corporation In our opinion, the consolidated statements of operations, of shareholders' equity and other comprehensive income and of cash flows for the year ended December 31, 1999 present fairly, in all material respects, the results of operations and cash flows of Encompass Services Corporation and its subsidiaries for the year ended December 31, 1999, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. PricewaterhouseCoopers LLP Minneapolis, Minnesota February 12, 2000, except as to Note 13, which is as of March 5, 2002, and Note 17, which is as of June 28, 2002 17 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except par value)
December 31, ---------------------- ASSETS 2001 2000 ------ ---------- ---------- Current Assets: Cash and cash equivalents...................................................... $ 20,572 $ 10,094 Accounts receivable, net of allowance of $45,344 and $17,270, respectively..... 728,203 969,469 Inventories.................................................................... 26,128 32,172 Costs and estimated earnings in excess of billings on uncompleted contracts.... 101,719 119,997 Deferred tax assets............................................................ 19,219 17,296 Prepaid expenses and other current assets...................................... 25,880 30,266 ---------- ---------- Total current assets....................................................... 921,721 1,179,294 Property and equipment, net....................................................... 124,548 123,945 Goodwill, net..................................................................... 1,285,625 1,328,884 Other intangible assets, net...................................................... 13,529 15,905 Deferred debt issuance costs, net................................................. 19,577 17,039 Other long-term assets............................................................ 36,326 32,815 ---------- ---------- Total assets............................................................... $2,401,326 $2,697,882 ========== ========== LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------ Current Liabilities: Short-term borrowings and current maturities of long-term debt................. $ 4,551 $ 5,805 Accounts payable............................................................... 269,226 280,630 Billings in excess of costs and estimated earnings on uncompleted contracts.... 159,226 208,302 Accrued compensation........................................................... 88,578 105,343 Other accrued liabilities...................................................... 74,915 76,494 Due to related parties......................................................... 989 11,385 ---------- ---------- Total current liabilities.................................................. 597,485 687,959 Long-term debt, net of current portion............................................ 810,263 961,606 Deferred tax liabilities.......................................................... 7,384 11,029 Other long-term liabilities....................................................... 20,461 4,404 Commitments and contingencies Mandatorily redeemable convertible preferred stock, $.001 par value; 50,000 shares authorized; 256 shares issued and outstanding................................... 289,621 269,009 Shareholders' equity: Common stock, $.001 par value; 200,000 shares authorized; 63,793 and 63,501 shares outstanding, respectively............................................. 65 64 Additional paid-in capital..................................................... 622,783 624,926 Retained earnings.............................................................. 67,307 139,045 Treasury stock, at cost........................................................ (10,425) (160) Accumulated other comprehensive loss........................................... (3,618) -- ---------- ---------- Total shareholders' equity................................................. 676,112 763,875 ---------- ---------- Total liabilities and shareholders' equity................................. $2,401,326 $2,697,882 ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 18 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)
Year Ended December 31, ---------------------------------- 2001 2000 1999 ---------- ---------- ---------- Revenues..................................................... $3,825,268 $3,902,734 $1,731,649 Cost of services............................................. 3,221,586 3,208,050 1,389,340 ---------- ---------- ---------- Gross profit.............................................. 603,682 694,684 342,309 Selling, general and administrative expenses................. 443,432 431,019 195,215 Provision for doubtful accounts.............................. 37,258 6,894 766 Amortization of goodwill and other intangible assets......... 36,274 32,724 15,620 Merger and related charges................................... -- 7,800 -- Costs to exit certain activities and related costs........... -- 12,200 -- Restructuring and recapitalization charges................... -- -- 8,020 ---------- ---------- ---------- Operating income.......................................... 86,718 204,047 122,688 Other income (expense): Interest income........................................... 966 825 5,737 Interest expense.......................................... (84,311) (88,101) (35,618) Other, net................................................ (1,764) (503) 255 ---------- ---------- ---------- Income from continuing operations before income tax provision 1,609 116,268 93,062 Income tax provision......................................... 16,022 57,011 41,111 ---------- ---------- ---------- Income (loss) from continuing operations..................... (14,413) 59,257 51,951 Income (loss) from discontinued operations, net of tax....... (10,222) 4,096 1,111 Loss on disposal of discontinued operations, net of tax...... (26,491) -- -- ---------- ---------- ---------- Income (loss) before extraordinary loss...................... (51,126) 63,353 53,062 Extraordinary loss on debt settlement, net of tax............ -- (8,057) -- ---------- ---------- ---------- Net income (loss)............................................ (51,126) 55,296 53,062 Less convertible preferred stock dividends................... (20,612) (16,568) -- ---------- ---------- ---------- Net income (loss) available to common shareholders........... $ (71,738) $ 38,728 $ 53,062 ========== ========== ========== Basic earnings (loss) per share: Income (loss) from continuing operations.................. $ (.55) $ .72 $ 1.25 Income (loss) from discontinued operations, net of tax.... (.16) .07 .03 Loss on disposal of discontinued operations, net of tax... (.41) -- -- ---------- ---------- ---------- Income (loss) before extraordinary loss................... (1.12) .79 1.28 Extraordinary loss on debt settlement, net of tax......... -- (.14) -- ---------- ---------- ---------- Net income (loss)......................................... $ (1.12) $ .65 $ 1.28 ========== ========== ========== Weighted average shares outstanding....................... 63,845 59,234 41,538 ========== ========== ========== Diluted earnings (loss) per share: Income (loss) from continuing operations.................. $ (.55) $ .70 $ 1.19 Income (loss) from discontinued operations, net of tax.... (.16) .07 .02 Loss on disposal of discontinued operations, net of tax... (.41) -- -- ---------- ---------- ---------- Income (loss) before extraordinary loss................... (1.12) .77 1.21 Extraordinary loss on debt settlement, net of tax......... -- (.14) -- ---------- ---------- ---------- Net income (loss)......................................... $ (1.12) $ .63 $ 1.21 ========== ========== ========== Weighted average shares outstanding....................... 63,845 61,089 46,406 ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. 19 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND OTHER COMPREHENSIVE INCOME (In thousands)
Common Stock ---------------------------- Additional Shares Paid-in Retained Treasury Outstanding Amount Capital Earnings Stock ----------- ------ ---------- -------- -------- BALANCE, December 31, 1998.......................................... 56,574 $ 56 $ 832,503 $ 47,255 $(41,832) Shares purchased under stock purchase and option plans............ 233 1 1,811 -- -- Common stock issued or to be issued in acquisitions............... 9,101 9 96,980 -- -- Cancellation of treasury stock.................................... -- -- (41,832) -- 41,832 Repurchase of shares in Tender Offer.............................. (30,773) (31) (562,973) -- -- Compensation expense related to options exercised in Tender Offer. -- -- 2,629 -- -- Unrealized loss on marketable securities, net of tax of $179...... -- -- -- -- -- Net income........................................................ -- -- -- 53,062 -- Total comprehensive income........................................ -- -- -- -- -- ------- ---- --------- -------- -------- BALANCE, December 31, 1999.......................................... 35,135 35 329,118 100,317 -- Shares purchased under stock purchase and option plans............ 232 -- 1,074 -- -- Common stock issued in Merger..................................... 27,909 28 282,404 -- -- Common stock issued or to be issued in other acquisitions......... 441 1 13,390 -- -- Purchase of treasury stock........................................ (32) -- -- -- (160) Shares received in settlement of litigation....................... (184) -- (1,060) -- -- Reclassification adjustment, net of tax of $476................... -- -- -- -- -- Net income........................................................ -- -- -- 55,296 -- Convertible preferred stock dividends............................. -- -- -- (16,568) -- Total comprehensive income........................................ -- -- -- -- -- ------- ---- --------- -------- -------- BALANCE, December 31, 2000.......................................... 63,501 64 624,926 139,045 (160) Shares purchased under stock purchase and option plans............ 774 -- 3,020 -- -- Common stock issued in acquisitions............................... 1,129 1 (4,656) -- -- Purchase of treasury stock........................................ (1,382) -- -- -- (9,130) Treasury stock acquired in connection with sales of businesses.... (301) -- -- -- (1,519) Treasury stock issued in acquisitions............................. 72 -- (507) -- 384 Cumulative effect of an accounting change, net of tax of $912..... -- -- -- -- -- Net losses on interest rate swaps, net of tax of $2,759........... -- -- -- -- -- Reclassification adjustments related to interest rate swaps, net of tax of $1,454............................................. -- -- -- -- -- Net loss.......................................................... -- -- -- (51,126) -- Convertible preferred stock dividends............................. -- -- -- (20,612) -- Total comprehensive loss.......................................... -- -- -- -- -- ------- ---- --------- -------- -------- BALANCE, December 31, 2001.......................................... 63,793 $ 65 $ 622,783 $ 67,307 $(10,425) ======= ==== ========= ======== ========
Accumulated Other Total Total Comprehensive Shareholders' Comprehensive Loss Equity Income (Loss) ------------- ------------- ------------- BALANCE, December 31, 1998.......................................... $ (445) $ 837,537 Shares purchased under stock purchase and option plans............ -- 1,812 Common stock issued or to be issued in acquisitions............... -- 96,989 Cancellation of treasury stock.................................... -- -- Repurchase of shares in Tender Offer.............................. -- (563,004) Compensation expense related to options exercised in Tender Offer. -- 2,629 Unrealized loss on marketable securities, net of tax of $179...... (268) (268) $ (268) Net income........................................................ -- 53,062 53,062 -------- Total comprehensive income........................................ -- -- $ 52,794 ------- --------- ======== BALANCE, December 31, 1999.......................................... (713) 428,757 Shares purchased under stock purchase and option plans............ -- 1,074 Common stock issued in Merger..................................... -- 282,432 Common stock issued or to be issued in other acquisitions......... -- 13,391 Purchase of treasury stock........................................ -- (160) Shares received in settlement of litigation....................... -- (1,060) Reclassification adjustment, net of tax of $476................... 713 713 $ 713 Net income........................................................ -- 55,296 55,296 Convertible preferred stock dividends............................. -- (16,568) -------- Total comprehensive income........................................ -- -- $ 56,009 ------- --------- ======== BALANCE, December 31, 2000.......................................... -- 763,875 Shares purchased under stock purchase and option plans............ -- 3,020 Common stock issued in acquisitions............................... -- (4,655) Purchase of treasury stock........................................ -- (9,130) Treasury stock acquired in connection with sales of businesses.... -- (1,519) Treasury stock issued in acquisitions............................. -- (123) Cumulative effect of an accounting change, net of tax of $912..... (1,488) (1,488) $ (1,488) Net losses on interest rate swaps, net of tax of $2,759........... (4,503) (4,503) (4,503) Reclassification adjustments related to interest rate swaps, net of tax of $1,454............................................. 2,373 2,373 2,373 Net loss.......................................................... -- (51,126) (51,126) Convertible preferred stock dividends............................. -- (20,612) -------- Total comprehensive loss.......................................... -- -- $(54,744) ------- --------- ======== BALANCE, December 31, 2001.......................................... $(3,618) $ 676,112 ======= =========
The accompanying notes are an integral part of these consolidated financial statements. 20 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
Year Ended December 31, --------------------------------- 2001 2000 1999 --------- ----------- --------- Cash flows from operating activities: Net income (loss)............................................................ $ (51,126) $ 55,296 $ 53,062 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Loss (income) from discontinued operations, net of tax..................... 10,222 (4,096) (1,111) Loss on disposal of discontinued operations, net of tax.................... 26,491 -- -- Extraordinary loss on debt settlement, net of tax.......................... -- 8,057 -- Depreciation and amortization.............................................. 72,222 62,517 30,858 Provision for doubtful accounts............................................ 37,258 6,894 766 Provision (benefit) for deferred income taxes.............................. 2,579 4,453 (843) Other non-cash charges..................................................... 6,403 6,356 2,978 Changes in operating assets and liabilities: Accounts receivable....................................................... 147,359 (199,791) (89,156) Costs and estimated earnings in excess of billings on uncompleted contracts................................................... 10,520 (6,649) (22,849) Prepaid expenses and other current assets................................. 12,946 10,443 (11,635) Billings in excess of costs and estimated earnings on uncompleted contracts................................................... (46,288) 56,153 15,778 Accounts payable and accrued liabilities.................................. (7,252) 66,078 18,213 Change in other assets and liabilities.................................... 10,061 (16,074) 394 --------- ----------- --------- Net cash provided by (used in) operating activities..................... 231,395 49,637 (3,545) --------- ----------- --------- Cash flows from investing activities: Cash paid for acquisitions, net of cash acquired............................. (16,872) (59,617) (161,084) Purchases of property and equipment.......................................... (41,550) (42,139) (27,264) Proceeds from sales of businesses, property and equipment.................... 5,370 4,994 584 Other, net................................................................... -- (2,098) (258) --------- ----------- --------- Net cash used in investing activities................................... (53,052) (98,860) (188,022) --------- ----------- --------- Cash flows from financing activities: Net payments on short-term debt.............................................. (1,003) (9,869) (4,907) Payments on long-term debt................................................... (918,063) (1,462,243) (45,914) Proceeds from long-term debt issuance........................................ 765,800 1,522,078 630,592 Payment of debt issuance costs............................................... (7,522) (11,952) (22,467) Issuance of preferred stock, net of issuance costs........................... -- 146,250 -- Repurchase and retirement of GroupMAC common stock in the Merger............. -- (150,000) -- Repurchase of common stock in Tender Offer, including related expenses....... -- -- (564,407) Purchase of treasury stock................................................... (9,130) (160) -- Distribution to minority shareholders........................................ -- -- (842) Proceeds from issuance of stock under employee stock purchase and stock option plans.......................................................... 2,950 1,074 1,812 --------- ----------- --------- Net cash provided by (used in) financing activities..................... (166,968) 35,178 (6,133) --------- ----------- --------- Net cash flows provided by (used in) discontinued operations................... (897) 7,054 1,689 --------- ----------- --------- Net increase (decrease) in cash and cash equivalents........................... 10,478 (6,991) (196,011) Cash and cash equivalents, beginning of period................................. 10,094 17,085 213,096 --------- ----------- --------- Cash and cash equivalents, end of period....................................... $ 20,572 $ 10,094 $ 17,085 ========= =========== ========= Supplemental Disclosures of Cash Flow Information: Interest paid................................................................ $ 80,032 $ 85,146 $ 22,422 Income taxes paid............................................................ 16,559 39,820 53,673
The accompanying notes are an integral part of these consolidated financial statements. 21 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data) 1. BUSINESS AND ORGANIZATION Encompass Services Corporation ("Encompass", or the "Company"), a Texas corporation, was formed to build a national company providing mechanical and electrical services in the commercial, industrial and residential markets. On February 22, 2000, the shareholders of Group Maintenance America Corp. ("GroupMAC") and Building One Services Corporation ("Building One") approved a merger of the two companies (the "Merger"). In connection with the Merger, GroupMAC changed its name to Encompass Services Corporation. GroupMAC was the surviving legal entity in the Merger. However, for accounting purposes, Building One was deemed to be the acquirer and, accordingly, the Merger was accounted for as a "reverse acquisition". Under this method of accounting, Encompass' historical results for periods prior to the Merger are the same as Building One's historical results. All share and per share information has been restated to reflect the exchange ratio on a retroactive basis. See Note 3 for discussion of the Merger. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying consolidated financial statements and related notes include the accounts of Encompass and the companies acquired in business combinations accounted for under the purchase method from their respective acquisition dates. Principles of Consolidation The consolidated financial statements include the accounts of Encompass and its majority owned subsidiaries. All significant intercompany transactions and accounts are eliminated in consolidation. The Company's Global Technologies segment was discontinued in September 2001 and three additional business units were discontinued in 2002. See Notes 16 and 17 for further discussion. Certain prior year amounts have been reclassified to conform to the current year presentation. Use of Estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition Revenues from construction contracts are recognized on the percentage-of-completion accounting method, measured by the percentage of costs incurred to date to the estimated total costs at completion for each contract (the "cost-to-cost" method). Provisions for estimated losses on uncompleted contracts are made in the period in which such losses are determined. Changes in job performance, job conditions, and estimated profitability may result in revisions to estimated costs and revenues and are recognized in the period in which the revisions are determined. Revenues from work orders are recognized as services are performed. Revenues from service and maintenance contracts are recognized over the life of contracts. 22 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Receivable balances pursuant to retainage provisions in construction contracts are due upon completion of the contracts and acceptance by the customer. Based upon the Company's experience in recent years with similar contracts, the retention balance at each balance sheet date is generally billed and collected within the subsequent year. The unbilled retainage balance at December 31, 2001 and 2000 was $122,872 and $151,477, respectively, and is included in accounts receivable in the consolidated balance sheets. Concentration of Credit Risk Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of trade accounts receivable. The Company grants credit, generally without collateral, to its customers, which primarily include general contractors, property owners and developers, governmental agencies, educational and medical institutions, and commercial and industrial companies in a variety of industries. The Company is subject to potential credit risk related to changes in business and economic factors throughout the United States. However, the Company is entitled to payment for work performed and often has certain lien rights in that work. Additionally, management continually monitors the financial condition of its customers to reduce risk of loss. The Company provides an allowance for doubtful accounts when future collection is considered doubtful. Financial Instruments The Company's financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, interest rate swaps and short- and long-term debt. At December 31, 2001 and 2000, the Company's 101/2% Senior Subordinated Notes had a carrying value, excluding unamortized discount, of $335,000 and $200,000, respectively, and a fair value of $217,750 and $130,000, respectively. The fair value of the Company's interest rate swaps at December 31, 2001 was a liability of $6,761. The Company believes that, with the exception of the 101/2% Senior Subordinated Notes, the carrying values of financial instruments on the consolidated balance sheets approximate their fair value. See Note 5. Cash and Cash Equivalents The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. Inventories Inventories consist primarily of purchased materials, parts and supplies held for use in the ordinary course of business. Inventories are valued at the lower of cost or market, with cost determined on a first-in, first-out ("FIFO") basis. Property and Equipment Property and equipment is stated at cost. Depreciation is computed principally using the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized over the shorter of the remaining lease term or the estimated useful life of the asset. As events or circumstances dictate, the Company reviews the carrying amounts of property and equipment for impairment. The amount of impairment, if any, is measured based on comparing the estimated future undiscounted cash flows associated with the asset to its carrying value. 23 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Expenditures for repairs and maintenance are charged to expense when incurred. Expenditures for major renewals and betterments, which extend the useful lives of existing equipment, are capitalized and depreciated. Upon retirement or disposition of property or equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized as other income (expense) in the consolidated statements of operations. Goodwill Goodwill represents the excess of the aggregate purchase price over the fair value of net identifiable assets of businesses acquired under the purchase method of accounting. Goodwill is amortized on a straight-line basis over a period of 40 years. The Company assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of goodwill impairment, if any, is measured based on projected discounted future operating cash flows compared to the carrying value of goodwill. The Company reviews the carrying value of goodwill for impairment whenever events or circumstances indicate that the carrying amount may not be recoverable. At December 31, 2001 and 2000, accumulated amortization of goodwill was $89,306 and $55,010, respectively. See Note 18 for discussion of new accounting policy adopted January 1, 2002. Other Intangible Assets Other intangible assets represent the portion of purchase price paid in the Merger which has been allocated, based on independent appraisals, to the value of acquired customer lists and the value of dedicated workforces. Costs allocated to these assets are being amortized on a straight-line basis over the remaining estimated useful lives of these assets, as determined principally by the underlying characteristics of customer retention and workforce turnover. The amounts allocated to the value of the customer lists and dedicated workforce at the Merger date are being amortized over 15 years and 5 years, respectively. The Company reviews the carrying value of these intangibles for impairment whenever events or circumstances indicate that the carrying amounts may not be recoverable. At December 31, 2001 and 2000, accumulated amortization related to other intangible assets was $4,356 and $1,980, respectively. See Note 18 for discussion of new accounting policy adopted January 1, 2002. Deferred Debt Issuance Costs Deferred debt issuance costs relate to the Company's primary credit facility and senior subordinated notes and are amortized to interest expense over the scheduled maturity of the related debt. Stock-Based Compensation The Company accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees", as amended. Accordingly, compensation expense for stock options is measured as the excess, if any, of the quoted market price of the Company's common stock at the date of grant over the amount an employee must pay to acquire the common stock. The Company has also provided the pro forma disclosures required by Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation". 24 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Warranty Costs The Company generally warrants all of its work for a period of one year from the date of installation. A provision for estimated warranty costs is recorded at the time a product is sold or service is rendered based on the historical level of warranty claims and management's estimate of future costs. Income Taxes The Company uses the asset and liability method to account for income taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established when necessary to reduce net deferred tax assets to the amount expected to be realized. Earnings Per Share Basic earnings per share have been calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the year. Diluted earnings per share are computed considering the dilutive effect of stock options, warrants, the Convertible Preferred Stock and, in 1999, the convertible junior subordinated debentures. See Note 15. Other Comprehensive Income Other comprehensive income refers to revenues, expenses, gains and losses that under generally accepted accounting principles are included in comprehensive income but are excluded from net income as these amounts are recorded directly as an adjustment to shareholders' equity. The Company's other comprehensive income is attributed to adjustments for unrealized losses, net of tax, on marketable securities available for sale and changes in the fair value of interest rate swap agreements. See Note 5 for further discussion of accounting for interest rate swap agreements. New Accounting Pronouncements In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, and specifies criteria for recording intangible assets other than goodwill in business combinations, noting that values allocated to dedicated workforce may not be reported separately from goodwill. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives will no longer be amortized to expense, but instead will be tested for impairment at least annually. Intangible assets with definite useful lives will continue to be amortized to expense. The Company adopted the provisions of SFAS No. 141 in July 2001 and the provisions of SFAS No. 142 effective January 1, 2002. See Note 18 for further discussion. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which supersedes both SFAS No. 121 and the accounting and reporting provisions of APB No. 30, for the disposal of a business. SFAS No. 144 provides a single accounting model for long-lived assets to be 25 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) disposed of. Although retaining many of the fundamental recognition and measurement provisions of SFAS No. 121, the new rules change the criteria to be met to classify an asset as held-for-sale. The new rules also broaden the criteria regarding classification of a discontinued operation. The Company adopted the provisions of SFAS No. 144 effective January 1, 2002. See Note 17 for further discussion. 3. BUSINESS COMBINATIONS On February 22, 2000, the shareholders of GroupMAC and Building One approved the Merger. Under the terms of the Merger, each outstanding share of Building One common stock was converted into 1.25 shares of GroupMAC common stock. As part of the Merger, GroupMAC shareholders could elect to receive cash for up to 50% of their shares of Encompass common stock at $13.50 per share, subject to proration. As a result of this election, 11,052 shares of Encompass common stock were canceled in the Merger. The Merger was accounted for as a purchase under generally accepted accounting principles. GroupMAC, which changed its name to Encompass Services Corporation, was the surviving legal entity in the Merger. However, for accounting purposes, Building One was deemed to be the acquirer and, accordingly, the Merger was accounted for as a "reverse acquisition". Concurrent with the closing of the Merger, affiliates of Apollo Management, L.P. ("Apollo") exchanged approximately $106,191 of Building One convertible junior subordinated debentures and $150,000 in cash for 256 shares of Encompass Convertible Preferred Stock. See Note 7 for further discussion of the Convertible Preferred Stock. The cash proceeds from the issuance of the Convertible Preferred Stock were used to fund the cash election feature of the Merger discussed above. In connection with the Merger, Apollo received a fee of $2,500. Pursuant to the Merger, Encompass entered into a new credit agreement, the proceeds of which were used to repay the existing revolving credit facilities of GroupMAC and Building One, as well as GroupMAC's senior subordinated notes. See Note 5 for further discussion of the credit agreement. The allocation of the total consideration to the assets and liabilities of GroupMAC and the resultant goodwill are summarized as follows: Estimated fair value of common stock consideration.... $282,432 Long-term debt assumed................................ 407,904 Other long-term liabilities assumed................... 7,320 Transaction costs..................................... 7,358 Working capital....................................... (47,807) Property and equipment, net and other long-term assets (63,859) Intangible asset--value of dedicated workforce........ (8,878) Intangible asset--value of customer list.............. (9,007) -------- Goodwill.............................................. $575,463 ========
26 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) The following unaudited pro forma combined statement of operations data utilize the financial information of GroupMAC and Building One for the periods indicated, which give effect to the Merger and the acquisitions made by each company during 1999 including amounts owed in connection with those acquisitions, as if the Merger and all of the acquisitions were effective as of the beginning of the period presented.
Year Ended December 31, ----------------------- 2000 1999 ---------- ---------- Revenues................................... $4,164,004 $3,559,661 Net income................................. 68,578 95,900 Net income available to common shareholders 49,182 76,503 Net income per share:...................... Basic................................... $ 0.75 $ 1.17 Diluted................................. $ 0.75 $ 1.13
Significant pro forma adjustments included in the above amounts consist of (i) compensation differentials, (ii) goodwill amortization over a period of 40 years, (iii) interest expense as if borrowings outstanding as of March 31, 2000 had been outstanding for the first quarter of 2000 and throughout 1999 at interest rates in effect on March 31, 2000, (iv) the issuance of the Convertible Preferred Stock concurrent with the Merger and (v) federal and state income tax provisions based on pro forma operating results. Net income per share assumes all shares issued for the Merger and the acquisitions, including subsequently earned contingent consideration, were outstanding from the beginning of the periods presented. The pro forma results presented above are not necessarily indicative of actual results that might have occurred had the Merger and the acquisitions occurred at the beginning of the period presented. Merger and Related Charges In connection with the Merger and related transactions, the Company recorded the following costs and expenses related to severance, office closing costs and other related costs:
Office Severance Closing Other Total --------- ------- ----- ------- Total charges................ $ 6,100 $1,000 $ 700 $ 7,800 Non-cash portion............. -- -- (400) (400) Payments in 2000............. (6,100) (329) -- (6,429) ------- ------ ----- ------- Accrual at December 31, 2000. -- 671 300 971 Payments in 2001............. -- (671) (300) (971) ------- ------ ----- ------- Accrual at December 31, 2001. $ -- $ -- $ -- $ -- ======= ====== ===== =======
The severance and office closing costs relate to the closing of Building One's corporate headquarters in Minneapolis, Minnesota and the resulting consolidation with the GroupMAC corporate office in Houston, Texas. As a result of this plan, the Company incurred severance costs for substantially all of the employees in the Building One corporate office, identified certain assets which were no longer of service and incurred lease termination costs. Severance costs covered 20 employees, all of whom were terminated in 2000. In addition, in connection with the Merger, the Company recorded costs of $3,500 related to severance for twelve former GroupMAC employees, all of whom were terminated in 2000. These costs were charged to goodwill, and substantially all amounts were paid during 2000. 27 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Costs to Exit Certain Activities and Related Costs In connection with the Merger and related transactions, the Company recorded a charge for the shutdown of certain operations, the reorganization of other operations and other costs resulting from the Merger. The following table sets forth a summary of these costs: Shutdown of demolition and site preparation operations $ 9,800 Relocation of cleaning systems management offices..... 1,600 Other costs resulting from the Merger................. 800 ------- Total.............................................. $12,200 =======
The costs related to the shutdown of the demolition and site preparation operations include (i) $5,200 related to obligations under existing jobs in progress, (ii) $2,000 estimated for uncollectible accounts receivable, (iii) $1,100 related to claims against the Company, (iv) $800 for impaired assets and (v) $700 related to lease termination costs and other expenses. The Company substantially completed the shutdown of these operations during 2001. The Company relocated the cleaning systems management offices from January through May 2000. The related costs included (i) $600 for severance and related costs, (ii) $500 for impaired assets, (iii) $300 related to lease termination and related costs and (iv) $200 for other miscellaneous items. Substantially all of these amounts were paid during 2000. Other Business Combinations The Company has not acquired any businesses since May 2000. In May 2000, the Company acquired a business for cash paid of $10,207 and 296 shares of common stock. The Company assumed approximately $1,518 of debt in this transaction. The total purchase price was allocated to the fair value of the net assets acquired, resulting in goodwill of $9,397. During the year ended December 31, 1999, the Company completed 23 business combinations that were accounted for under the purchase method of accounting. The consolidated financial statements include the results of these acquired businesses from their respective dates of acquisition. The aggregate consideration paid for these acquisitions consisted of 5,216 shares of the Company's common stock, $123,380 in cash, including applicable professional fees, and $2,410 of debt assumed. The total purchase price was allocated to the fair value of the net assets acquired, resulting in goodwill of $133,818. Contingent Consideration Agreements In conjunction with acquisitions, the Company entered into certain contingent consideration agreements which provided for the payment of cash and/or shares of common stock based on the financial performance of such acquired operations during the one- to two-year period immediately following the acquisition. During the years ended December 31, 2001 and 2000, $3,224 and $62,297, respectively, of consideration was recorded to goodwill related to contingent consideration and final purchase price settlements of acquired companies. The cash payable is reflected as due to related parties and the estimated value of the shares to be issued is reflected as additional paid-in capital in the consolidated balance sheet. These common shares to be issued are included in weighted average shares outstanding since the date earned for purposes of computing basic earnings per share and since the later of the date of acquisition or the beginning of the year for purposes of computing diluted earnings per share. 28 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) During the years ended December 31, 2001 and 2000, $16,872 and $63,030 of cash was paid, respectively, and 1,201 and 145 shares were issued, respectively, related to previously recorded contingent consideration and final purchase price settlements. There are no significant amounts of unearned contingent consideration under these agreements at December 31, 2001. A rollforward of the due to related parties balance in the consolidated balance sheets related to the above activity is as follows:
2001 2000 -------- -------- Balance at beginning of year............................................ $ 11,385 $ 10,290 Balances assumed in the Merger.......................................... -- 13,207 Record cash contingent consideration and final purchase price settlement 6,476 50,918 Payments................................................................ (16,872) (63,030) -------- -------- Balance at end of year.................................................. $ 989 $ 11,385 ======== ========
4. CERTAIN BALANCE SHEET ACCOUNTS Allowance for Doubtful Accounts The following summarizes the activity in the allowance for doubtful accounts:
2001 2000 -------- ------- Balance at beginning of year........................ $ 17,270 $ 2,976 Provision for bad debts from continuing operations.. 37,258 6,894 Provision for bad debts from discontinued operations 18,658 1,349 Allowance balances from acquired companies.......... -- 11,427 Write-off of bad debts, net of recoveries........... (27,842) (5,376) -------- ------- Balance at end of year.............................. $ 45,344 $17,270 ======== =======
Costs and Estimated Earnings on Uncompleted Contracts The summary of the status of uncompleted contracts is as follows:
December 31, ------------------------ 2001 2000 ----------- ----------- Costs incurred on uncompleted contracts..... $ 3,864,476 $ 3,636,828 Estimated earnings recognized, net of losses 627,496 675,568 ----------- ----------- 4,491,972 4,312,396 Less billings to date....................... (4,549,479) (4,400,701) ----------- ----------- $ (57,507) $ (88,305) =========== ===========
29 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data)
December 31, -------------------- 2001 2000 --------- --------- Costs and estimated earnings in excess of billings on uncompleted contracts...................................................... $ 101,719 $ 119,997 Billings in excess of costs and estimated earnings on uncompleted contracts...................................................... (159,226) (208,302) --------- --------- $ (57,507) $ (88,305) ========= =========
Property and Equipment The principal categories and estimated useful lives of property and equipment are as follows:
December 31, Estimated ------------------ Useful Lives 2001 2000 ------------ -------- -------- Land.................................... -- $ 1,596 $ 2,264 Buildings and improvements.............. 20-30 years 9,444 11,363 Service and other vehicles.............. 4-7 years 32,881 35,159 Machinery and equipment................. 5-10 years 64,039 54,960 Office equipment, furniture and fixtures 5-10 years 66,084 45,915 Leasehold improvements.................. 2-15 years 35,289 23,801 -------- -------- 209,333 173,462 Less accumulated depreciation........... (84,785) (49,517) -------- -------- $124,548 $123,945 ======== ========
5. SHORT- AND LONG-TERM DEBT Short- and long-term debt consists of the following:
December 31, ------------------ 2001 2000 -------- -------- Revolving Credit Facility (7.4% and 9.0%, respectively) $ 90,000 $369,000 Term loans (6.1% and 8.9%, respectively)............... 294,000 297,000 Institutional term loan (7.0% and 10.2%, respectively). 98,250 99,500 101/2% Senior Subordinated Notes, net of discount...... 327,900 196,243 Other borrowings....................................... 4,664 5,668 -------- -------- 814,814 967,411 Less: short-term borrowings and current maturities..... (4,551) (5,805) -------- -------- Total long-term debt................................... $810,263 $961,606 ======== ========
30 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Credit Facility On February 22, 2000, in connection with the Merger, the Company entered into an $800,000 senior credit facility (the "Credit Facility") and borrowed funds thereunder to repay prior indebtedness of GroupMAC and Building One. At December 31, 2001, the Credit Facility included a revolving credit facility described below expiring in February 2005, a $130,000 term loan, a $170,000 term loan and a $100,000 institutional term loan. Borrowings under the Credit Facility are secured by substantially all assets of the Company. The availability of borrowings under the Credit Facility is subject to the Company's ability to meet certain specified conditions, including compliance with certain financial covenants and ratios measured as of the end of each fiscal quarter. On November 9, 2001, the Company amended the Credit Facility. At December 31, 2001, the amended terms provided for a revolving credit facility of $300,000, increasing to $350,000 once certain debt leverage ratios were achieved. At December 31, 2001, borrowings under the amended Credit Facility bore interest at variable rates, ranging from 2.0% to 3.75% over the Eurodollar Rate (as defined in the Credit Facility) and from 0.50% to 2.25% over the Alternate Base Rate (as defined in the Credit Facility), depending, in each case, on the Company's total debt-to-EBITDA ratio. In addition, the amendment established certain restrictions on the Company's ability to make acquisitions, capital expenditures and investments and required debt prepayment with future issuances of debt or equity. As of December 31, 2001, the Company also had $1,457 in letters of credit outstanding, and $208,543 available for borrowing under the revolving credit facility. The Credit Facility was amended again effective as of June 26, 2002 (as amended, the "Amended Facility"). See Note 19 for further discussion of the Amended Facility. Debt issuance costs associated with the Credit Facility totaling $14,229 at December 31, 2001 have been deferred and are being amortized over the five-year, six-year and seven-year terms of the revolving credit facility, the term loans, and the institutional term loan portions of the Credit Facility, respectively. In connection with the amendment of the Credit Facility in November 2001, $1,580 of debt issuance costs related to the Credit Facility deferred prior to the amendment were charged to interest expense. The unamortized portion of debt issuance costs associated with the Credit Facility was approximately $8,451 and $9,980 at December 31, 2001 and 2000, respectively, and is included in deferred debt issuance costs in the consolidated balance sheets. 101/2% Senior Subordinated Notes In April 1999, the Company completed a private offering of $200,000 of 101/2% senior subordinated notes (the "Senior Subordinated Notes"). In June 2001, the Company completed a private offering of an additional $135,000 of Senior Subordinated Notes. The Senior Subordinated Notes are unsecured and are guaranteed by the Company's subsidiaries, require interest to be paid semi-annually on May 1 and November 1 of each year and mature on May 1, 2009. Borrowings outstanding under the Senior Subordinated Notes are subordinated in all material respects to amounts outstanding under the Credit Facility. The Senior Subordinated Notes were issued at discounts totaling $8,558, which are being amortized to interest expense over the term of the notes. Additionally, debt issuance costs totaling $13,715 incurred in connection with the offerings have been deferred and are being amortized to interest expense over the term of the notes. The unamortized portion of these costs was approximately $11,126 and $7,059 at December 31, 2001 and 2000, respectively, and is included in deferred debt issuance costs in the consolidated balance sheets. The fair value of the Senior Subordinated Notes, based on quoted market values, was approximately $217,750 and $130,000 at December 31, 2001 and 2000, respectively. 31 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) The Senior Subordinated Notes are guaranteed by all of the Company's current and future U.S. subsidiaries other than "Unrestricted Subsidiaries" (as defined in the indenture governing the Notes). As of December 31, 2001, there were no "Unrestricted Subsidiaries." These guarantees are full, unconditional and joint and several. In addition, Encompass has no non-guarantor subsidiaries and no independent assets or operations outside of its ownership of the subsidiaries. Accordingly, no separate financial statements or consolidating information of the guarantor subsidiaries are presented because management believes this information is not material to users of the Company's financial statements. The Company may redeem the Senior Subordinated Notes, in whole or in part, at any time on or after May 1, 2004 at specified redemption prices, plus accrued interest. At any time (which may be more than once) before May 1, 2002, the Company may redeem up to 35% of the outstanding Senior Subordinated Notes with money raised in equity offerings under certain circumstances. Upon a change in control of the Company (as defined in the indenture for the Senior Subordinated Notes), the Company will be required to offer to purchase all of the outstanding Senior Subordinated Notes at 101% of the face amount plus accrued interest. Additionally, the indenture governing the Senior Subordinated Notes contains certain covenants relating to, among other things, the Company's ability to incur indebtedness, pay dividends or repurchase capital stock, incur liens, sell or otherwise dispose of a substantial portion of its assets or merge or consolidate with another entity. The aggregate maturities of debt as of December 31, 2001 are as follows: 2002...... $ 4,551 2003...... 5,613 2004...... 6,500 2005...... 94,000 2006...... 283,000 Thereafter 421,150 -------- $814,814 ========
Interest Rate Swap Agreements The Company has entered into interest rate swap agreements in the aggregate notional amount of $110,000 to manage its mix of fixed and floating rate debt to partially hedge its exposure to potential fluctuations in interest rates. All such agreements are with large creditworthy financial institutions and result in the Company paying a fixed rate of interest and receiving a floating rate. At December 31, 2001, the Company's ratio of fixed rate debt to total debt was 41% and the weighted average interest rate on its total debt was 8.64%, before considering the aforementioned interest rate swap agreements. After giving effect to the interest rate swap agreements in effect at December 31, 2001, the ratio of fixed rate debt was 52% and the weighted average interest rate on total debt was 9.19%. Effective January 1, 2001, the Company adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", and SFAS No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities, an Amendment of FASB Statement No. 133". These statements establish accounting and reporting standards requiring that derivative instruments, including certain derivative instruments embedded in other contracts, be recorded on the balance sheet at fair value as either assets or liabilities. The accounting for changes in the fair value of a derivative instrument depends on the intended use and designation of the derivative at its inception. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related 32 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) results of the hedged item in the statement of operations, and requires the Company to formally document, designate and assess the effectiveness of the hedge transaction to receive hedge accounting treatment. For derivatives designated as cash flow hedges, changes in fair value, to the extent the hedge is effective, are recognized in other comprehensive income until the hedged item is recognized in earnings. Overall hedge effectiveness is measured at least quarterly. Any changes in the fair value of the derivative instruments resulting from hedge ineffectiveness, as defined by SFAS No. 133 and measured based on the cumulative changes in the fair value of the derivative instrument and the cumulative changes in the estimated future cash flows of the hedged item, are recognized immediately in earnings. The Company has designated its interest rate swap agreements as cash flow hedges. Adoption of SFAS No. 133 at January 1, 2001 resulted in the recognition of approximately $1,488, net of tax effect of $912, of hedging losses included in accumulated other comprehensive loss as the cumulative effect of a change in accounting principle and $2,400 of derivative liabilities which are included in other long-term liabilities in the consolidated balance sheet. During the year ended December 31, 2001, the Company recognized $2,373, net of tax effect of $1,454, in additional interest expense attributable to the difference in the variable interest receivable and fixed interest payable under the interest rate swap agreements. No significant gain or loss from hedge ineffectiveness was required to be recognized. At December 31, 2001, the fair value of the interest rate swap agreements was a liability of $6,761. The Company estimates that approximately $1,800, net of tax, of such amount is expected to be recognized as additional interest expense over the next twelve months as interest costs on the underlying debt are recognized. Amounts were determined as of the balance sheet date based on quoted market values, the Company's portfolio of interest rate swap agreements and the Company's measurement of hedge effectiveness. 6. INCOME TAXES Total income taxes are allocated as follows:
Year Ended December 31, ------------------------- 2001 2000 1999 ------- ------- ------- Income from continuing operations.......... $16,022 $57,011 $41,111 Income (loss) from discontinued operations. (5,244) 2,734 916 Loss on disposal of discontinued operations (7,819) -- -- Extraordinary loss on debt settlement...... -- (4,338) -- Other comprehensive income (loss).......... (2,217) 476 (179) ------- ------- ------- $ 742 $55,883 $41,848 ======= ======= =======
Income tax provision attributable to income from continuing operations consists of the following:
Year Ended December 31, ----------------------- 2001 2000 1999 ------- ------- ------- Current:............. Federal........... $11,571 $45,429 $37,186 State............. 2,067 7,852 4,768 ------- ------- ------- 13,638 53,281 41,954 Deferred:............ Federal and state. 2,384 3,730 (843) ------- ------- ------- $16,022 $57,011 $41,111 ======= ======= =======
33 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Total income tax expense attributable to income from continuing operations differs from the amounts computed by applying the U.S. federal statutory income tax rate to income from continuing operations before income tax provision as a result of the following:
Year Ended December 31, -------------------------- 2001 2000 1999 ------- -------- ------- Income from continuing operations before income tax provision $ 1,609 $116,268 $93,062 ------- -------- ------- Applicable U.S. federal statutory rate....................... 35% 35% 35% ------- -------- ------- Tax provision at statutory rate.............................. 563 40,694 32,572 Increase (decrease) resulting from:.......................... State income taxes, net of federal benefit................ 1,313 5,053 3,050 Non-deductible goodwill amortization...................... 10,800 9,825 5,105 Non-deductible meals and entertainment.................... 1,476 1,941 380 Other, net................................................ 1,870 (502) 4 ------- -------- ------- $16,022 $ 57,011 $41,111 ======= ======== =======
The components of the deferred income tax assets and liabilities are as follows:
December 31, ------------------ 2001 2000 -------- -------- Deferred income tax assets: Allowance for doubtful accounts.................. $ 11,257 $ 6,735 Inventories...................................... 296 976 Accrued expenses................................. 16,170 13,834 Deferred revenue................................. 2,161 1,974 Unrealized loss on interest rate swap agreements. 2,217 -- Net operating loss carryforward.................. 288 308 -------- -------- Total deferred income tax assets............. 32,389 23,827 -------- -------- Deferred income tax liabilities:.................... Depreciation..................................... (4,854) (3,730) Completed contract accounting for tax purposes... (3,845) (5,475) Amortization of goodwill......................... (9,547) (6,683) Other............................................ (2,308) (1,672) -------- -------- Total deferred income tax liabilities........ (20,554) (17,560) -------- -------- Net deferred income tax assets............... $ 11,835 $ 6,267 ======== ========
These deferred income tax assets and liabilities are included in the consolidated balance sheets under the following captions:
December 31, ----------------- 2001 2000 ------- -------- Deferred tax assets--current....... $19,219 $ 17,296 Deferred tax liabilities--long-term (7,384) (11,029) ------- -------- $11,835 $ 6,267 ======= ========
34 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Management believes it is more likely than not that the Company will have future taxable income to allow it to realize the benefits of the net deferred tax assets. Accordingly, no valuation allowance has been recorded as of December 31, 2001 or 2000. 7. CONVERTIBLE PREFERRED STOCK In connection with the Merger, the Company issued 256 shares of 7.25% Convertible Preferred Stock (the "Convertible Preferred Stock") to affiliates of Apollo at a value of $1,000 per share in exchange for $150,000 in cash and all of the outstanding 71/2% convertible junior subordinated debentures of Building One (with an aggregate value of approximately $106,191). The Convertible Preferred Stock is convertible at the option of the holders into shares of the Company's common stock at any time prior to maturity at a conversion price of $14.00 per common share, subject to adjustment under certain circumstances. Upon their maturity in February 2012, the Company is required to redeem all shares of Convertible Preferred Stock then outstanding at the redemption price per share equal to the Liquidation Amount (defined as the original cost of $1,000 per share plus all accrued and accumulated and unpaid dividends). As of December 31, 2001, the Liquidation Amount was $292,799. The Company has the right to redeem, at any time after February 22, 2005, all, but not less than all, of the shares of Convertible Preferred Stock then outstanding at an amount per share equal to 103% of the Liquidation Amount; this amount declines to 102% after February 22, 2006 and 101% after February 22, 2008. The Convertible Preferred Stock bears a preferred cumulative dividend at the rate of 7.25% per year, payable quarterly. Under the terms of the Convertible Preferred Stock agreement, until February 22, 2003, dividends on the Convertible Preferred Stock may be paid in cash on a current basis or accumulated at the option of the Company. However, the Company's amended Credit Facility (see Note 5) prohibits the payment of cash dividends. At December 31, 2001, accrued dividends were approximately $36,608 and are included in the carrying value of the Convertible Preferred Stock in the consolidated balance sheet. The Company has elected to defer the payment of the dividends payable to date and that would otherwise be payable on March 31, 2002. Holders of the Convertible Preferred Stock are also entitled to share in any dividends the Company may declare on its common stock. Holders of the Convertible Preferred Stock are entitled to vote on all matters presented to the holders of common stock. Each share of Convertible Preferred Stock entitles the holder thereof to cast the number of votes such holder would have been entitled to cast had such holder converted such share of Convertible Preferred Stock into shares of common stock (common stock equivalents). As of December 31, 2001, the Convertible Preferred Stock comprised approximately 25% of the voting power of Encompass. Convertible Preferred Stock issuance costs of approximately $3,750 are being amortized against retained earnings over the 12-year term of the Convertible Preferred Stock. The unamortized portion of these costs of approximately $3,178 at December 31, 2001 is recorded against mandatorily redeemable convertible preferred stock in the consolidated balance sheets. Pursuant to the Statement of Designation related to the Convertible Preferred Stock and the Investors' Rights Agreement between Apollo and the Company, Apollo currently has appointed three members of the Company's board of directors. If the Company violates certain protective covenants, which include a total debt leverage covenant under the Investors' Rights Agreement, Apollo will have the right to appoint additional directors, such that the Apollo-appointed directors would constitute a majority of the board of directors. This debt leverage covenant differs from the similar covenant included in the Credit Facility, and is not as clearly defined. See Note 19 for further discussion. 35 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) 8. SHAREHOLDERS' EQUITY Common Stock The Company has not paid dividends on its common stock since its incorporation and does not anticipate paying dividends on its common stock in the foreseeable future. The Amended Facility (see Note 19) prohibits the payment of dividends. In December 2000, the Board of Directors authorized a stock buyback program, pursuant to which the Company may purchase up to 2,500 shares of its common stock on the open market. As of December 31, 2001, the Company had repurchased 1,414 shares of its common stock under this program for an aggregate cost of $9,290. Under the terms of the Amended Facility (see Note 19), the Company is prohibited from making further repurchases of its common stock. Warrants The Company has 4,446 shares of common stock reserved for issuance upon exercise of warrants. The warrants have a weighted average exercise price of $16.25 per share. These warrants are currently exercisable. Of these warrants, 1,413 expire on November 25, 2002, 2,438 expire on November 25, 2007 and the remainder expire on various dates ranging from December 2003 to July 2007. The warrants also contain certain rights for registration. 9. STOCK-BASED PLANS The Company has a number of stock-based incentive and awards plans in place, which provide the Company the latitude to grant a variety of awards, including stock options, stock appreciation rights ("SARs"), restricted stock awards, performance awards and phantom stock awards, to officers, directors, key employees and other persons working for the Company and its subsidiaries. The plans require that stock options be granted at exercise prices not less than the fair market value of the underlying common stock on the grant date. Stock options vest at varying time periods ranging from six months to four years and expire after five to ten years from the date of grant. At December 31, 2001, stock-based awards equivalent to approximately 3,900 shares were generally available for granting under such plans. There are an additional 4,900 shares available for granting under Building One stock option plans (the "Building One Plans") however, the Company does not intend to issue additional options under the Building One Plans over and above the number of options (approximately 5,800) that were issued and outstanding under the Building One Plans as of the date of the Merger. 36 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) The following is a summary of stock option and warrant activity:
Outstanding Exercisable --------------------------- --------------------------- Number of Weighted Number of Weighted Options Average Options Average and Warrants Exercise Price and Warrants Exercise Price ------------ -------------- ------------ -------------- Balance at December 31, 1998.............. 8,939 $15.41 4,919 $14.81 Granted................................... 2,216 12.37 1,840 16.00 Exercised................................. (1,145) 12.14 (1,145) 12.14 Surrendered............................... (413) 16.10 -- -- ------ ------ ------ ------ Balance at December 31, 1999.............. 9,597 15.07 5,614 15.18 Options and warrants assumed in the Merger 5,282 12.79 1,908 14.30 Granted................................... 2,050 6.73 641 15.68 Exercised................................. (5) 3.87 (5) 3.87 Surrendered............................... (2,125) 13.87 -- -- ------ ------ ------ ------ Balance at December 31, 2000.............. 14,799 13.27 8,158 15.02 Granted................................... 1,560 6.08 2,648 11.10 Exercised................................. (189) 3.74 (189) 3.74 Surrendered............................... (957) 11.74 (341) 12.99 ------ ------ ------ ------ Balance at December 31, 2001.............. 15,213 $12.75 10,276 $14.28 ====== ====== ====== ======
A summary of outstanding and exercisable options and warrants as of December 31, 2001 follows:
Weighted Weighted Average Average Weighted Exercise Number of Option Number of Average Price of Exercisable and Outstanding Remaining Exercisable Options Warrant Options and Contractual Options and Range of Option and Warrant Prices Prices Warrants Life (Years) and Warrants Warrants ---------------------------------- -------- ----------- ------------ ------------ ----------- $ 3.08 to $ 5.00.......... $ 3.97 977 5.2 $ 3.66 616 $ 5.01 to $10.00.......... 6.95 3,070 7.9 7.44 498 $10.01 to $15.00.......... 12.93 4,949 4.6 13.05 3,397 $15.01 to $20.00.......... 16.58 5,762 4.5 16.51 5,404 $20.01 to $20.20.......... 20.19 455 6.5 20.19 361 ------ ------ 15,213 10,276 ====== ======
37 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) The following pro forma data are calculated as if compensation expense for the Company's stock option plans and warrants were determined based on the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123, "Accounting for Stock-Based Compensation":
Year Ended Year Ended Year Ended December 31, 2001 December 31, 2000 December 31, 1999 ------------------ ---------------- ---------------- As Pro As Pro As Pro Reported Forma Reported Forma Reported Forma -------- -------- -------- ------- -------- ------- Net income (loss) available to common shareholders....................... $(71,738) $(77,552) $38,728 $27,693 $53,062 $45,449 Net income (loss) per share: Basic............................. $ (1.12) $ (1.21) $ 0.65 $ 0.47 $ 1.28 $ 1.10 Diluted........................... $ (1.12) $ (1.21) $ 0.63 $ 0.45 $ 1.21 $ 1.05
The pro forma compensation cost may not be representative of that to be expected in future years because options vest over several years and additional awards may be made each year. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:
2001 2000 1999 ----- ----- ----- Dividend yield..................... -- -- -- Expected volatility................ 75.0% 68.0% 58.2% Risk-free interest rate............ 4.5% 5.1% 5.6% Expected lives (years)............. 10 9 5 Fair value of options at grant date $2.30 $5.24 $6.81
Employee Stock Purchase Plan The Company has an Employee Stock Purchase Plan (the "Purchase Plan"), which permits eligible employees of the Company to purchase shares of common stock at a discount. Employees who elect to participate have amounts withheld through payroll deduction during purchase periods. At the end of each purchase period, accumulated payroll deductions are used to purchase common stock at a price equal to 85% of the market price at the beginning of the period or the end of the period, whichever is lower. Shares purchased under the Purchase Plan are subject to a one-year holding period. During the years ended December 31, 2001, 2000 and 1999, 584, 227 and 195 shares, respectively, were issued pursuant to the Purchase Plan and its predecessor. In 2001, the Company's shareholders approved an increase in the number of shares permitted to be issued under the Purchase Plan from 1,000 to 3,000. As of December 31, 2001, 1,903 shares were available for issuance under the Purchase Plan. 10. EMPLOYEE BENEFIT PLANS The Company maintains a defined contribution savings plan (the "Savings Plan"), which is available to most employees after 90 days of service. Employee contributions and employer matching contributions occur at different rates and the matched portions of the funds vest over a one-year period. Company contributions to the Savings Plan and predecessor plans maintained by certain of the Company's subsidiaries totaled approximately $14,920, $13,930 and $5,300 for the years ended December 31, 2001, 2000 and 1999, respectively. 38 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Certain of the Company's subsidiaries make contributions to union-administered benefit funds, which cover the majority of the Company's union employees. For the years ended December 31, 2001 and 2000, the participant costs charged to operations were approximately $35,346 and $32,302, respectively. Governmental regulations require that, in the event of plan termination or employer withdrawal, an employer may be liable for a portion of the plan's unfunded vested benefits, if any. The Company is not aware of any liabilities resulting from unfunded vested benefits related to union-administered benefit plans. The Company does not anticipate withdrawal from the plans, nor is the Company aware of any expected plan terminations. 11. COMMITMENTS AND CONTINGENCIES Operating leases for certain facilities, transportation equipment and office equipment expire at various dates through 2015. Certain leases contain renewal options. Minimum future rental payments at December 31, 2001 are as follows: 2002...... $ 41,640 2003...... 37,719 2004...... 31,491 2005...... 25,230 2006...... 16,633 Thereafter 73,689 -------- $226,402 ========
Total rental expense for the years ended December 31, 2001, 2000 and 1999 was approximately $76,400, $41,600 and $10,900, respectively (including $8,700, $8,200 and $3,600, respectively, to related parties). The Company is involved in various legal actions in the normal course of business. It is not possible to predict the outcome of these matters; however, in the opinion of management, the resolution of these matters will not have a material adverse effect on the Company's consolidated financial position or results of operations. The Company has provided accruals for probable losses and legal fees incurred with respect to certain of these actions. 12. RESTRUCTURING AND RECAPITALIZATION CHARGES Recapitalization charges On May 11, 1999, Building One completed its recapitalization plan under a tender offer (the "Tender Offer"), pursuant to which Building One repurchased 30,772 shares of its common stock at $18 per share for cash and 1,104 shares of its common stock underlying stock options at $18 per share less the exercise price per share of the options. In conjunction with the recapitalization, compensation expense of $2,770 ($1,662 after the associated tax benefit) was recognized for stock options exercised and the underlying shares of common stock repurchased by Building One. In addition, $4,323 of costs incurred in connection with the Tender Offer have been reflected as a reduction of shareholders' equity. Friedman, Billings, Ramsey Group, Inc. ("FBR") acted as a financial advisor to Building One in connection with the Tender Offer, and received a fee of $3,000. One of Building One's directors at that time is President and a principal stockholder of FBR. 39 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Restructuring charges In the second quarter of 1999, Building One's Board of Directors approved a restructuring plan which included a relocation of Building One's corporate headquarters and integration of the cleaning systems operations. The corporate headquarters was relocated from Washington, D.C. to Minneapolis, Minnesota. In addition, certain back office operations of the cleaning systems operations were consolidated into two locations. The restructuring costs included costs directly related to Building One's restructuring plan in accordance with EITF No. 94-3 which provides specific requirements as to the appropriate recognition of costs associated with employee termination benefits and other exit costs. As a result of this restructuring plan, Building One incurred severance costs for certain employees, identified certain assets which were no longer of service and incurred certain lease termination costs. Severance costs covered 33 employees, of which 30 were terminated as of December 31, 1999 and the remaining three were terminated in 2000. The following table sets forth a summary of these restructuring costs:
Corporate Cleaning Headquarters Systems Total ------------ -------- ------ Severance...... $3,530 $ 900 $4,430 Impaired assets 55 520 575 Lease costs.... 205 40 245 ------ ------ ------ Total.......... $3,790 $1,460 $5,250 ====== ====== ======
Included in the $5,250 restructuring charge incurred in the second quarter of 1999 are $4,675 of cash costs and $575 in non-cash related costs. The following table is a detailed reconciliation of the restructuring reserve balance reflecting the accruals recorded and payments applied:
Lease Severance Costs Total --------- ----- ------- Restructuring accruals recorded in 1999 $ 4,430 $ 245 $ 4,675 Payments............................... (4,173) (183) (4,356) ------- ----- ------- Balance at December 31, 1999........... 257 62 319 Payments............................... (257) (62) (319) ------- ----- ------- Balance at December 31, 2000........... $ -- $ -- $ -- ======= ===== =======
13. OPERATING SEGMENTS The Company modified its internal organizational structure during fiscal 2001, combining the Electrical Technologies, Mechanical Services and Industrial Services businesses into one Commercial/Industrial business aligned geographically. The corresponding segment information for 2000 and 1999 has been restated to conform to the new business segment presentation. The Company's reportable segments are strategic business units that, for the most part, offer products and services to distinct customer groups. They are managed separately because each business requires different operating and marketing strategies. Intersegment transactions are established based on negotiations among the parties at rates generally consistent with those charged to third parties. Intersegment revenues in 1999 were not significant. 40 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) After discontinuing the Global Technologies segment as discussed in Note 16, the Company has three reportable segments: Commercial/ Industrial Services, Residential Services and Cleaning Systems. The Commercial/Industrial Services Group provides installation and repair services to the electrical, heating, ventilation and air conditioning ("HVAC"), plumbing, control and monitoring and process piping systems of commercial and industrial facilities. The Residential Services Group provides mechanical, plumbing and other contracting services primarily in single family and low-rise multifamily housing units. The Cleaning Systems Group provides a wide variety of facility cleaning and maintenance management services nationwide. From time to time, management may move business units from one segment to another for management reporting and evaluation purposes. The Company evaluates performance based on income from operations before amortization of goodwill and other intangibles, unallocated corporate expenses, merger and related charges, costs to exit certain activities and related costs and restructuring and recapitalization charges. While amortization of goodwill is not considered in evaluating segment performance, the goodwill associated with each segment is included in the total assets of each segment. Unallocated corporate expenses primarily include corporate overhead and savings from national purchase agreements relating to materials and property/casualty insurance. Costs related to group and regional management, operational, sales and marketing, accounting and administrative support are included in the operating costs of each segment. Corporate assets primarily include cash, deferred tax assets, deferred debt issuance costs and other intangible assets, certain computer hardware and software, fixed assets related to the Company's corporate office, cost-based investments and miscellaneous non-trade accounts receivable. 41 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) Segment information is as follows:
Commercial/ Residential Cleaning Corporate/ Industrial Services Systems Eliminations Total ----------- ----------- -------- ------------ ---------- YEAR ENDED DECEMBER 31, 2001: Third-party revenues............................................... $3,200,967 $331,166 $293,135 $ -- $3,825,268 Intersegment revenues.............................................. 17,385 18 21 (17,424) -- ---------- -------- -------- -------- ---------- Total revenues..................................................... 3,218,352 331,184 293,156 (17,424) 3,825,268 Operating costs.................................................... 3,132,059 300,913 275,446 (6,142) 3,702,276 ---------- -------- -------- -------- ---------- Segment operating earnings......................................... $ 86,293 $ 30,271 $ 17,710 $(11,282) 122,992 ========== ======== ======== ======== Amortization of goodwill and other intangible assets............... 36,274 ---------- Operating income................................................... $ 86,718 ========== Capital expenditures............................................... $ 26,400 $ 1,115 $ 9,536 $ 4,499 $ 41,550 Depreciation expense............................................... 25,634 2,262 5,152 2,900 35,948 YEAR ENDED DECEMBER 31, 2000: Third-party revenues............................................... $3,350,097 $287,477 $265,160 $ -- $3,902,734 Intersegment revenues.............................................. 12,397 151 52 (12,600) -- ---------- -------- -------- -------- ---------- Total revenues..................................................... 3,362,494 287,628 265,212 (12,600) 3,902,734 Operating costs.................................................... 3,143,258 257,308 248,615 (3,218) 3,645,963 ---------- -------- -------- -------- ---------- Segment operating earnings......................................... $ 219,236 $ 30,320 $ 16,597 $ (9,382) 256,771 ========== ======== ======== ======== Amortization of goodwill and other intangible assets............... 32,724 Merger and related charges and costs to exit certain activities and related costs..................................................... 20,000 ---------- Operating income................................................... $ 204,047 ========== Capital expenditures............................................... $ 34,890 $ 1,632 $ 4,976 $ 641 $ 42,139 Depreciation expense............................................... 22,013 2,209 4,564 1,007 29,793 YEAR ENDED DECEMBER 31, 1999: Third-party revenues............................................... $1,491,794 $ -- $245,790 $ (5,935) $1,731,649 Operating costs.................................................... 1,358,906 -- 227,116 (701) 1,585,321 ---------- -------- -------- -------- ---------- Segment operating earnings......................................... $ 132,888 $ -- $ 18,674 $ (5,234) 146,328 ========== ======== ======== ======== Amortization of goodwill and other intangible assets............... 15,620 Restructuring and recapitalization charges......................... 8,020 ---------- Operating income................................................... $ 122,688 ========== Capital expenditures............................................... $ 15,099 $ -- $ 10,585 $ 1,580 $ 27,264 Depreciation expense............................................... 9,237 -- 3,329 2,672 15,238 TOTAL ASSETS: As of December 31, 2001............................................ $1,980,868 $148,394 $148,740 $123,324 $2,401,326 As of December 31, 2000............................................ 2,255,065 153,813 146,092 142,912 2,697,882 As of December 31, 1999............................................ 1,111,341 -- 152,614 49,799 1,313,754
42 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) 14. QUARTERLY FINANCIAL SUMMARY (UNAUDITED)
First (a) Second (b) Third Fourth (c) Full Year (d) --------- ---------- ---------- ---------- ------------- 2001: Revenues................................................ $992,901 $ 996,551 $ 921,624 $ 914,192 $3,825,268 Operating income (loss)................................. 45,670 49,532 2,416 (10,900) 86,718 Income (loss) from continuing operations................ 12,416 15,877 (18,986) (23,720) (14,413) Income (loss) from discontinued operations.............. 1,380 (7,082) (3,931) (589) (10,222) Loss on disposal of discontinued operations............. -- -- (23,055) (3,436) (26,491) Income (loss) before extraordinary loss................. 13,796 8,795 (45,972) (27,745) (51,126) Net income (loss)....................................... 13,796 8,795 (45,972) (27,745) (51,126) Net income (loss) available to common shareholders...... 8,779 3,688 (51,170) (33,035) (71,738) Earnings per share: Basic Income (loss) from continuing operations......... $ 0.12 $ 0.17 $ (0.38) $ (0.46) $ (0.55) Income (loss) from discontinued operations....... 0.02 (0.11) (0.06) -- (0.16) Loss on disposal of discontinued operations...... -- -- (0.36) (0.06) (0.41) Net income (loss)................................ 0.14 0.06 (0.80) (0.52) (1.12) Diluted Income (loss) from continuing operations......... $ 0.12 $ 0.17 $ (0.38) $ (0.46) $ (0.55) Income (loss) from discontinued operations....... 0.02 (0.11) (0.06) -- (0.16) Loss on disposal of discontinued operations...... -- -- (0.36) (0.06) (0.41) Net income (loss)................................ 0.14 0.06 (0.80) (0.52) (1.12) 2000: Revenues................................................ $654,472 $1,036,106 $1,110,148 $1,102,008 $3,902,734 Operating income........................................ 15,542 71,023 53,342 64,140 204,047 Income (loss) from continuing operations................ (2,197) 26,679 13,976 20,799 59,257 Income from discontinued operations..................... 680 1,736 1,045 635 4,096 Income (loss) before extraordinary loss................. (1,517) 28,415 15,021 21,434 63,353 Net income (loss)....................................... (9,574) 28,415 15,021 21,434 55,296 Net income (loss) available to common shareholders...... (11,612) 23,657 10,178 16,505 38,728 Earnings per share: Basic Income (loss) from continuing operations......... $ (0.09) $ 0.35 $ 0.14 $ 0.24 $ 0.72 Income from discontinued operations.............. 0.01 0.02 0.02 0.01 0.07 Income (loss) before extraordinary loss.......... (0.08) 0.37 0.16 0.25 0.79 Net income (loss)................................ (0.26) 0.37 0.16 0.25 0.65 Diluted Income (loss) from continuing operations......... $ (0.09) $ 0.33 $ 0.14 $ 0.24 $ 0.70 Income from discontinued operations.............. 0.01 0.02 0.02 0.01 0.07 Income (loss) before extraordinary loss.......... (0.08) 0.35 0.16 0.25 0.77 Net income (loss)................................ (0.26) 0.35 0.16 0.25 0.63
-------- (a) The first quarter of 2000 includes merger and related charges and costs to exit certain activities and related costs discussed in Note 3 totaling $20,000 or $0.28 per basic and diluted share for the first quarter, and $0.21 and $0.20 per basic and diluted share, respectively, for the full year. (b) Continuing operations in the second quarter of 2001 includes a provision for doubtful accounts receivable from telecommunication customers of $9,800, or $0.09 per basic and diluted share. (c) Continuing operations in the fourth quarter of 2001 includes a provision for doubtful accounts receivable from telecommunication customers of $18,000, or $0.18 per basic and diluted share. (d) The arithmetic total of the individual quarterly net income per share amounts does not reconcile to the annual amount of net income per share in all instances due to the timing of net income in relation to the issuance of common shres during the course of the year. 43 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) 15. EARNINGS PER SHARE The following table reconciles the numerators and denominators of the basic and diluted earnings per share computations for the years ended December 31, 2001, 2000 and 1999.
Year Ended December 31, --------------------------- 2001 2000 1999 -------- -------- ------- Basic earnings per share: Income (loss) from continuing operations.......................................................... $(14,413) $ 59,257 $51,951 Less: convertible preferred stock dividends....................................................... (20,612) (16,568) -- -------- -------- ------- Income (loss) from continuing operations available to common shareholders......................... (35,025) 42,689 51,951 Income (loss) from discontinued operations........................................................ (10,222) 4,096 1,111 Loss on disposal of discontinued operations....................................................... (26,491) -- -- Extraordinary loss on debt settlement............................................................. -- (8,057) -- -------- -------- ------- Net income (loss) available to common shareholders................................................ $(71,738) $ 38,728 $53,062 ======== ======== ======= Weighted average shares outstanding--Basic........................................................ 63,845 59,234 41,538 ======== ======== ======= Income (loss) from continuing operations.......................................................... $ (.55) $ .72 $ 1.25 Income (loss) from discontinued operations........................................................ (.16) .07 .03 Loss on disposal of discontinued operations....................................................... (.41) -- -- Extraordinary loss on debt settlement............................................................. -- (.14) -- -------- -------- ------- Net income (loss) per share--Basic................................................................ $ (1.12) $ .65 $ 1.28 ======== ======== ======= Diluted earnings per share: Income (loss) from continuing operations available to common shareholders......................... $(35,025) $ 42,689 $51,951 Income (loss) from discontinued operations........................................................ (10,222) 4,096 1,111 Loss on disposal of discontinued operations....................................................... (26,491) -- -- Extraordinary loss on debt settlement............................................................. -- (8,057) -- -------- -------- ------- Net income (loss) available to common shareholders................................................ (71,738) 38,728 53,062 Plus: interest expense on convertible junior subordinated debentures and related amortization of debt issuance costs.............................................................................. -- -- 3,205 -------- -------- ------- Net income (loss) on an as-if converted basis..................................................... $(71,738) $ 38,728 $56,267 ======== ======== ======= Weighted average shares outstanding--Diluted...................................................... 63,845 61,089 46,406 ======== ======== ======= Income (loss) from continuing operations.......................................................... $ (.55) $ .70 $ 1.19 Income (loss) from discontinued operations........................................................ (.16) .07 .02 Loss on disposal of discontinued operations....................................................... (.41) -- -- Extraordinary loss on debt settlement............................................................. -- (.14) -- -------- -------- ------- Net income (loss) per share--Diluted.............................................................. $ (1.12) $ .63 $ 1.21 ======== ======== ======= Weighted average shares (in thousands): Weighted average shares outstanding--Basic........................................................ 63,845 59,234 41,538 Common stock equivalents from stock options and warrants.......................................... -- 181 160 Contingently issuable shares...................................................................... -- 1,674 932 Convertible junior subordinated debentures, on an as-if converted basis........................... -- -- 3,776 -------- -------- ------- Weighted average shares outstanding--Diluted...................................................... 63,845 61,089 46,406 ======== ======== ======= Common stock equivalents excluded from the computation of diluted earnings per share due to their anti-dilutive effect: Convertible Preferred Stock....................................................................... 20,914 19,464 -- Stock options and warrants........................................................................ 15,213 12,464 8,970
44 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) 16. DISCONTINUED OPERATIONS On September 25, 2001, the Company announced its decision to cease operations of its Global Technologies segment effective September 30, 2001. With the exception of some minor job wrap-up and receivables collection, substantially all of these operations were terminated as of December 31, 2001. The shutdown of these operations represents the disposal of a business segment under APB No. 30. Accordingly, the consolidated statements of operations have been restated to reflect the historical, after-tax results of these operations as "Income (loss) from discontinued operations, net of tax". Revenues from the discontinued Global Technologies segment were $75,750, $117,168 and zero in the years ended December 31, 2001, 2000 and 1999, respectively. Assets and liabilities attributable to the Global Technologies operations were as follows:
December 31, --------------- 2001 2000 ------- ------- Current assets.......................... $ 4,394 $48,827 Goodwill and other long-term assets, net 468 14,428 Current liabilities..................... 15,166 39,042 Long-term liabilities................... 10,440 --
In connection with the decision to discontinue these operations, a charge of $26,491, net of the related income tax benefit of $7,819, was recorded in 2001 to provide for the estimated costs of disposal of these operations. This charge is reported under the caption "Loss on disposal of discontinued operations, net of tax" in the consolidated statements of operations. The loss on disposal of discontinued operations primarily consists of the write-off of non-deductible, unamortized goodwill of $11,972, net facility and equipment lease obligations of $12,449, net asset writedowns of $3,779 and estimated net operating losses and severance costs incurred subsequent to September 30, 2001 of $6,110. 17. SUBSEQUENT EVENT--DISCONTINUED OPERATIONS During the three months ended March 31, 2002, the Company sold three business units in the Northeast region of the Company's Commercial/Industrial Services Group for aggregate cash proceeds of $9,592, resulting in a loss on sale of $1,132, net of tax benefit. In accordance with the provisions of SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which was adopted effective January 1, 2002, these business units are classified as discontinued operations. Accordingly, the accompanying consolidated statements of operations and other amounts disclosed herein have been restated to classify these business units as discontinued operations and, therefore, to reflect after-tax results of these operations as "Income (loss) from discontinued operations, net of tax". These businesses generated aggregate revenues in 2001, 2000 and 1999 of $79,467, $79,532 and $40,935, respectively. 18. SUBSEQUENT EVENT--ADOPTION OF SFAS NO. 142 Effective January 1, 2002, the Company adopted the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets," which establish new accounting and reporting requirements for goodwill and other intangible assets. Under the new standard, goodwill and intangible assets with indefinite useful lives are no longer amortized to expense, but instead are tested for impairment at least annually. At January 1, 2002, net goodwill balances attributable to each of the Company's reporting units were tested for impairment by comparing the fair 45 ENCOMPASS SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (In thousands, except per share data) value of each reporting unit to its carrying value. Fair value was determined using capitalization of earnings estimates and market multiples of earnings estimates. Significant estimates used in the methodologies included estimates of future earnings, future growth rates, weighted average cost of capital and market valuation multiples for each reporting unit. Based upon these impairment tests performed upon adoption of SFAS No. 142, the Company recognized a charge of $451,858, or $7.06 per share, net of tax benefit of $48,218, at January 1, 2002, which is shown as a cumulative effect of a change in accounting principle in the 2002 consolidated statement of operations. This non-cash impairment charge has no impact on the calculation of financial covenants under the Company's debt agreements. Also as prescribed by SFAS No. 142, the Company reclassified the unamortized balance of its acquired dedicated workforce, which was $5,623 at January 1, 2002, from intangible assets to goodwill. The carrying amount of goodwill attributable to each reportable operating segment was as follows:
Commercial/ Residential Cleaning Industrial Services Services Systems Total ------------------- ----------- -------- ---------- Balance at December 31, 2001....................... $1,101,394 $ 99,126 $ 85,105 $1,285,625 Reclassification of value of dedicated workforce to goodwill......................................... 4,430 1,193 -- 5,623 Impairment charge.................................. (448,235) -- (51,841) (500,076) ---------- -------- -------- ---------- Balance at January 1, 2002......................... $ 657,589 $100,319 $ 33,264 $ 791,172 ========== ======== ======== ==========
Income (loss) before extraordinary loss, net income (loss) and basic and diluted earnings (loss) per share, adjusted to exclude amortization of goodwill, net of tax effect, was as follows:
Year Ended December 31, ------------------------- 2001 2000 1999 -------- ------- ------- Income (loss) before extraordinary loss $(17,441) $93,919 $67,880 Net income (loss)...................... (17,441) 85,862 67,880 Basic earnings (loss) per share........ $ (0.60) $ 1.17 $ 1.63 Diluted earnings (loss) per share...... (0.60) 1.17 1.53
A reconciliation of net income (loss) as reported to the adjusted net income (loss) follows:
Year Ended December 31, -------------------------- 2001 2000 1999 -------- ------- ------- Net income (loss) as reported............................. $(51,126) $55,296 $53,062 Add: goodwill amortization................................ 33,898 30,744 15,620 Add: amortization of acquired asset for value of dedicated workforce............................................... 1,776 1,480 -- Less: tax benefit of deductible goodwill amortization..... (1,989) (1,658) (802) -------- ------- ------- Adjusted net income (loss)................................ $(17,441) $85,862 $67,880 ======== ======= =======
46 19. SUBSEQUENT EVENT (UNAUDITED)--AMENDMENT TO CREDIT FACILITY AND RIGHTS OFFERING Effective June 26, 2002, the Company entered into the Amended Facility, which provides long-term financial covenant modification through February 2005. On June 27, 2002, the Company entered into a Securities Purchase Agreement with affiliates of Apollo, whereby Apollo agreed to purchase $35,000 of equity securities of the Company (the "Apollo Investment"). The Apollo Investment is subject to shareholder approval. The Amended Facility provides for term loans totaling approximately $400,000 and a revolving credit facility of $300,000, temporarily limited to $250,000 until funding of the Apollo Investment. In the event the Apollo Investment is not received by October 15, 2002, the Company will be in immediate default under the Amended Facility. The $35,000 of proceeds from the Apollo Investment, net of up to $4,000 of certain permitted expenses, are required to be applied against the term loans. Borrowings under the Amended Facility bear interest at variable rates, ranging from 2.0% to 4.25% over the Eurodollar Rate (as defined in the Amended Facility) and from 0.50% to 2.75% over the Alternate Base Rate (as defined in the Amended Facility), depending, in each case, on the Company's total debt-to-EBITDA ratio. In addition, the Amended Facility places restrictions upon the Company's ability to pay dividends, make acquisitions, capital expenditures and investments and requires debt prepayment with future issuances of debt or equity, assets sales and excess cash flow, as defined in the Amended Facility. The Amended Facility prohibits the payment of dividends on the Convertible Preferred Stock, which the Convertible Preferred Stock agreement requires beginning in April 2003. As a result, beginning in April 2003, the Convertible Preferred Stock will accrue dividends at an annual rate of 9.25%. However, such event does not trigger a right of acceleration of the Company's redemption obligation. The Company plans to enter into a rights offering in order to effect the Apollo Investment, whereby holders of common stock, certain options and warrants, and the Convertible Preferred Stock will receive rights to purchase up to $50,000 of Company equity securities. If the rights offering is fully subscribed, the total amount raised, including the Apollo Investment, will be $72,500. Pursuant to the Amended Facility, 50 percent of the proceeds received from the rights offering in excess of the $35,000 Apollo Investment, less certain permitted expenses, will be applied toward permanent reduction of the revolving credit facility and the term loans on a pro-rata basis. The rights offering is conditioned upon shareholder approval of the Apollo Investment and customary regulatory approvals. Pursuant to the Statement of Designation related to the Convertible Preferred Stock and the Investors' Rights Agreement between Apollo and the Company, Apollo currently has appointed three members of the Company's Board of Directors. Under the Investors' Rights Agreement, the Company is required to maintain a total debt leverage ratio (total debt to EBITDA, as defined) of 4.00 to 1. This debt leverage covenant differs from the similar covenant included in the Amended Facility and is not as clearly defined. The Company believes that it did not maintain a leverage ratio less than 4.00 to 1 during the second quarter of 2002. If such event is deemed both material and intentional, and so long as the requirements of the covenant are not met, Apollo would be entitled to appoint additional directors to the Company's Board of Directors, such that the Apollo-appointed directors would constitute a majority of the Board of Directors. Not meeting the total debt leverage covenant does not trigger a right of acceleration of the Company's obligations under any of its debt or outstanding participating preferred stock instruments. 47 PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) The following documents are filed as part of this report: 1. Financial statements Independent Auditors' Report Report of Independent Accountants Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Shareholders' Equity and Other Comprehensive Income Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements 2. Financial statement schedules None. 3. Exhibits.
Exhibit No. Description of Exhibit --- ---------------------- 23.1 --Consent of KPMG LLP. 23.2 --Consent of PricewaterhouseCoopers LLP.
(b) Reports on Form 8-K On June 28, 2002, Encompass filed a Current Report on Form 8-K with respect to its announcement of, among other things, a $50 million rights offering in which two affiliates of Apollo have committed to purchase $35 million of the Company's securities and an amendment to the Company's Credit Facility. The Current Report included the Company's press release, the agreement with Apollo and the amendment to the Credit Facility. (c) None. (d) None. 48 SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized. ENCOMPASS SERVICES CORPORATION /S/ DARREN B. MILLER By: ----------------------------------- Name: Darren B. Miller Title: Senior Vice President and Chief Financial Officer Dated: July 1, 2002 49 INDEX OF EXHIBITS Exhibits not incorporated by reference to a prior filing are designated by an asterisk; all exhibits not so designated are incorporated to a prior filing as indicated.
Exhibit Number Description ------ ----------- 23.1* --Consent of KPMG LLP. 23.2* --Consent of PricewaterhouseCoopers LLP.
50