UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

Commission File Number: 1-8929

 

ABM INDUSTRIES INCORPORATED

(Exact name of registrant as specified in its charter)

 

 

(Registrant’s telephone number, including area code) 415/733-4000

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 the filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

(Check one): Large accelerated filer þ Accelerated filer  o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of April 30, 2007 (the last business day of registrant’s most recently completed second fiscal quarter), non-affiliates of the registrant beneficially owned shares of the registrant’s common stock with an aggregate market value of $1,250,916,453, computed by reference to the price at which the common stock was last sold.

 

Number of shares of common stock outstanding as of November 30, 2007: 50,037,914.

 

DOCUMENTS INCORORATED BY REFERENCE

 

Portions of the Proxy Statement to be used by the Company in connection with its 2008 Annual Meeting of Stockholders are incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

ABM Industries Incorporated
Form 10-K
For the Fiscal Year Ended October 31, 2007

 

TABLE OF CONTENTS

 

PART I

 

 

ABM Industries Incorporated (“ABM”) is a leading facility services contractor in the United States. With 2007 revenues in excess of $2.8 billion, ABM and its subsidiaries (the “Company” or “we”) provide janitorial, parking, security, engineering and lighting services for thousands of commercial, industrial, institutional and retail facilities in hundreds of cities throughout the United States and in British Columbia, Canada. ABM was reincorporated in Delaware on March 19, 1985, as the successor to a business founded in California in 1909.

 

On November 14, 2007, ABM acquired OneSource Services, Inc. (“OneSource”), a company formed under the laws of Belize with US operations headquartered in Atlanta, Georgia. The consideration was $365.0 million, which was paid by a combination of cash on hand and borrowings under the Company’s line of credit. In addition, following the closing, the Company paid in full approximately $21 million outstanding under OneSource’s then–existing credit facility. With annual revenues of approximately $825 million during the fiscal year ended March 31, 2007 and approximately 30,000 employees, OneSource is a provider of outsourced facility services, including janitorial, landscaping, general repair and maintenance and other specialized services, for more than 10,000 commercial, industrial, institutional and retail accounts in the United States and Puerto Rico, as well as in British Columbia, Canada. OneSource’s operations will be included in the Janitorial segment and use the ABM Janitorial name.

 

The corporate headquarters of the Company is located at 160 Pacific Avenue, Suite 222, San Francisco, California 94111, and the Company’s telephone number at that location is (415) 733-4000. In 2008, the Company will move its corporate headquarters to 551 Fifth Avenue, Suite 300, New York, New York 10176. The Company’s telephone number at that location is (212) 297-0200.

 

The Company’s Website is www.abm.com. Through the “Financials” link on the Investor Relations section of the Company’s Website, the following filings and amendments to those filings are made available free of charge, as soon as reasonably practicable after they are electronically filed with or furnished to the SEC: (1) Annual Reports on Form 10-K, (2) Quarterly Reports on Form 10-Q, (3) Current Reports on Form 8-K and (4) filings by ABM’s directors and executive officers under Section 16(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). The Company also makes available on its Website and in print, free of charge, to those who request them its Corporate Governance Guidelines, Code of Business Conduct & Ethics and the charters of its Audit, Compensation and Governance Committees. Information contained on the Company’s Website shall not be deemed incorporated into, or to be a part of, this Annual Report on Form 10-K.

 

Industry Information

 

The Company conducts business through a number of subsidiaries, which are grouped into five segments based on the nature of the business operations. The operating subsidiaries within each segment generally report to the same senior management. Referred to collectively as the “ABM Family of Services,” the five segments are:

 

 

The business activities of the Company by industry segment are more fully described below.

 

n Janitorial.  The Company performs janitorial services through a number of the Company’s subsidiaries, primarily operating under the names “ABM Janitorial Services” and “American Building Maintenance.” The Company provides a wide range of basic janitorial services for a variety of facilities, including commercial office buildings, industrial plants, financial institutions, retail stores, shopping centers, warehouses, airport terminals, health and educational facilities, stadiums and arenas, and government buildings. Services provided include floor cleaning and finishing, window washing, furniture polishing, carpet cleaning and dusting, as well as other building cleaning services. At October 31, 2007, the Company’s Janitorial subsidiaries maintained 116 offices and operated in 49 states, the District of Columbia and British Columbia. OneSource’s acquisition adds an additional 93 offices and expands the Company’s scope of operations to all 50 states and Puerto Rico. Certain of these offices are expected to be consolidated as the Company integrates the OneSource operations. The Janitorial segment operates under thousands of individually negotiated building maintenance contracts, nearly all of which are obtained by competitive bidding. The Company’s Janitorial contracts are either fixed price agreements or “cost-plus” (i.e., the customer agrees to reimburse the agreed upon amount of wages and benefits, payroll taxes, insurance charges and other expenses plus a profit percentage). Generally,

profit margins on contracts tend to be inversely proportional to the size of the contract. In addition to services defined within the scope of the contract, the Company also generates sales from extra services (or “tags”), such as additional cleaning requirements, with extra services frequently providing higher margins. The majority of Janitorial contracts are for one- to three-year periods, but are subject to termination by either party after 30 to 90 days’ written notice and contain automatic renewal clauses.

 

n Parking.  The Company provides parking services through a number of subsidiaries, primarily operating under the names “Ampco System Parking,” “Ampco System Airport Parking,” “Ampco Express Airport Parking” and “HealthCare Parking Services of America.” The Company’s Parking subsidiaries maintain 27 offices and operate in 39 states. The Company operates approximately 1,775 parking lots and garages, including, but not limited to, facilities at the following airports: Austin, Texas; Dallas/Ft. Worth, Texas; Denver, Colorado; Honolulu, Hawaii; Minneapolis/St. Paul, Minnesota; Omaha, Nebraska; Orlando, Florida; San Jose, California; and Tampa, Florida. Included in the 27 offices and 1,775 parking lots were an office and 143 parking lots and garages acquired in the acquisition of HealthCare Parking Services of America (“HPSA”) in the second quarter of 2007. The Company also operates off-airport parking facilities in Houston, Texas and San Diego, California, and provides parking shuttle bus services at an additional 40 airports. The Company expanded its valet parking service through the acquisition of HPSA. Approximately 45% of the parking lots and garages are leased and 55% are operated through management contracts for third parties, nearly all of which contracts are obtained by competitive bidding. The Company operated over 770,000 parking spaces as of October 31, 2007. Under leased lot arrangements, the Company leases the parking lot from the owner and is responsible for all expenses incurred, retains all revenues from monthly and transient parkers and pays rent to the owner per the terms and conditions of the lease. The lease terms generally range from one to five years and provide for payment of a fixed amount of rent plus a percentage of revenue. The leases usually contain renewal options and may be terminated by the customer for various reasons, including development of the real estate. Leases which expire may continue on a month-to-month basis. Under the management contracts, the Company manages the parking lot for the owner in exchange for a management fee, which could be a fixed fee, a performance-based fee such as a percentage of gross or net revenues, or a combination of both. Management contract terms are generally from one to three years, and often can be terminated without cause by the customer upon 30 days’ notice and may also contain renewal clauses. The revenue and expenses are passed through by the Company to the owner under the terms and conditions of the management contract. More than half of the Company’s Parking revenues come from reimbursements of expenses.

 

n Security.  The Company provides security services through a number of subsidiaries, primarily operating under the names “ABM Security Services,” “SSA Security, Inc.,” “Security Services of America,” “Silverhawk Security Specialists” and “Elite Protection Services.” The Company provides security officers; investigative services; electronic monitoring of fire, life safety systems and access control devices; and security consulting services to a wide range of businesses. The Company’s Security subsidiaries maintain 61 offices and operate in 34 states and the District of Columbia. Sales are generally based on actual hours of service at contractually specified rates. The majority of Security contracts are for one-year periods, but are subject to termination by either party after 30 to 90 days’ written notice and contain automatic renewal clauses. Nearly all Security contracts are obtained by competitive bidding.

 

n Engineering.  The Company provides engineering services through a number of subsidiaries, primarily operating under the name “ABM Engineering Services.” The Company provides facilities with on-site engineers to operate and maintain mechanical, electrical and plumbing systems utilizing, in part, computerized maintenance management systems. These services are designed to maintain equipment at optimal efficiency for customers such as high-rise office buildings, schools, computer centers, shopping malls, manufacturing facilities, museums and universities. The Company’s Engineering subsidiaries maintain 12 branches and operate in 31 states and the District of Columbia. The majority of Engineering contracts contain clauses under which the customer agrees to reimburse the full amount of wages, payroll taxes, insurance charges and other expenses plus a profit percentage. Additionally, the majority of Engineering contracts are for three-year periods, but are subject to termination by either party after 30 to 90 days’ written notice and may contain renewal clauses. Nearly all Engineering contracts are obtained by competitive bidding. ABM Engineering Services Company, a wholly owned subsidiary of ABM, has maintained ISO 9000 Certification since 1999, the only national engineering services provider of on-site operating engineers to earn this prestigious designation. ISO is a quality standard comprised of a rigorous set of

guidelines and good business practices against which companies are evaluated through a comprehensive independent audit process.

 

The Company’s Engineering segment also provides facility services through a number of subsidiaries, primarily operating under the name “ABM Facility Services.” The Company provides customers with streamlined, centralized control and coordination of multiple facility service needs. This process is consistent with the greater competitive demands on corporate organizations to become more efficient in the business market today. By leveraging the core competencies of the Company’s other service offerings, the Company attempts to reduce overhead (such as redundant personnel) for its customers by providing multiple services under a single contract, with one contact and one invoice. Its National Service Call Center provides centralized dispatching, emergency services, accounting and related reports to financial institutions, high-tech companies and other customers regardless of industry or size.

 

n Lighting.  The Company provides lighting services through a number of subsidiaries, primarily operating under the name “Amtech Lighting Services.” The Company provides relamping, fixture cleaning, energy retrofits and lighting maintenance service to a variety of commercial, industrial and retail facilities. The Company’s Lighting subsidiaries also repair and maintain electrical outdoor signage, and provide electrical service and repairs. The Company’s Lighting subsidiaries maintain 26 offices and operate in 50 states and the District of Columbia. Lighting contracts are either fixed-price (long-term full service or maintenance only contracts), project work or time and materials-based, where the customer is billed according to actual hours of service and materials used at specified prices. Contracts range from one to six years, but the majority are subject to termination by either party after 30 to 90 days’ written notice and may contain renewal clauses. Nearly all Lighting contracts are obtained by competitive bidding.

 

Additional information relating to the Company’s industry segments for the three most recent fiscal years appears in Note 19 of the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplementary Data.”

 

Trademarks

 

We believe that the Company owns or is licensed to use all corporate names, tradenames, trademarks, service marks, copyrights, patents and trade secrets which are material to the Company’s operations.

 

Competition

 

We believe that each aspect of the Company’s business is highly competitive, and that such competition is based primarily on price and quality of service. The Company provides nearly all its services under contracts originally obtained through competitive bidding. The low cost of entry to the facility services business has led to strongly competitive markets made up of large numbers of mostly regional and local owner-operated companies, located in major cities throughout the United States and in British Columbia, Canada (with particularly intense competition in the janitorial business in the Southeast and South Central regions of the United States). The Company also competes with the operating divisions of a few large, diversified facility services and manufacturing companies on a national basis. Indirectly, the Company competes with building owners and tenants that can perform internally one or more of the services provided by the Company. These building owners and tenants might have a competitive advantage when the Company’s services are subject to sales tax and internal operations are not. Furthermore, competitors may have lower costs because privately owned companies operating in a limited geographic area may have significantly lower labor and overhead costs. These strong competitive pressures could inhibit the Company’s success in bidding for profitable business and its ability to increase prices even as costs rise, thereby reducing margins.

 

Sales and Marketing

 

The Company’s sales and marketing efforts are conducted by its corporate, subsidiary, regional, branch and district offices. Sales, marketing, management and operations personnel in each of these offices participate directly in selling and servicing customers. The broad geographic scope of these offices enables the Company to provide a full range of facility services through intercompany sales referrals, multi-service “bundled” sales and national account sales.

 

The Company has a broad customer base, including, but not limited to, commercial office buildings, industrial plants, financial institutions, retail stores, shopping centers, warehouses, airports, health and educational facilities, stadiums and arenas, and government buildings. No customer accounted for more than 5% of its revenues during the fiscal year ended October 31, 2007.

Employees

 

As of November 30, 2007, the Company employed approximately 107,000 persons, including approximately 30,000 OneSource employees, of whom the vast majority are service employees who perform janitorial, parking, security, engineering and lighting services. Approximately 39,000 of these employees are covered under collective bargaining agreements at the local level. There are approximately 5,000 employees with executive, managerial, supervisory, administrative, professional, sales, marketing or clerical responsibilities, or other office assignments.

 

Environmental Matters

 

The Company’s operations are subject to various federal, state and/or local laws regulating the discharge of materials into the environment or otherwise relating to the protection of the environment, such as discharge into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and hazardous substances. These laws generally have the effect of increasing costs and potential liabilities associated with the conduct of the Company’s operations, although historically they have not had a material adverse effect on the Company’s financial position, results of operations or cash flows. In addition, from time to time, the Company is involved in environmental issues at certain of its locations or in connection with its operations. While it is difficult to predict the ultimate outcome of any of these matters, based on information currently available, we believe that none of these matters, individually or in the aggregate, are reasonably likely to have a material adverse effect on the Company’s financial position, results of operations or cash flows.

Executive Officers of the Registrant

 

The executive officers of ABM on December 21, 2007 were as follows:

 

ITEM 1A.  RISK FACTORS

 

(Cautionary Statements Under the Private Securities Litigation Reform Act of 1995)

 

The disclosure and analysis in this Annual Report on Form 10-K contain some forward-looking statements that set forth anticipated results based on management’s plans and assumptions. From time to time, we also provide forward-looking statements in other written materials released to the public, as well as oral forward-looking statements. Such statements give the Company’s current expectations or forecasts of future events; they do not relate strictly to historical or current facts. In particular, these include statements relating to future actions, future performance or results of current and anticipated sales efforts, expenses, and the outcome of contingencies and other uncertainties, such as legal proceedings, and financial results. Management tries, wherever possible, to identify such statements by using words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project” and similar expressions.

 

Set forth below are factors that we think, individually or in the aggregate, could cause the Company’s actual results to differ materially from past results or those anticipated, estimated or projected. We note these factors for investors as permitted by the Private Securities Litigation Reform Act of 1995. Investors should understand that it is not possible to predict or identify all such factors. Consequently, the following should not be considered to be a complete list of all potential risks or uncertainties.

 

OneSource and other acquisitions may divert our focus and lead to unexpected difficulties.  On November 14, 2007, the Company acquired OneSource, which effectively increased the Company’s janitorial operations by approximately 50% (when measured by revenues). Realization of the benefits of the acquisition will depend, among other things, upon our ability to integrate the businesses successfully and on schedule and to achieve the anticipated savings associated with reductions in offices, staffing and other costs. There can be no assurance that the acquisition of OneSource or any acquisition that we make in the future will provide the benefits that were anticipated when entering the transaction. The process of integrating an acquired business may create unforeseen difficulties and expenses. The areas in which we may face risks include:

 

 

In addition, pursuit of our announced strategy of international growth will entail new risks associated with currency fluctuations, international economic fluctuations, and language and cultural differences.

 

Our technology environment may be inadequate to support growth.  Although we use centralized accounting systems, we rely on a number of legacy information technology systems, particularly our payroll systems, as well as manual processes, to operate. These systems and processes may be unable to provide adequate support for the business and create excessive reliance upon manual rather than system controls. Use of the legacy payroll systems could result, for instance, in delays in meeting payroll obligations, in difficulty calculating and tracking appropriate governmental withholding and other payroll regulatory obligations, and in higher internal and external expenses to work around these systems. Additionally, the current technology environment is unable to support the integration of acquired businesses and anticipated internal growth. Effective October 2006, the Company entered into an outsourcing agreement with International Business Machines Corporation (“IBM”) to provide information technology infrastructure and services. We are implementing a new payroll and human resources information system, and upgrading the accounting systems. The upgrade of the accounting systems includes the consolidation of multiple databases, the potential replacement of custom systems and business process redesign to facilitate the implementation of shared-services functions across the Company. In addition to the risk of potential failure in

each project, supporting multiple concurrent projects may result in resource constraints and the inability to complete projects on schedule. The acquisition of OneSource will necessitate integration and consolidation. We plan to continue to use the OneSource information technology systems during a transition period and are evaluating their integration with our systems. IBM supports our current technology environment and assists us in selecting new technology and upgrading current technology. It is also assisting in the evaluation of the OneSource technology environment. While we believe that IBM’s experience and expertise will lead to improvements in our technology environment, the risks associated with outsourcing include the dependence upon a third party for essential aspects of the Company’s business and risks to the security and integrity of the Company’s data in the hands of third parties. We may also have potentially less control over costs associated with necessary systems when they are supported by a third party, as well as potentially less responsiveness from vendors than employees.

 

Transition to a Shared Services Center could create disruption in functions affected.  The Company has historically performed accounting functions, such as accounts payable, accounts receivable collection and payroll, in a decentralized manner through regional accounting centers in its businesses. In 2007, we began consolidating these functions in a Shared Services Center in Houston, Texas. The consolidation has taken place in certain accounting functions for Janitorial and over the next two years other functions and additional business units (including OneSource) will be moved to the Shared Services Center. The timing of the consolidation of different functions is tied to the upgrade of the Company’s accounting systems and implementation of a new payroll system and human resources information system. In addition to the risks associated with technology changes, the Shared Services Center implementation could lead to the turnover of personnel with critical knowledge, which could impede our ability to bill customers and collect receivables and might cause customer dissatisfaction associated with an inability to respond to questions about billings and other information until new employees can be retained and fully trained. Because the consolidation of functions in the Shared Services Center is tied to the upgrade of the Company’s accounting systems and implementation of a new payroll system and human resources information system, delays in the implementation of the technology changes would lead to delays in the Company’s ability to realize the benefits associated with the Shared Services Center.

 

The move of our corporate headquarters will lead to loss of personnel and institutional knowledge, and may disrupt the continuity of control functions.  In March 2007, we announced the relocation of our corporate headquarters to New York City beginning in 2008. This move will begin January 1, 2008 and continue over the following two years. In addition, certain functions that have operated centrally from corporate headquarters, such as the finance and legal organizations, will be dispersed in a combination of corporate headquarters, field headquarters and shared service center locations. These moves will increase employee turnover, particularly in finance, legal and human resources. The loss of personnel could lead to disruptions in control functions stemming from delays in filling vacant positions and a lack of personnel with institutional knowledge.

 

A change in the frequency or severity of claims, a deterioration in claims management, the cancellation or non-renewal of primary insurance policies or a change in our customer’s insurance needs could adversely affect results.  Many customers, particularly institutional owners and large property management companies, prefer to do business with contractors, such as the Company, with significant financial resources, who can provide substantial insurance coverage. In fact, many of our clients choose to obtain insurance coverage for the risks associated with our services by being named as additional insureds under our master liability insurance policies and by seeking contractual indemnification for any damages associated with our services. In addition, pursuant to our management and service contracts, we charge certain clients an allocated portion of our insurance-related costs, including workers’ compensation insurance, at rates that, because of the scale of our operations and claims experience, we believe are competitive. A material change in insurance costs due to a change in the number of claims, claims costs or premiums could have a material effect on our operating income. In addition, should we be unable to renew our umbrella and other commercial insurance policies at competitive rates, it would have an adverse impact on the Company’s business, as would catastrophic uninsured claims or the inability or refusal of our insurance carriers to pay otherwise insured claims. Furthermore, where the Company self-insures, a deterioration in claims management, whether by the Company or by a third party claims administrator, could lead to mismanagement of claims thereby increasing claim costs, particularly in the workers’ compensation area.

 

A change in estimated claims costs could affect results.  We periodically evaluate estimated claims

costs and liabilities to ensure that self-insurance reserves are appropriate. Additionally, we monitor new claims and claims development to assess the adequacy of insurance reserves. Trend analysis is complex and highly subjective. The interpretation of trends requires the knowledge of all factors affecting the trends that may or may not be reflective of adverse developments (e.g., changes in regulatory requirements and changes in reserving methodology). If the trends suggest that the frequency or severity of claims incurred has increased, we might be required to record additional expenses for self-insurance liabilities. In addition, variations in estimates that cause changes in our insurance reserves may not always be related to changes in claims experience. Changes in insurance reserves as a result of a review can cause swings in operating results that are unrelated to our ongoing business. In addition, because of the time required for the analysis, we may not learn of a deterioration in claims, particularly claims administered by a third party, until additional costs have been incurred or are projected. Because we base pricing in part on our estimated insurance costs, our prices could be higher or lower than they otherwise might be if better information were available resulting in a competitive disadvantage in the former case and reduced margins or unprofitable contracts in the latter.

 

Debt to fund the acquisition of OneSource, as well as any future increase in the level of debt or in interest rates, can effect our results of operations.  Incurring debt to acquire OneSource, and any future increase in the level of debt, will require that a portion of cash flow from operating activities be dedicated to interest payments and principal payments at maturity. Unless the cash flows generated by OneSource (or future acquisitions funded by debt) exceed the required payments, debt service requirements could reduce our ability to use our cash flow to fund operations and capital expenditures, and to capitalize on future business opportunities (including additional acquisitions). Because current interest rates on our debt are variable, an increase in prevailing rates would increase our interest costs. Further, our credit facility agreement contains both financial covenants and covenants that limit our ability to engage in specified transactions, which may also constrain our flexibility.

 

Our ability to operate and pay our debt obligations depends upon our access to cash.  Because ABM conducts business operations through operating subsidiaries, we depend on those entities to generate the funds necessary to meet financial obligations. Delays in collections or legal restrictions could restrict ABM’s subsidiaries’ ability to make distributions or loans to ABM. The earnings from, or other available assets of, these operating subsidiaries may not be sufficient to make distributions to enable ABM to pay interest on debt obligations when due or to pay the principal of such debt at maturity. In addition, a substantial portion of our investment portfolio is invested in auction rate securities and, if an auction fails for securities in which we have invested, the investment will not be liquid. In 2007, auctions for $25.0 million of these securities failed and such failures could occur in the future. In the event we need to access these funds, we will not be able to do so until a future auction is successful, the issuer redeems the outstanding securities or the securities mature (between 20 and 50 years). If the issuer of the securities is unable to successfully close future auctions and its credit rating deteriorates, we may be required to adjust the carrying value of the securities through an impairment charge.

 

Labor disputes could lead to loss of sales or expense variations.  At November 30, 2007, approximately 36% of the Company’s employees were subject to various local collective bargaining agreements, some of which will expire or become subject to renegotiation during the year. In addition, we are facing a number of union organizing drives. When one or more of the Company’s major collective bargaining agreements becomes subject to renegotiation or when we face union organizing drives, we and the union may disagree on important issues which, in turn, could lead to a strike, work slowdown or other job actions at one or more of our locations. In a market where the Company and a number of major competitors are unionized but other competitors are not unionized, we could lose customers to competitors who are not unionized. A strike, work slowdown or other job action could in some cases disrupt us from providing services, resulting in reduced revenue. If declines in customer service occur or if our customers are targeted for sympathy strikes by other unionized workers, contract cancellations could result. The result of negotiating a first time agreement or renegotiating an existing collective bargaining agreement could be a substantial increase in labor and benefits expenses that we may be unable to pass through to customers for some period of time, if at all.

A decline in commercial office building occupancy and rental rates could affect sales and profitability.  Our sales directly depend on commercial real estate occupancy levels. Decreases in occupancy levels reduce demand and also create pricing pressures on building maintenance and other services provided by the Company. In certain geographic areas and service segments, the Company’s most profitable sales are known as tag jobs, which are services performed for tenants in buildings in which it performs building services for the property owner or management company. A decline in occupancy rates could result in a decline in fees paid by landlords, as well as tenant work, which would lower sales and margins. In addition, in those areas where the workers are unionized, decreases in sales can be accompanied by relative increases in labor costs if we are obligated by collective bargaining agreements to retain workers with seniority and consequently higher compensation levels and cannot pass through these costs to customers.

 

The financial difficulties or bankruptcy of one or more of our major customers could adversely affect results.  Future sales and our ability to collect accounts receivable depend, in part, on the financial strength of customers. We estimate an allowance for accounts we do not consider collectible and this allowance adversely impacts profitability. In the event customers experience financial difficulty, and particularly if bankruptcy results, profitability is further impacted by the Company’s failure to collect accounts receivable in excess of the estimated allowance. Additionally, the Company’s future sales would be reduced by the loss of these customers.

 

Acquisition activity could slow.  A significant portion of our historic growth has come through acquisitions and we expect to continue to acquire businesses in the future as part of our growth strategy. A slowdown in acquisitions could lead to a slower growth rate. Because new contracts frequently involve start-up costs, sales associated with acquired operations generally have higher margins than sales associated with internal growth. Therefore, a slowdown in acquisition activity could lead to constant or lower margins, as well as lower revenue growth.

 

Our success depends on our ability to preserve our long-term relationships with customers.  Our contracts with our customers can generally be terminated upon relatively short notice. However, the business associated with long-term relationships is generally more profitable than that from short-term relationships because we incur start-up costs with many new contracts, particularly for training, operating equipment and uniforms. Once these costs are expensed or fully depreciated over the appropriate periods, the underlying contracts become more profitable. Therefore, our loss of long-term customers could have an adverse impact on our profitability even if we generate equivalent sales from new customers.

 

We are subject to intense competition that can constrain our ability to gain business, as well as our profitability.  We believe that each aspect of our business is highly competitive, and that such competition is based primarily on price and quality of service. We provide nearly all our services under contracts originally obtained through competitive bidding. The low cost of entry to the facility services business has led to strongly competitive markets consisting primarily of regional and local owner-operated companies, with particularly intense competition in the janitorial business in the Southeast and South Central regions of the United States. We also compete with a few large, diversified facility services and manufacturing companies on a national basis. Indirectly, we compete with building owners and tenants that can perform internally one or more of the services that we provide. These building owners and tenants have a competitive advantage in locations where the Company’s services are subject to sales tax and internal operations are not. Furthermore, competitors may have lower costs because privately owned companies operating in a limited geographic area may have significantly lower labor and overhead costs. These strong competitive pressures could impede our success in bidding for profitable business and our ability to increase prices even as costs rise, thereby reducing margins. Further, if sales decline, we may not be able to reduce expenses correspondingly.

 

An increase in costs that we cannot pass on to customers could affect profitability.  We negotiate many contracts under which our customers agree to pay certain costs at rates set by the Company, particularly workers’ compensation and other insurance coverage where the Company self insures much of its risk. If actual costs exceed the rates we set, then our profitability may decline unless we can negotiate increases in these rates. In addition, if our costs, particularly workers’ compensation and other insurance costs, exceed those of our competitors, we may lose business unless we establish rates that do not fully cover our costs.

 

Natural disasters or acts of terrorism could disrupt services.  Storms, earthquakes, drought, floods or other natural disasters or acts of terrorism may result in reduced sales or property damage. Disasters

may also cause economic dislocations throughout the country. In addition, natural disasters or acts of terrorism may increase the volatility of financial results, either due to increased costs caused by the disaster with partial or no corresponding compensation from customers, or, alternatively, increased sales and profitability related to tag jobs, special projects and other higher margin work necessitated by the disaster. In addition, a significant portion of Parking sales is tied to the numbers of airline passengers and hotel guests and Parking results could be adversely affected if people curtail business and personal travel as a result of any such event.

 

We incur significant accounting and other control costs that reduce profitability.  As a publicly traded corporation, we incur certain costs to comply with regulatory requirements. If regulatory requirements were to become more stringent or if controls thought to be effective later fail, we may be forced to make additional expenditures, the amounts of which could be material. Most of our competitors are privately owned so our accounting and control costs can be a competitive disadvantage. Should sales decline or if we are unsuccessful at increasing prices to cover higher expenditures for internal controls and audits, the costs associated with regulatory compliance will rise as a percentage of sales.

 

Other issues and uncertainties may include:

 

 

We believe that the Company has the human and financial resources for business success, but future profit and cash flow can be adversely (or advantageously) influenced by a number of factors, including those listed above, any and all of which are inherently difficult to forecast. We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events or otherwise.

 

 

None.

 

ITEM 2.  PROPERTIES

 

As of November 30, 2007, the Company had corporate, subsidiary, regional, branch or district offices in over 330 locations throughout the United States (including Puerto Rico) and in British Columbia, Canada. Fourteen of these facilities are owned by the Company, of which two were obtained in the acquisition of OneSource. At October 31, 2007, the 12 facilities then owned by the Company had an aggregate net book value of $2.3 million and were located in: Phoenix, Arizona; Jacksonville and Tampa, Florida; Portland, Oregon; Houston and San Antonio, Texas; and Kennewick, Seattle, Spokane and Tacoma, Washington. The OneSource facilities were carried at net book value of $0.1 million prior to the acquisition and were located in New Orleans, Louisiana, and Lake Tansi, Tennessee.

 

Rental payments under long and short-term lease agreements amounted to $97.6 million for the fiscal year ended October 31, 2007. Of this amount, $64.0 million in rental expense was attributable to public parking lots and garages leased and operated by Parking. The remaining expense was for the rental or lease of office space, computers, operating equipment and motor vehicles. These amounts do not include OneSource rental payments.

 

ITEM 3.  LEGAL PROCEEDINGS

 

The Company is involved in various claims and legal proceedings of a nature considered normal to its business, as well as, from time to time, in additional matters. The Company records accruals for contingencies when it is probable that a liability has been incurred and the amount can be reasonably estimated. These accruals are adjusted periodically as assessments change or additional information becomes available.

 

The Company is a defendant in the following purported class action lawsuits related to alleged violations of federal or California wage-and-hour laws: (1) The consolidated cases of Augustus, Hall and Davis v.

American Commercial Security Services (“ACSS”) filed July 12, 2005, in the Superior Court of California, Los Angeles County (“L.A. Superior Ct.”); (2) Augustus and Hernandez v. ACSS filed on February 23, 2006, in L.A. Superior Ct.; (3) the recently consolidated cases of Bucio/Morales and Martinez/Lopez v. ABM Janitorial Services filed on April 7, 2006, in the Superior Court of California, County of San Francisco; (4) the consolidated cases of Batiz/Heine v. ACSS filed on June 7, 2006, in the U.S. District Court of California, Central District; (5) Joaquin Diaz v. Ampco System Parking filed on December 5, 2006, in L.A. Superior Ct; (6) Castellanos v. ABM Industries filed on April 5, 2007, in the U.S. District Court of California, Central District; (7) Villacres v. ABM Security filed on August 15, 2007, in the U.S. District Court of California, Central District; (8) Jose Morales v. Ampco System Parking filed on November 19, 2007, in the L.A. Superior Ct. and (9) Freddy Reyes v. Ampco System Parking filed on November 30, 2007, in the L.A. Superior Ct. The named plaintiffs in these lawsuits are current or former employees of ABM subsidiaries who allege, among other things, that they were required to work “off the clock,” were not paid for all overtime and were not provided work breaks or other benefits. The plaintiffs generally seek unspecified monetary damages, injunctive relief or both. The Company believes it has meritorious defenses to these claims and intends to continue to vigorously defend itself on claims not settled. On April 25, 2007, a settlement was reached in Augustus and Hernandez v. ACSS, which was approved by the court on August 23, 2007.

 

As described in more detail in Note 2 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K, the Company self-insures certain insurable risks and, based on its periodic evaluations of estimated claim costs and liabilities, accrues self-insurance reserves to the Company’s best estimate. One such evaluation, completed in November 2004, indicated adverse developments in the insurance reserves that were primarily related to workers’ compensation claims in the state of California during the four-year period ended October 31, 2003 and resulted in the Company recording a charge of $17.2 million in the fourth quarter of 2004. The Company believes a substantial portion of the $17.2 million, as well as other costs incurred by the Company in its insurance claims, was related to poor claims management by a third party administrator that no longer performs these services for the Company. The Company believes that poor claims administration in certain other states, particularly New York, also led to higher costs for the Company. The Company has filed a claim against its former third party administrator for its damages related to claims mismanagement. The Company is actively pursuing this claim, which is subject to arbitration in accordance with the rules of the American Arbitration Association. The three-person arbitration panel has been designated and discovery is underway, including examination of a sample of claims by insurance experts.

 

In August 2005, ABM filed an action for declaratory relief, breach of contract and breach of the implied covenant of good faith and fair dealing in U.S. District Court in The Northern District of California against its insurance carriers, Zurich American Insurance Company (“Zurich American”) and National Union Fire Insurance Company (“National Union”) relating to the carriers’ failure to provide coverage for ABM and one of its Parking subsidiaries. In September 2006, the Company settled its claims against Zurich American for $400,000. Zurich American had provided $850,000 in coverage. In September 2006, the Company lost a motion for summary adjudication filed by National Union on the issue of the duty to defend. The Company has appealed that ruling and filed its reply brief in March 2007. ABM’s claim includes “bad faith” allegations for National Union’s breach of its duty to defend the Company in litigation with IAH-JFK Airport Parking Co., LLC. In early 2006, ABM paid $6.3 million in settlement costs in the IAH-JFK litigation and seeks to recover $5.3 million of these settlement costs and legal fees from National Union.

 

While the Company accrues amounts it believes are adequate to address any liabilities related to litigation that the Company believes will result in a probable loss, the ultimate resolution of such matters is always uncertain. It is possible that litigation brought against the Company in the future could have a material adverse impact on its financial condition and results of operations. At October 31, 2007, the Company’s contingent loss reserves for legal proceedings aggregated $2.2 million, which included the estimated liability for the settlement of Augustus and Hernandez vs. ACSS.

 

 

None.

 

PART II

 

 

Market Information and Dividends

 

ABM’s common stock is listed on the New York Stock Exchange (NYSE: ABM). The following table sets forth the high and low intra-day prices of ABM’s common stock on the New York Stock Exchange and quarterly cash dividends declared on shares of common stock for the periods indicated:

 

 

To our knowledge, there are no current factors that are likely to materially limit the Company’s ability to pay comparable dividends for the foreseeable future.

 

Stockholders

 

At November 30, 2007, there were 3,460 registered holders of ABM’s common stock.

 

Issuer Purchases of Equity Securities

 

On December 12, 2006, ABM’s Board of Directors authorized the purchase of up to 2,000,000 shares of ABM’s outstanding common stock during the fiscal year ended October 31, 2007. No stock repurchases were made in the fourth quarter of 2007. The authorization expired with 2,000,000 shares remaining.

Performance Graph

 

Set forth below is a graph comparing the five-year cumulative total stockholder return of ABM common stock with the five-year cumulative total of: (1) the Standard & Poor’s 500 Index and (2) the Standard & Poor’s 1500 Environmental & Facilities Services Index, including, in each case, reinvestment of dividends. The comparisons in the following graph are based on historical data and are not indicative of, or intended to forecast, the possible future performance of ABM common stock.

 

COMPARISON OF CUMULATIVE FIVE YEAR TOTAL RETURN

 

 

 

Performance graph information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission.

 

ITEM 6.  SELECTED FINANCIAL DATA

 

The following selected financial data is derived from the Company’s consolidated financial statements for each of the years in the five-year period ended October 31, 2007. It should be read in conjunction with the consolidated financial statements and the notes thereto, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”), which are included elsewhere in this Annual Report on Form 10-K.

 

 

(1) Other income included a $5.0 million gain from the termination of an off-airport parking garage lease in 2007 and a $4.3 million gain from the termination of another off-airport parking garage lease in 2005.

 

(2) The World Trade Center formerly represented the Company’s largest job-site; its destruction on September 11, 2001 has directly and indirectly impacted subsequent Company results. Amounts for 2006 and 2005 consist of gains in connection with World Trade Center insurance claims.

 

(3) Operating expenses in 2007, 2006 and 2005 included net benefits of $1.8 million, $14.1 million and $8.2 million, respectively, from the reduction of the Company’s self-insurance reserves attributable to prior years. Operating expenses in 2004 included a $17.2 million expense from the increase of the Company’s self-insurance reserves attributable to prior years. See Note 2 of the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplementary Data.”

 

(4) Selling, general and administrative expenses in 2006 included $3.3 million of transition costs associated with the outsourcing of the Company’s information technology infrastructure and support services. Selling, general and administrative expenses in 2007 and 2006 also included $4.6 million and $0.7 million of costs associated with the implementation of a new payroll and human resources information system, and the upgrade of the Company’s accounting systems; the transition of certain back office functions to the Company’s Shared Services Center in Houston, Texas; and the move of the Company’s corporate headquarters to New York. No other year presented included similar charges. Selling, general and administrative expenses in 2007 included losses of $1.7 million related to a major lawsuit. Selling, general and administrative expenses in 2005

included losses related to three major lawsuits against the Company totaling $12.8 million. There were no significant litigation losses in the other years presented.

 

(5) Due to the Company’s adoption of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” effective November 1, 2005, which required the recognition of compensation expense associated with stock awards, selling, general and administrative expenses in 2007 included share-based compensation expense of $8.2 million, of which $4.0 million related to the acceleration of price-vested stock options. In 2006, $3.2 million of share-based compensation expense was recorded in selling, general and administrative expenses. No other years presented included share-based compensation expense, except for $42,000 of compensation expense recorded in 2005 due to the accelerated vesting of options in connection with an employee termination.

 

(6) Stockholders’ equity per common share is calculated by dividing stockholders’ equity at the end of the fiscal year by the number of shares of ABM common stock outstanding at that date. This calculation may not be comparable to similarly titled measures reported by other companies.

 

The following discussion should be read in conjunction with the consolidated financial statements of the Company and the notes thereto contained in Item 8, “Financial Statements and Supplementary Data.” All information in the discussion and references to the years are based on the Company’s fiscal year that ends on October 31. Except where specifically referenced, this discussion does not include the operations of OneSource Services, Inc. (“OneSource”), which the Company acquired in November 2007, and includes other acquired operations from the dates of the respective purchases.

 

Overview

 

ABM Industries Incorporated (“ABM”) and its subsidiaries (the “Company”) provide janitorial, parking, security, engineering and lighting services for thousands of commercial, industrial, institutional and retail facilities in hundreds of cities throughout the United States and in British Columbia, Canada. The largest segment of the Company’s business is Janitorial which generated over 57% of the Company’s sales and other income (hereinafter called “Sales”) and over 67% of its operating profit before corporate expenses for 2007. The Company also previously provided mechanical and elevator services. (See “Divestitures and Results from Discontinued Operations.”)

 

The Company’s Sales are substantially based on the performance of labor-intensive services at contractually specified prices. The level of Sales directly depends on commercial real estate occupancy levels. Decreases in occupancy levels reduce demand and also create pricing pressures on building maintenance and other services provided by the Company.

 

Janitorial and other maintenance service contracts are either fixed-price or “cost-plus” (i.e., the customer agrees to reimburse the agreed upon amount of wages and benefits, payroll taxes, insurance charges and other expenses plus a profit percentage), or are time and materials based. In addition to services defined within the scope of the contract, the Company also generates Sales from extra services (or “tags”), such as additional cleaning requirements or emergency repair services, with extra services frequently providing higher margins. The quarterly profitability of fixed-price contracts is impacted by the variability of the number of work days in the quarter.

 

The majority of the Company’s contracts are for one-year periods, but are subject to termination by either party after 30 to 90 days’ written notice. Upon renewal of the contract, the Company may renegotiate the price although competitive pressures and customers’ price sensitivity could inhibit the Company’s ability to pass on cost increases. Such cost increases include, but are not limited to, labor costs, workers’ compensation and other insurance costs, any applicable payroll taxes and fuel costs. However, for some renewals the Company is able to restructure the scope and terms of the contract to maintain or increase profit margin.

 

Sales have historically been the major source of cash for the Company, while payroll expenses, which are substantially related to Sales, have been the largest use of cash. Hence operating cash flows primarily depend on the Sales level and timing of collections, as well as the quality of the customer accounts receivable. The timing and level of the payments to suppliers and other vendors, as well as the magnitude of self-insured claims, also affect operating cash flows. The Company’s management views operating cash flows as a good indicator of financial strength. Strong operating cash flows provide opportunities for growth both internally and through acquisitions.

 

The Company’s growth in Sales in 2007 from 2006 is attributable to internal growth and growth from acquisitions. Internal growth in Sales represents not only Sales from new customers, but also expanded services or increases in the scope of work for existing customers. In the long run, achieving the desired levels of Sales and profitability will depend on the Company’s ability to gain and retain, at acceptable profit margins, more customers than it loses, pass on cost increases to customers, and keep overall costs down to remain competitive, particularly against privately owned facility services companies that typically have the lower cost advantage. Recent acquisitions contributing to the growth in sales in 2007 are described in Note 12 of the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplementary Data.” Subsequent to October 31, 2007, ABM acquired OneSource, a company formed under the laws of Belize with US operations headquartered in Atlanta, Georgia. The consideration was $365.0 million which was paid by a combination of current cash and borrowings from the Company’s line of credit. In addition, following the closing, the Company paid in full approximately $21 million outstanding under OneSource’s then existing

credit facility. With annual revenues of approximately $825 million during the fiscal year ended March 31, 2007 and approximately 30,000 employees, OneSource is a provider of outsourced facilities services including janitorial, landscaping, general repair and maintenance and other specialized services, for more than 10,000 commercial, industrial, institutional and retail accounts in the United States and Puerto Rico, as well as in British Columbia, Canada. OneSource’s operations will be included in the Janitorial segment. The Company expects to achieve operating margins for the OneSource business consistent with the remaining Janitorial segment and attain annual cost synergies of between $45 million to $50 million, which are expected to be fully implemented within 12 months after the acquisition. In 2008, the Company expects to realize between $28 million and $32 million of synergies before giving effect for costs to achieve these synergies, as discussed below. This will be achieved primarily through a reduction in duplicative positions and back office functions, the consolidation of facilities, and elimination of professional fees and other services. Furthermore, the Company expects to realize approximately $14 million in incremental cash flow in 2008 from acquiring net operating loss carry forwards and existing goodwill amortization related to the OneSource acquisition.

 

In the long term, the Company expects to focus its financial and management resources on those businesses in which it can grow to be a leading national service provider. It also plans to increase Sales by expanding its services into international markets.

 

In the short-term, management is focused on pursuing new business, increasing operating efficiencies, and integrating its most recent acquisitions, particularly OneSource. The Company is also relocating its Janitorial headquarters to Houston, concentrating its other business units in southern California and, in 2008, relocating its corporate headquarters to New York City. In addition, the Company is implementing a new payroll and human resources information system and upgrading its accounting systems and expects full implementation by the end of 2009. In 2008, the Company expects to incur one–time expenses of approximately $20 million associated with the upgrade of the existing accounting systems, implementation of a new payroll system and human resources information system, Shared Services Center implementation, relocation of corporate headquarters and costs to achieve synergies with OneSource.

 

Liquidity and Capital Resources

 

 

 

 

Funds provided by operations and bank borrowings have historically been the sources for meeting working capital requirements, financing capital expenditures and acquisitions, repurchasing shares of ABM common stock and paying cash dividends. As of October 31, 2007 and October 31, 2006, the Company’s cash and cash equivalents totaled $136.2 million and $134.0 million, respectively.

 

At October 31, 2007, the Company had $25.0 million of auction rate securities that had long-term ratings in the highest classification by recognized rating agencies. Auction rate securities are debt instruments with long-term nominal maturities (typically 20 to 50 years), for which the interest rate is reset through Dutch auctions approximately every 30 days. These auction rate securities failed to trade at recent auctions due to insufficient bids from buyers and, therefore, were considered illiquid as of October 31, 2007. As a result, they were classified in long-term investments on the Consolidated Balance Sheet. The Company did not hold auction rate securities at October 31, 2006 and 2005.

 

On November 14, 2007, the Company acquired OneSource for $365.0 million in cash, which was paid by a combination of cash on hand and borrowings under the Company’s line of credit. In addition, the approximately $21 million outstanding debt under OneSource’s then existing credit facility was paid in full following the closing.

 

Working Capital.  Working capital increased by $40.6 million to $353.1 million at October 31, 2007 from $312.5 million at October 31, 2006, primarily due to income generated during 2007. Trade accounts receivable is the largest component of working capital and totaled $370.5 million at October 31, 2007 compared to $384.0 million at October 31, 2006. These amounts were net of allowances for doubtful accounts and sales totaling $6.9 million and $8.0 million at October 31, 2007 and 2006, respectively. At October 31, 2007, accounts receivable that were over 90 days past due had decreased by $4.9 million to $27.9 million (7.4% of the total outstanding) from $32.8 million (8.4% of the total outstanding) at October 31, 2006. This decrease is a result of improved collection efforts in the Janitorial, Engineering and Security segments.

 

Cash Flows from Operating Activities.  Continuing operations provided net cash of $54.3 million, $130.4 million and $44.8 million in 2007, 2006 and 2005, respectively. The $76.1 million decrease in cash provided by continuing operations between 2007 and 2006 was primarily due to the inclusion in 2006 of the $80.0 million received in the fourth quarter from the settlement of the World Trade Center (“WTC”) insurance claims, a $34.9 million income tax payment in 2007 relating to the WTC insurance claims settlement and $6.6 million of pre-payments to International Business Machines Corporation (“IBM”) associated with IBM transition and maintenance services in 2007, as discussed below. An increase in collection of accounts receivable in 2007 and the receipt of the $7.5 million in connection with the termination of the airport parking garage lease in 2007 also impacted the change. Cash flows from continuing operations increased by $85.6 million in 2006 from 2005 primarily due to the $80.0 million received in settlement of WTC insurance claims, although payments in 2006 of litigation settlements that were pending at October 31, 2005 reduced cash flow from continuing operations.

 

Cash Flows from Investing Activities.  Net cash used in investing activities was $54.8 million and $21.8 million in 2007 and 2006, respectively, and net cash provided by investing activities was $16.5 million in 2005. The $33.0 million increase in 2007 compared to 2006 is primarily due to the net investment of

$25.0 million in auction rate securities as described above and a $8.0 million increase in additions to property, plant and equipment, which mainly reflects capitalized costs associated with the upgrade of the Company’s accounting systems and the implementation of a new payroll and human resources information system (discussed below). The $38.3 million increase in cash used in investing activities in 2006 compared to 2005 was primarily due to the receipt of $32.3 million from the sales of the operating assets of the Mechanical segment (see “Divestitures and Results from Discontinued Operations”) and net proceeds of $29.6 million from the sale of auction rate securities in 2005. The 2006 and 2005 statements of cash flows were adjusted in 2007 to conform to the 2007 presentation. See Long-term investments in Note 1 of the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplemental Data.” This was partially offset by the use of $16.9 million less cash to purchase businesses and $3.7 million less cash to acquire property, plant, and equipment in 2006 compared to 2005.

 

Cash Flows from Financing Activities.  Net cash provided by financing activities was $2.7 million in 2007 and net cash used in financing activities was $31.3 million and $30.9 million in 2006 and 2005, respectively. The Company did not repurchase any ABM common stock in 2007, compared to 2006 when it repurchased $26.0 million of ABM common stock. The net cash provided by financing activities in 2007 is also attributable to a $12.3 million increase in funds from common stock issuances as a result of the increase in stock option exercises in 2007, partially offset by a $2.0 million decrease in 2004 Employee Stock Purchase Plan (“ESPP”) purchases compared to 2006. In 2006, the Company purchased $5.4 million less ABM common stock than in 2005 while issuing $4.9 million less ABM common stock through the Company’s stock option and employee stock purchase plans.

 

Line of Credit.  At October 31, 2007, ABM had a $300.0 million syndicated line of credit scheduled to expire in May 2010. As of October 31, 2007 and 2006, the total outstanding amounts under the facility were $108.0 million and $98.7 million, respectively, in the form of standby letters of credit. The facility included usual and customary covenants for a credit facility of this type, including covenants limiting liens, dispositions, fundamental changes, investments, indebtedness, and certain transactions and payments. In addition, the facility also required that the Company satisfy certain financial covenants. The Company was in compliance with all covenants as of October 31, 2007.

 

In connection with the acquisition of OneSource, the Company terminated the $300.0 million line of credit on November 14, 2007 and replaced it with a new $450.0 million five-year syndicated line of credit that is scheduled to expire on November 14, 2012 (“the new Facility”). Borrowings under the new Facility were used to acquire OneSource on November 14, 2007. The new Facility is available for working capital, the issuance of standby letters of credit, the financing of capital expenditures and other general corporate purposes.

 

Under the new Facility, no compensating balances are required and the interest rate is determined at the time of borrowing based on the London Interbank Offered Rate (“LIBOR”) plus a spread of 0.625% to 1.375% or, at ABM’s election, at the higher of the federal funds rate plus 0.5% and the Bank of America prime rate (“Alternate Base Rate”) plus a spread of 0.000% to 0.375%. A portion of the new Facility is also available for swing line (same-day) borrowings at the Interbank Offered Rate (“IBOR”) plus a spread of 0.625% to 1.375% or, at ABM’s election, at the Alternate Base Rate plus a spread of 0.000% to 0.375%. The new Facility calls for a non-use fee payable quarterly, in arrears, of 0.125% to 0.250% of the average, daily, unused portion of the new Facility. For purposes of this calculation, irrevocable standby letters of credit issued primarily in conjunction with ABM’s self-insurance program and cash borrowings are included as usage of the new Facility. The spreads for LIBOR, Alternate Base Rate and IBOR borrowings, and the commitment fee percentage are based on ABM’s leverage ratio. The new Facility permits ABM to request an increase in the amount of the line of credit by up to $100.0 million (subject to receipt of commitments for the increased amount from existing and new lenders). The standby letters of credit outstanding under the prior facility have been replaced and are now outstanding under the new Facility. As of November 30, 2007, the total outstanding amounts under the new Facility in the form of cash borrowings and standby letters of credit were $295.0 million and $113.3 million, respectively.

 

The new Facility includes customary covenants for a credit facility of this type, including covenants limiting liens, dispositions, fundamental changes, investments, indebtedness, and certain transactions and payments. In addition, the new Facility also requires that ABM maintain three financial covenants: (1) a fixed charge coverage ratio greater than or equal to 1.50 to 1.0 at each fiscal quarter-end; (2) a leverage ratio of less than or equal to 3.25 to 1.0 at each fiscal quarter-end; and (3) a consolidated net worth of greater than or equal to the sum of (i) $475.0 million, (ii) an amount equal to

50% of the consolidated net income earned in each full fiscal quarter ending after November 14, 2007 (with no deduction for a net loss in any such fiscal quarter), and (iii) an amount equal to 100% of the aggregate increases in stockholders’ equity of ABM and its subsidiaries after November 14, 2007 by reason of the issuance and sale of capital stock or other equity interests of ABM or any subsidiary, including upon any conversion of debt securities of ABM into such capital stock or other equity interests, but excluding by reason of the issuance and sale of capital stock pursuant to ABM’s employee stock purchase plans, employee stock option plans and similar programs.

 

If an event of default occurs under the new Facility, including certain cross-defaults, insolvency, change in control, and violation of specific covenants, among others, the lenders can terminate or suspend ABM’s access to the new Facility, declare all amounts outstanding under the new Facility, including all accrued interest and unpaid fees, to be immediately due and payable, and/or require that ABM cash collateralize the outstanding letter of credit obligations.

 

Commitments

 

As of October 31, 2007, the Company’s future contractual payments, commercial commitments and other long-term liabilities were as follows:

 

 

The amounts set forth under operating leases represent the Company’s contractual obligations to make future payments under non-cancelable operating lease agreements for various facilities, vehicles and other equipment.

 

On September 29, 2006, the Company entered into a Master Professional Services Agreement (the “Services Agreement”) with IBM that became effective October 1, 2006. Under the Services Agreement, IBM is responsible for substantially all of the Company’s information technology infrastructure and support services. Prior to the Services Agreement, the Company maintained its equipment and had in-house personnel providing such services. The base fee for these services is $116.6 million payable over the initial term of 7 years and 3 months. As of October 31, 2007, aggregate payments of $26.2 million had been made to IBM since the Services Agreement became effective. Services covered by the Services Agreement may be expanded at rates set forth in the Services Agreement, or later agreed to by the parties, which would increase amounts payable to IBM.

 

As a result of a January 23, 2007 amendment to expand its services, IBM is also providing maintenance and support services for the Company’s legacy payroll systems. The base fee for these services is $2.3 million payable over a 3 year and 7 month term that commenced April 1, 2007. As of October 31, 2007, aggregate payments of $0.4 million had been made to IBM for these services.

The Company also completed an evaluation of its existing accounting, payroll and human resources information systems in the first quarter of 2007. On April 4, 2007, the Company further expanded services covered by the Services Agreement. IBM is assisting in the upgrade of the Company’s existing accounting systems and the implementation of a new payroll system and human resources information system. IBM will also provide post-implementation support services beginning July 1, 2008 through December 31, 2013. The base fee for this upgrade and implementation is $13.3 million, and $12.9 million for post implementation support services for a total of $26.2 million payable over 6 years and 10 months. As of October 31, 2007, aggregate payments of $5.1 million had been made to IBM. The Company began the design phase of the project in the second quarter of 2007. The implementation of the new systems is scheduled to commence in July 2008 with completion by the end of 2009.

 

The total anticipated cost for the upgrade of the existing accounting systems and implementation of the new payroll system and human resources system is approximately $35 million, which includes IBM contracted system upgrade and implementation costs of $13.3 million, as well as licensing fees and other external costs.

 

The Company has two unfunded defined benefit plans, an unfunded post-retirement benefit plan and two unfunded deferred compensation plans that are described in Note 6 of the Notes to Consolidated Financial Statements contained in this Annual Report on Form 10-K. At October 31, 2007, the liability reflected on the Company’s consolidated balance sheet for these five plans totaled $20.6 million, with the amount expected to be paid over the next 20 years estimated at $30.2 million. With the exception of the deferred compensation plans, the liabilities for which are reflected on the Company’s consolidated balance sheet at the amount of compensation deferred plus accrued interest, the plan liabilities at that date assume future annual compensation increases of 3.50% (for those plans affected by compensation changes) and have been discounted at 6.0%, a rate based on Moody’s Investor Services Aa-rated long-term corporate bonds (i.e., 20 years). Because the deferred compensation plans’ liabilities reflect the actual obligations of the Company and the post-retirement benefit plan and two defined benefit plans have been frozen, variations in assumptions would be unlikely to have a material effect on the Company’s financial condition and operating performance. The Company expects to fund payments required under the plans from operating cash as payments are due to participants.

 

Not included in the unfunded employee benefit plans in the table above are union-sponsored multi-employer defined benefit plans under which certain union employees of the Company are covered. These plans are not administered by the Company and contributions are determined in accordance with provisions of negotiated labor contracts. Contributions made for these plans were $37.1 million, $34.5 million and $34.4 million in 2007, 2006 and 2005, respectively.

 

The Company uses surety bonds, principally performance and payment bonds, to guarantee performance under various customer contracts in the normal course of business. These bonds typically remain in force for one to five years and may include optional renewal periods. At October 31, 2007, outstanding surety bonds totaled $62.8 million. The Company does not believe these bonds will be required to be drawn upon.

 

The Company self-insures certain insurable risks such as general liability, automobile, property damage and workers’ compensation. Commercial policies are obtained to provide for $150.0 million of coverage for certain risk exposures above the self-insured retention limits (i.e., deductibles). Net of the estimated recoverable from the insurers, the estimated liability for claims incurred at October 31, 2007 and 2006 was $205.1 million and $195.2 million, respectively. The Company periodically evaluates its estimated claim costs and liabilities and accrues self-insurance reserves to its best estimate. The self-insurance claims paid in 2007, 2006 and 2005 were $56.3 million, $57.4 million and $55.2 million, respectively. Claim payments vary based on the frequency and/or severity of claims incurred and timing of the settlements and therefore may have an uneven impact on the Company’s cash balances.

 

The Company believes that the current cash and cash equivalents, cash generated from operations and the new Facility will be sufficient to meet the Company’s cash requirements for the long-term, except for cash required for significant acquisitions.

 

Environmental Matters

 

The Company’s operations are subject to various federal, state and/or local laws regulating the discharge of materials into the environment or otherwise relating to the protection of the environment, such as discharge into soil, water and air, and the generation, handling, storage, transportation and disposal of waste and

hazardous substances. These laws generally have the effect of increasing costs and potential liabilities associated with the conduct of the Company’s operations, although historically they have not had a material adverse effect on the Company’s financial position, results of operations, or cash flows. In addition, from time to time, the Company is involved in environmental issues at certain of its locations or in connection with its operations. While it is difficult to predict the ultimate outcome of any of these matters, based on information currently available, management believes that none of these matters, individually or in the aggregate, are reasonably likely to have a material adverse effect on the Company’s financial position, results of operations or cash flows.

 

Off-Balance Sheet Arrangements

 

The Company is party to a variety of agreements under which it may be obligated to indemnify the other party for certain matters. Primarily, these agreements are standard indemnification arrangements in its ordinary course of business. Pursuant to these arrangements, the Company may agree to indemnify, hold harmless and reimburse the indemnified parties for losses suffered or incurred by the indemnified parties, generally its customers, in connection with any claims arising out of the services that the Company provides. The Company also incurs costs to defend lawsuits or settle claims related to these indemnification arrangements and in most cases these costs are included in its insurance program. The term of these indemnification arrangements is generally perpetual with respect to claims arising during the service period. Although the Company attempts to place limits on this indemnification reasonably related to the size of the contract, the maximum obligation may not be explicitly stated and, as a result, the maximum potential amount of future payments the Company could be required to make under these arrangements is not determinable.

 

ABM’s certificate of incorporation and bylaws may require it to indemnify Company directors and officers against liabilities that may arise by reason of their status as such and to advance their expenses incurred as a result of any legal proceeding against them as to which they could be indemnified. ABM has also entered into indemnification agreements with its directors to this effect. The overall amount of these obligations cannot be reasonably estimated, however, the Company believes that any loss under these obligations would not have a material adverse effect on the Company’s financial position, results of operations or cash flows. The Company currently has directors’ and officers’ insurance, which has a deductible of up to $1.0 million.

 

Effect of Inflation

 

The rates of inflation experienced in recent years have had no material impact on the financial statements of the Company. The Company attempts to recover increased costs by increasing sales prices to the extent permitted by contracts and competition.

 

Acquisitions

 

The operating results of businesses acquired during the periods presented have been included in the accompanying Consolidated Financial Statements from their respective dates of acquisition. Acquisitions made during the three years ended October 31, 2007 are discussed in Note 12 of the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplementary Data,” and contributed $107.7 million (3.8%) to 2007 Sales.

 

Subsequent to October 31, 2007, ABM acquired OneSource. The consideration was $365.0 million in cash. See Note 18, Subsequent Event, of the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplementary Data.”

 

Divestitures and Results from Discontinued Operations

 

On June 2, 2005, the Company sold substantially all of the operating assets of CommAir Mechanical Services, which represented the Company’s Mechanical segment, to Carrier Corporation (“Carrier”). The operating assets sold included customer contracts, accounts receivable, inventories, facility leases and other assets, as well as rights to the name “CommAir Mechanical Services.” The consideration was $32.0 million in cash, subject to certain adjustments, and Carrier’s assumption of trade payables and accrued liabilities. The Company realized a pre-tax gain of $21.4 million ($13.1 million after-tax) on the sale of these assets in 2005.

 

On July 31, 2005, the Company sold the remaining operating assets of Mechanical, consisting of its water treatment business, to San Joaquin Chemicals, Incorporated for $0.5 million, of which $0.25 million was paid in cash and $0.25 million in the form of a note, which was paid in October 2005. The operating assets sold included customer contracts and inventories. The Company realized a pre-tax gain of $0.3 million ($0.2 million after-tax) on the sale of these assets in 2005.

On August 15, 2003, the Company sold substantially all of the operating assets of Amtech Elevator Services, Inc., which represented the Company’s Elevator segment, to Otis Elevator Company. In June 2005, the Company settled litigation that arose from and was directly related to the operations of Elevator prior to its disposal. An estimated liability of $0.5 million for several Elevator commercial litigation matters was recorded on the date of disposal. The settlement was less than the estimated liability by $0.2 million, pre-tax. This difference was recorded as income from discontinued operations in 2005. In addition, a $0.9 million benefit was recorded in gain on sale of discontinued operations in 2005, which resulted from the correction of the overstatement of income taxes provided for the gain on sale of assets of Elevator.

 

Revenues and net income from discontinued operations for Mechanical and the Elevator adjustments in 2005 were $24.8 million and $0.2 million, respectively. Operating results for 2005 for the portion of Mechanical’s business sold to Carrier are for the period beginning November 1, 2004 through the date of sale, June 2, 2005. Operating results for 2005 for Mechanical’s water treatment business are for the period beginning November 1, 2004 through the date of sale, July 31, 2005.

 

Results of Operations

 

COMPARISON OF 2007 TO 2006

 

 

Net Income.  Net income in 2007 decreased by $40.8 million, or 43.7%, to $52.4 million ($1.04 per diluted share) from $93.2 million ($1.88 per diluted share) in 2006 primarily due to the $80.0 million ($45.1 million after-tax and $0.91 per diluted share) recognized into income in the fourth quarter of 2006 for the settlement of insurance claims related to recovery of the Company’s loss of business profits from the destruction of the WTC complex. In addition, the benefit from the reduction of self-insurance reserves related to prior years’ claims was $12.3 million ($7.4 million after-tax) lower in 2007 compared to 2006 (amounting to $1.8 million in 2007 and $14.1 million in 2006), as further discussed below. At the same time, profits in all operating segments except Engineering and Lighting improved in 2007 from 2006, with Parking recording a $5.0 million ($3.0 million after tax) gain in connection with the termination of an airport parking garage lease in 2007. Results in 2007 also included a $2.4 million increase in income tax benefits compared to 2006 primarily due to tax law changes and the elimination of state tax liabilities for closed years.

 

Three major evaluations covering substantially all of the Company’s self-insurance reserves were completed during 2007 and showed net favorable developments in the California workers’ compensation and general liability claims that exceeded the adverse developments in the workers’ compensation claims outside of California resulting in an aggregate net benefit of $1.0 million, which was attributable to the years prior to 2007 and recorded in Corporate. Separate evaluations, updating other minor programs specific to Janitorial and Parking showed favorable developments in self-insurance reserves, resulting in aggregate benefits of $0.6 million and $0.2 million, which were attributable to reserves in years prior to 2007 and recorded in Janitorial and Parking, respectively. Two major evaluations covering substantially all of the Company’s self-insurance reserves completed during 2006 also showed favorable developments in the California workers’ compensation and general liability claims that exceeded the adverse developments in the workers’ compensation claims outside of California resulting in an aggregate benefit of $14.5 million, which was attributable to the years prior to 2006 and recorded in Corporate. Separate evaluations, updating other minor programs, showed adverse developments in self-insurance reserves, resulting in an expense of $0.4 million, which was attributable to reserves in years prior to 2006 and recorded in Parking.

 

Revenues.  Revenues in 2007 increased $50.1 million, or 1.8%, to $2,842.8 million from $2,792.7 million in 2006. Sales, which excludes the $80.0 million gain from the 2006 settlement of the WTC

insurance claims, increased $130.1 million, or 4.8%, in 2007 compared to 2006, primarily due to new business and expansion of services or increases in the scope of work for existing customers. In addition, the acquisition of HealthCare Parking Systems of America (“HPSA”) contributed $18.1 million in Sales and Parking’s reimbursements for out-of-pocket expenses from managed parking lot clients were $14.9 million higher (which includes $2.7 million in Sales contributed by HPSA) in 2007 than in 2006. Parking Sales in 2007 also included the $5.0 million gain in connection with the lease termination.

 

Operating Expenses and Cost of Goods Sold.  As a percentage of Sales, gross profit (Sales minus operating expenses and cost of goods sold) was 10.6% in 2007 compared to 10.7% in 2006. The decrease in margin was primarily due to the $12.3 million lower benefit in 2007 compared to 2006 from the self-insurance reserve reduction related to prior years, partially offset by the $5.0 million gain in Parking in connection with the airport parking lease termination, lower insurance rates and elimination of unprofitable contracts.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses for 2007 increased $9.7 million, or 4.7%, compared to 2006, primarily due to a $9.2 million increase in selling and administrative payroll and severance costs as a result of new hires, annual compensation increases, and increased bonuses, which included $1.4 million in such expenses associated with the move of the corporate headquarters to New York. The increase was also due to $4.0 million of share-based compensation expense recognized when target prices for ABM common stock were achieved, $1.5 million of expenses associated with the start up of the Shared Services Center and a $3.0 million increase in litigation expenses. In addition, the Company recorded $1.7 million in expenses related to upgrade of the Company’s existing accounting systems and the implementation of a new payroll system and human resources information system in 2007 compared to $0.7 million recorded in 2006. The impact of these increases in selling, general and administrative expenses was offset, in part, by the absence of a $3.3 million transition charge in 2006 related to the outsourcing of the Company’s information technology infrastructure and support services, the absence of $2.4 million of professional fees associated with the Audit Committee’s independent investigation of accounting at a subsidiary, Security Services of America (“SSA”) included in 2006, and a $2.4 million reduction in 2007 from 2006 in professional fees related to the Sarbanes-Oxley internal controls certification requirement.

 

Income Taxes.  The effective tax rates were 34.3% and 40.9% in 2007 and 2006, respectively. The overall effective state tax rate was higher in 2006 reflecting the impact of the high level of state income tax rates in the jurisdictions where the WTC settlement gain was subject to state income taxation. The Texas requirement to file a combined gross margin tax return in 2007 partly offset that impact. The Company also recorded a $0.9 million tax benefit in 2007 due mostly from the increase in the Company’s net deferred tax assets that resulted primarily from the state of New York requirement to file combined returns effective in 2008. This new regulatory requirement will result in an increase in the future effective state tax rate. An additional $0.9 million tax benefit was also recorded in 2007, mostly from the elimination of state tax liabilities for closed years. Income tax expense in 2007 had a further $0.6 million benefit primarily due to the inclusion of Work Opportunity Tax Credits attributable to 2006, but not recognizable in 2006 because the program had expired and was not extended until the first quarter of 2007. The Company recorded a tax benefit in 2006 of $1.1 million, mostly from the reversal of state tax liabilities for closed years. This was offset by $1.1 million in income tax expense primarily arising from the adjustment of the valuation allowance for state net operating loss carryforwards and the adjustment of the income tax liability accounts after filing the 2005 tax returns and amendments of prior returns.

 

Segment Information

 

Under the criteria of Statement of Financial Accounting Standards (“SFAS”) No. 131, “Disclosures about Segments of an Enterprise and Related Information,” Janitorial, Parking, Security, Engineering, and Lighting are reportable segments. Most Corporate expenses are not allocated. Such expenses include the Company’s share-based compensation costs and adjustments to the Company’s self-insurance reserves relating to prior years, such as those made in 2006 and 2007. Until damages and costs are awarded or a matter is settled, the Company also accrues probable and estimable losses associated with pending litigation in Corporate.

 

 

Janitorial.  Janitorial Sales increased by $57.8 million, or 3.7%, during 2007 compared to 2006. All Janitorial regions, except Northern California, experienced Sales growth. This was due to new business, expansion of services to customers and price adjustments to pass through a portion of union cost increases. The decrease in Sales in Northern California was due to lost accounts.

 

Operating profit increased $5.9 million, or 7.2%, during 2007 compared to 2006. The increase was primarily attributable to operating profit from higher Sales, a $3.8 million reduction in insurance expense due to lower rates and a $0.6 million benefit from the reduction of insurance reserves related to prior years. These improvements were partially offset by a $1.3 million increase in legal expenses and higher union benefit costs. Operating profit improved in all regions except North Central, a region that had higher legal expense, labor costs and insurance expense.

 

Parking.  Parking Sales increased by $39.3 million, or 8.9%, during 2007 compared to 2006, primarily due to $18.1 million of Sales from HPSA, which was acquired on April 2, 2007, a $14.9 million increase in reimbursements for out-of-pocket expenses (which includes $2.7 million in Sales contributed by HPSA) from managed parking lot clients due to new contracts and growth of existing contracts and the $5.0 million gain in connection with the termination of the airport parking garage lease. Lease, allowance and management fee revenues also increased in 2007 compared to 2006. These increases were partially offset by Sales lost as a result of the termination of the airport parking garage lease. Operating profit increased $7.2 million, or 52.4%, during 2007 compared to 2006 primarily as a result of the $5.0 million lease termination gain, $0.9 additional profits from HPSA and operating profit from the increase in sales. In addition, Parking recorded a $0.2 million benefit due to a favorable development in self-insurance reserves in 2007 and a $0.4 million charge due to an adverse development in self-insurance reserves in 2006.

 

Security.  Security Sales increased $13.6 million, or 4.4%, during 2007 compared to 2006 primarily due to business from new customers and increased levels of service to existing customers. The elimination of unprofitable customer accounts partially offset the impact of the new business on Sales. Operating profits increased $0.4 million, or 9.8%, in 2007 compared to 2006 primarily due to additional profit from increased Sales and the elimination of unprofitable customer contracts. These increases were largely offset by a $1.7 million litigation loss provision in 2007. Security also recorded $1.2 million and $1.0 million benefit in 2007 and 2006, respectively, for the reduction in a reserve provided for the amount the Company overpaid Security Services of America LLC (“SSA LLC”), from which it purchased the operating assets of SSA. This matter was settled in 2007.

 

Engineering.  Engineering Sales increased $16.4 million, or 5.7%, in 2007 compared to 2006, which was mainly due to new business and the expansion of services to existing customers in the Eastern, Northern California, and Mid-Atlantic regions. These increases were slightly offset by the loss of business in the Southern California and Midwest regions. Operating profits decreased by $1.1 million, or 6.8%, in 2007 compared to 2006 primarily due to reduced profit margins on the new business compared to business replaced. In addition, Engineering experienced higher payroll expense associated with increased management staff necessary to support the future growth of the business.

 

Lighting.  Lighting Sales decreased $0.6 million, or 0.6%, during 2007 compared to 2006 primarily due to decreased time and materials and fixed contract fee Sales in the Southeast and Northeast regions. Operating profit decreased $0.02 million, or 1.7% in 2007 compared to 2006 primarily due to the decreased Sales and a $0.5 million write-down of inventory to lower of cost or net realizable value, partially offset by overall increased operational efficiencies and higher margin

project work in the South Central and North California regions.

 

Corporate.  Corporate expense increased by $10.3 million, or 26.1%, in 2007 compared to 2006. Of the increase, $13.5 million was attributable to the difference between the reductions in self-insurance reserves in 2007 and 2006. In 2007, the Company recorded $4.0 million of share-based compensation expense from the acceleration of price vested options, a $4.4 million increase in payroll and severance costs, which included $1.4 million in expenses for bonuses, severance, and new hires associated with the move of the corporate headquarters to New York, $1.7 million in expenses related to upgrade of the Company’s existing accounting systems and the implementation of a new payroll system and human resources information system in 2007 compared to $0.7 million recorded in 2006, $1.5 million in expenses associated with the start up of the Shared Services Center, and a $0.9 million increase in share-based compensation expense not associated with accelerated stock options. Offsetting these increases in expenses in 2007 were a $3.5 million increase in interest income due to higher cash balances and interest rates, the absence of a $3.3 million transition charge in 2006 related to the outsourcing of the Company’s information technology infrastructure and support services, a $2.4 million reduction in professional fees related to the Sarbanes-Oxley internal controls certification requirement in 2007, the absence of $2.4 million of professional fees associated with the Audit Committee’s independent investigation of accounting at SSA included in 2006, and a $1.1 million decrease in legal expenses in 2007.

 

COMPARISON OF 2006 TO 2005 — CONTINUING OPERATIONS

 

 

Income from continuing operations.  Income from continuing operations in 2006 increased 114.0% to $93.2 million ($1.88 per diluted share) from $43.6 million (0.86 per diluted share) in 2005. The increase was primarily due to the $80.0 million ($45.1 million, after-tax) recognized into income in the fourth quarter of 2006 for the settlement of the WTC insurance claims. All operating segments, except Lighting, showed improvement in operating income. In addition, in 2006 the Company recognized a benefit that was $5.9 million ($3.6 million after-tax) higher than 2005 from the reduction of the Company’s self insurance reserves ($14.1 million benefit in 2006 and $8.2 million in 2005) related to prior years’ insurance claims as further described below. These improvements were partially offset by a $3.3 million ($2.0 million after-tax) charge related to outsourcing the management of the Company’s information technology infrastructure and support services in October 2006, $3.2 million ($2.6 million after-tax) of share-based compensation costs as a result of the adoption of SFAS No. 123R effective November 1, 2005, and $2.4 million ($1.5 million after-tax) of professional fees associated with the Audit Committee’s independent investigation of prior year accounting at SSA. Income from continuing operations in 2005 included $12.8 million ($7.8 million, after-tax) of losses from three major lawsuits, and a $3.4 million ($2.1 million after-tax) charge for a reserve provided for the amount the

Company believed it overpaid SSA LLC, which reserve was reduced by $1.0 million ($0.6 million after-tax) in 2006. Also included in 2005 was a $4.3 million ($2.6 million after-tax) gain on sale of a leasehold interest of an off-airport parking facility by Parking, a $2.7 million income tax benefit resulting from a state tax audit settlement and a $1.2 million ($0.7 million after-tax) gain on a WTC indemnity payment.

 

In 2006, two major evaluations of the Company’s insurance reserves were completed showing favorable developments in insurance reserves in years prior to 2006 and resulting in a net benefit of $14.1 million. A major evaluation was completed in 2005 covering substantially all of the Company’s general liability and workers’ compensation reserves showed favorable developments in the Company’s California workers’ compensation and general and auto liability claims exceeding the adverse developments in the Company’s workers’ compensation claims outside of California resulting in a net benefit of $5.5 million, which was attributable to reserves in years prior to 2005 and recorded in Corporate. Separate evaluations in 2005, updating other minor programs specific to Janitorial and Parking, showed favorable developments in self-insurance reserves, resulting in aggregate net benefits of $1.3 million and $1.4 million, which were mostly attributable to reserves in years prior to 2005 and recorded in Janitorial and Parking, respectively.

 

Revenues.  Revenues in 2006 of $2,792.7 million increased by $204.9 million or 7.9% from $2,587.8 million in 2005. The primary reason for the increase was the growth in Sales which increased by $126.1 million or 4.9% in 2006 from 2005. Acquisitions completed in 2005 and 2006 contributed $27.8 million to the Sales increase. Additionally, Parking’s reimbursements for out-of-pocket expenses from managed parking lot clients were $32.0 million higher. The remainder of the Sales increase was primarily due to new business, primarily in Janitorial, Security and Engineering. The $80.0 million gain from the settlement of the WTC insurance claim also positively impacted revenues.

 

Operating Expenses and Cost of Goods Sold.  As a percentage of Sales, gross profit was 10.7% in 2006 compared to 10.6% in 2005. The improvement in the margin was due to lower insurance expense and slightly higher margin contributions from Janitorial in 2006 compared to 2005, partially offset by the $32.0 million in additional reimbursements in 2006 compared to 2005 for out-of-pocket expenses from managed parking lot clients for which Parking had no margin benefit.

 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses were $207.1 million in 2006, compared to $204.1 million in 2005. The increase was primarily due to a $3.3 million transition charge related to outsourcing the management of Company’s information technology infrastructure and support services, $3.2 million of share-based compensation costs, a $2.6 million increase in payroll and payroll related costs due to annual salary increases and additional staff, $2.4 million of professional fees associated with the Audit Committee’s independent investigation of prior year accounting at SSA, and additional expenses from acquisitions made in 2005 and 2006. These increases were partially offset by a $2.6 million reduction in documentation and testing costs associated with the Sarbanes-Oxley certification effort in 2006 compared to the same period of 2005. In 2005, the Company recorded $12.8 million of pre-tax losses from three major lawsuits, and the $3.4 million charge for a reserve provided for the amount the Company believed it overpaid SSA LLC. The $3.4 million reserve was reduced by $1.0 million in 2006.

 

Interest Expense.  Interest expense, which includes loan amortization and commitment fees for the revolving credit facility, was 44.0% lower in 2006 compared to 2005 because the amortization of the initiation costs of the line of credit entered into in May 2005, which are being amortized over its term of five years, was lower than the amortization of the initiation costs incurred for the line of credit it replaced, which had a three-year term.

 

Income Taxes.  The effective tax rates were 40.9% and 32.4% for 2006 and 2005, respectively. The increase in 2006 was primarily due to a higher estimated state income tax rate and the effect of the non-deductible incentive stock option expense included in pre-tax income. The increase in the state income tax rate in 2006 was largely due to the higher tax rates in the jurisdictions where the WTC settlement gain was subject to state income taxation. An income tax expense of $34.9 million was recorded in the fourth quarter of 2006 attributable to the WTC settlement gain. A $1.1 million income tax benefit, mostly from the reversal of state tax liabilities for closed years, was recorded in 2006. However, this was offset by $1.1 million in income tax expense primarily arising from the adjustment of the valuation allowance for state net operating loss carryforwards and the adjustment of the income tax liability accounts after filing the 2005 tax returns and amendments of prior year returns. A $2.7 million income tax benefit was recorded in the second quarter of 2005

resulting from the favorable settlement of the audit of prior years’ state tax returns (tax years 2000 to 2003).

 

Segment Information

 

Under the criteria of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” Janitorial, Parking, Security, Engineering, and Lighting are reportable segments. The 2005 operating results of the former Mechanical segment are reported separately under discontinued operations and are excluded from the table below. (See Divestitures and Results from Discontinued Operations.) Most Corporate expenses are not allocated. Such expenses include the Company’s share-based compensation costs and adjustments to the Company’s self-insurance reserves relating to prior years such as those made in 2006. Until damages and costs are awarded or a matter is settled, the Company also accrues probable and estimable losses associated with pending litigation in Corporate.

 

 

Janitorial.  Janitorial Sales increased by $38.2 million, or 2.5%, in 2006 compared to 2005. The Sales increase is primarily attributable to additional Sales of $22.5 million from acquisitions in 2005 and 2006 including Brandywine Building Services, Inc., (“Brandywine”), Initial Contract Services, Inc., Baltimore (“Initial Baltimore”) and Colin Service Systems, Inc. (“Colin”), affecting both the Mid-Atlantic and Northeast regions. Sales also increased in the Northern California, Northwest, North and South Central and Southwest regions due to new business, expansion of services to existing customers, and price adjustments to pass through a portion of union cost increases. These increases were partially offset by reductions in Sales from the loss of accounts in the Midwest and Northeast regions.

 

Operating profit increased by $13.8 million, or 20.4%, in 2006 compared to 2005, primarily due to higher Sales and improved margins from the Northern California, Northwest, South Central and Southwest regions, which were partially offset by lower profit in the Midwest and North Central regions, both caused by scope reductions, competitive pressure and in the case of the Midwest region, loss of accounts. The Brandywine, Initial Baltimore and Colin acquisitions contributed $2.5 million additional profit. In 2005, the Company incurred a $5.0 million litigation loss; however, it recognized a $1.3 million benefit from the reduction of insurance reserves.

 

Parking.  Parking Sales increased by $30.1 million, or 7.4%, while operating profit increased $3.1 million, or 29.7%, in 2006 compared to 2005. The increase in Sales was primarily due to a $32.0 million increase in reimbursements for out-of-pocket expenses from managed parking lot clients, new contracts and higher fees received from managed parking lots. These improvements were partially offset by a reduction in lease revenue principally due to the October 2005 sale of a leasehold interest in an off-airport facility that had contributed $6.5 million in Sales in 2005. The increase in operating profit was principally due to the absence of $6.9 million of litigation losses and the partially offsetting $4.3 million gain from the sale of the leasehold interest of the off-airport parking facility, and $1.4 million benefit from the reduction of insurance reserves, all of which impacted 2005. In addition, insurance expense was lower in 2006 compared to 2005, although it included a $0.4 million charge for adverse developments pertaining to prior years. A new revenue control and reporting system increased 2006 operating expenses.

 

Security.  Security Sales increased $13.6 million, or 4.6%, in 2006 compared to 2005, primarily due to Sales from new business, although these new Sales were partially offset by lost Sales associated with the loss of a major customer account in June 2005. Operating profit increased $1.2 million, or 40.1%, in 2006 compared to 2005. Results in 2005 included a $3.4 million charge for a reserve provided for the amount the Company believed it overpaid SSA LLC, as well as a $0.4 million bad debt provision for a customer that declared bankruptcy in April 2005, a $0.3 million

charge to correct the understatement of payroll and payroll-related 2004 expenses and higher overtime expenses related to operations acquired from SSA LLC. However, the benefit of not incurring these charges and a $1.0 million reduction in the SSA LLC reserve in 2006 were partially offset by lower margins on new contracts, annual salary increases and increases in workers’ compensation, legal fees and settlements.

 

Engineering.  Engineering Sales increased $46.4 million, or 19.5%, during 2006 compared to 2005 due to successful sales initiatives resulting in new business and the expansion of services to existing customers across the country, most significantly in the Mid-Atlantic, Northern California, and Eastern regions. Operating profits increased $2.5 million, or 17.9%, during 2006 compared to 2005 due to increased Sales, offset by the increase in sub-contracting and insurance expense, and higher management headcount necessary to support the growth in business.

 

Lighting.  Lighting Sales and operating profit decreased $3.2 million, or 2.8%, and $2.4 million, or 63.9%, respectively, in 2006 compared to 2005. The Sales decrease was primarily due to a $4.3 million decrease in special project business. The decrease in operating profit was primarily due to the decrease in sales and higher subcontractor and fuel costs, which negatively impacted fixed price contracts.

 

Corporate.  Corporate recognized $80.0 million in revenues in 2006 for the settlement of WTC insurance claims. Corporate expenses in 2006 increased by $4.1 million, or 11.7%, compared to 2005 mainly due to the $3.3 million transition charge related to outsourcing the management of the Company’s information technology infrastructure and support services, $3.2 million of share-based compensation costs, $2.4 million of professional fees associated with the Audit Committee’s independent investigation of prior year accounting at SSA, annual salary increases, costs of additional staffing and higher legal expenses. These increases were partially offset by $9.0 million of additional reductions in insurance reserves recorded in Corporate in 2006 ($14.5 million) than in 2005 ($5.5 million). While virtually all insurance claims arise from the operating segments, these prior year reductions were included in unallocated Corporate expenses. In addition, documentation and testing costs associated with the Sarbanes-Oxley certification effort were $2.6 million lower in 2006 than in 2005.

 

Share-Based Compensation

 

Effective November 1, 2005, the Company began recording compensation expense associated with share-based payment awards in accordance with SFAS No. 123R, “Share-Based Payment,” as interpreted by SEC Staff Accounting Bulletin No. 107 (“SAB No. 107”). Prior to November 1, 2005, the Company accounted for stock options according to the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value. The Company adopted the modified prospective transition method provided for under SFAS No. 123R, and, consequently, has not retroactively adjusted results from prior periods. Under this transition method, compensation cost associated with share-based payment awards recognized in 2006 included: 1) amortization related to the remaining unvested portion of all stock option awards granted for the fiscal years beginning November 1, 1995 and ending October 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation;” and 2) amortization related to all share-based payment awards granted November 1, 2005 or after, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. The compensation cost is included in selling, general and administrative expenses.

 

The total compensation costs related to the 2006 Equity Incentive Plan (the “2006 Equity Plan”) options recognized during the years ended October 31, 2007 and 2006, were $0.2 million and $10,173, respectively. As of October 31, 2007, there was $0.8 million of total unrecognized compensation cost (net of estimated forfeitures) related to the 2006 Equity Plan unvested options which is expected to be recognized over a weighted-average vesting period of 1.7 years on a straight-line basis.

 

The total compensation costs related to the 2006 Equity Plan restricted stock units recognized during the years ended October 31, 2007 and 2006, were $1.3 million and $73,381, respectively. As of October 31, 2007, there was $4.4 million of total unrecognized compensation cost (net of estimated forfeitures) related to restricted stock units which is expected to be recognized over a weighted-average vesting period of 1.6 years on a straight-line basis.

 

The total compensation costs related to the 2006 Equity Plan performance shares recognized during the

years ended October 31, 2007 and 2006, were $1.2 million and $84,590, respectively. As of October 31, 2007, there was $1.7 million of total unrecognized compensation cost (net of estimated forfeitures) related to performance shares which is expected to be recognized over a weighted-average vesting period of 0.8 years on a straight-line basis.

 

The total compensation costs related to the “Time-Vested” Incentive Stock Option Plan (the “Time-Vested Plan”) options recognized during the years ended October 31, 2007 and 2006, were $0.9 million and $1.4 million, respectively. As of October 31, 2007, there was $1.8 million of total unrecognized compensation cost (net of estimated forfeitures) related to the Time-Vested Plan unvested options which is expected to be recognized over a weighted-average vesting period of 1.4 years.

 

The total compensation costs related to the 1996 and 2002 “Price-Vested” Performance Stock Option Plans (the “Price-Vested Plans”) options recognized during the years ended October 31, 2007 and 2006, were $4.5 million and $0.7 million, respectively. As of October 31, 2007, there was $0.9 million of total unrecognized compensation cost (net of estimated forfeitures) related to the Price-Vested Plans unvested options which is expected to be recognized over a weighted-average vesting period of 1.6 years.

 

The total compensation costs related to the Executive Stock Option Plan (also known as the “Age-Vested” Career Stock Option Plan) (the “Age-Vested Plan”) options recognized during both years ended October 31, 2007 and 2006, were $0.1 million. As of October 31, 2007, there was $0.6 million of total unrecognized compensation cost (net of estimated forfeitures) related to the Age-Vested Plan unvested options which is expected to be recognized over a weighted-average vesting period of 4.6 years.

 

The total compensation cost related to the ESPP recognized during the year ended October 31, 2006, was $0.8 million. Because of changes to the ESPP beginning in the third quarter of 2006, the value of the awards is no longer treated as share-based compensation and no share-based compensation expense was recognized under the ESPP after May 1, 2006.

 

The Company estimates the fair value of each option award on the date of grant using the Black-Scholes option valuation model. The Company uses an outside expert to determine the assumptions used in the option valuation model. The Company estimates forfeiture rates based on historical data and adjusts the rates periodically. The adjustment of the forfeiture rate may result in a cumulative adjustment in any period the forfeiture rate estimate is changed. In 2007, the Company recorded an adjustment to the forfeiture rate, resulting in a cumulative benefit adjustment of $33,124.

 

Adoption of Accounting Standards

 

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Emerging Issues Task Force (“EITF”) Issue No. 06-3 (“EITF 06-3”), “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation).” EITF 06-3 requires companies to disclose the presentation of any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer (e.g., sales and use tax) as either gross or net in the accounting policies included in the notes to the financial statements. EITF 06-3 became effective beginning in the second quarter of 2007. The Company continues to report revenues net of sales and use tax imposed on the related transaction.

 

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB No. 108”), “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” The guidance in SAB No. 108 requires companies to base their materiality evaluations on all relevant quantitative and qualitative factors. This involves quantifying the impact of correcting all misstatements, including both the carryover and reversing effects of prior year misstatements, on the current year financial statements. The implementation of SAB No. 108, which became effective beginning in the first quarter of 2007, did not have any impact on the Company’s evaluation.

 

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132 (R)” (“SFAS No. 158”). SFAS No. 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. SFAS No. 158 also requires an employer to measure the funded status of a plan as of the date of its year end statement of financial position. The recognition provisions of SFAS No. 158 became effective at

October 31, 2007 and resulted in a $0.2 million after-tax net unrecognized loss recorded in accumulated other comprehensive income at October 31, 2007 as a result of the evaluation at September 30, 2007. See Note 6 of the Notes to Consolidated Financial Statements contained in Item 8, “Financial Statements and Supplementary Data.” The measurement date provisions will be effective as of October 31, 2009.

 

Recent Accounting Pronouncements

 

In June 2006, the FASB issued FASB Interpretation Number 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” This interpretation prescribes a consistent recognition threshold and measurement standard, as well as clear criteria for subsequently recognizing, derecognizing, classifying and measuring tax positions for financial statement purposes. The interpretation also requires expanded disclosure with respect to uncertainties as they relate to income tax accounting. FIN 48 will be adopted by the Company at the beginning of its fiscal year ending October 31, 2008, as required. The cumulative effect of FIN 48 will be reflected as an adjustment to beginning retained earnings upon adoption. While the Company is still assessing the impact of FIN 48 on its consolidated financial statements, it currently estimates the cumulative effect of the adoption of FIN 48 to be an immaterial amount.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 was issued to provide guidance and consistency for comparability in fair value measurements and for expanded disclosures about fair value measurements. The Company does not anticipate that SFAS No. 157 will have an impact on the Company’s consolidated financial position, results of operations or disclosures in the Company’s financial statements. SFAS No. 157 will be effective beginning in 2009.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 was issued to permit entities to choose to measure many financial instruments and certain other items at fair value. The fair value option established by this SFAS No. 159 permits entities to choose to measure eligible items at fair value at specified election dates and includes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. If the Company chooses to adopt SFAS No. 159, the Company does not anticipate that SFAS No. 159 will have a material impact on the Company’s consolidated financial position, results of operations or disclosures in the Company’s financial statements. If adopted, SFAS No. 159 would be effective beginning in 2009.

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS No. 141R”). The purpose of issuing the statement is to replace current guidance in SFAS No. 141 to better represent the economic value of a business combination transaction. The changes to be effected with SFAS No. 141R from the current guidance include, but are not limited to: (1) acquisition costs will be recognized separately from the acquisition; (2) known contractual contingencies at the time of the acquisition will be considered part of the liabilities acquired measured at their fair value; all other contingencies will be part of the liabilities acquired measured at their fair value only if it is more likely than not that they meet the definition of a liability; (3) contingent consideration based on the outcome of future events will be recognized and measured at the time of the acquisition; (4) business combinations achieved in stages (step acquisitions) will need to recognize the identifiable assets and liabilities, as well as noncontrolling interests, in the acquiree, at the full amounts of their fair values; and (5) a bargain purchase (defined as a business combination in which the total acquisition-date fair value of the identifiable net assets acquired exceeds the fair value of the consideration transferred plus any noncontrolling interest in the acquiree) will require that excess to be recognized as a gain attributable to the acquirer. The Company does anticipate that the adoption of SFAS No. 141R will have an impact on the way in which business combinations will be accounted for compared to current practice. SFAS No. 141R will be effective for any business combinations that occur after November 1, 2009.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (“SFAS No. 160”). SFAS No. 160 was issued to improve the relevance, comparability, and transparency of financial information provided to investors by requiring all entities to report noncontrolling (minority) interests in subsidiaries in the same way, that is, as equity in the consolidated financial statements. Moreover, SFAS No. 160 eliminates the diversity that currently exists in accounting for transactions between an entity and noncontrolling interests by requiring they be treated as equity transactions. SFAS No. 160 will be effective at the beginning of the Company’s fiscal year ending October 31, 2010. The Company is currently evaluating

the impact that SFAS No. 160 will have on its financial statements and disclosures.

 

Critical Accounting Policies and Estimates

 

The preparation of consolidated financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses. On an ongoing basis, the Company evaluates its estimates, including those related to self-insurance reserves, allowance for doubtful accounts, sales allowance, valuation allowance for the net deferred income tax asset, estimate of useful life of intangible assets, impairment of goodwill and other intangibles, and contingencies and litigation liabilities. The Company bases its estimates on historical experience, independent valuations and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates under different assumptions or conditions.

 

The Company believes the following critical accounting policies govern its more significant judgments and estimates used in the preparation of its consolidated financial statements.

 

Self-Insurance Reserves.  Certain insurable risks such as general liability, automobile property damage and workers’ compensation are self-insured by the Company. However, commercial policies are obtained to provide coverage for certain risk exposures subject to specified limits. Accruals for claims under the Company’s self-insurance program are recorded on a claims-incurred basis. The Company periodically evaluates its estimated claim costs and liabilities and accrues self-insurance reserves to its best estimate. Additionally, management monitors new claims and claim development to assess the adequacy of the insurance reserves. The estimated future charge is intended to reflect the recent experience and trends. Trend analysis is complex and highly subjective. The interpretation of trends requires the knowledge of all factors affecting the trends that may or may not be reflective of adverse developments (e.g., changes in regulatory requirements and changes in reserving methodology). If the trends suggest that the frequency or severity of claims incurred has increased, the Company might be required to record additional expenses for self-insurance liabilities. Management also uses the information from its evaluations to develop insurance rates for each operation, expressed per $100 of exposure (labor and revenue).

 

Allowance for Doubtful Accounts.  Trade accounts receivable arise from services provided to the Company’s customers and are generally due and payable on terms varying from receipt of the invoice to net thirty days. The Company records an allowance for doubtful accounts to provide for losses on accounts receivable due to customers’ inability to pay. The allowance is typically estimated based on an analysis of the historical rate of credit losses or write-offs (due to a customer bankruptcy or failure of a former customer to pay) and specific customer concerns. The accuracy of the estimate is dependent on the future rate of credit losses being consistent with the historical rate. Changes in the financial condition of customers or adverse developments in negotiations or legal proceedings to obtain payment could result in the actual loss exceeding the estimated allowance. If the rate of future credit losses is greater than the historical rate, then the allowance for doubtful accounts may not be sufficient to provide for actual credit losses. Alternatively, if the rate of future credit losses is less than the historical rate, then the allowance for doubtful accounts will be in excess of actual credit losses. The Company does not believe that it has any material exposure due to either industry or regional concentrations of credit risk.

 

Sales Allowance.  Sales allowance is an estimate for losses on customer receivables resulting from customer credits (e.g., vacancy credits for fixed-price contracts, customer discounts, job cancellations and breakage cost). The sales allowance estimate is based on an analysis of the historical rate of sales adjustments (credit memos, net of re-bills). The accuracy of the estimate is dependent on the rate of future sales adjustments being consistent with the historical rate. If the rate of future sales adjustments is greater than the historical rate, then the sales allowance may not be sufficient to provide for actual sales adjustments. Alternatively, if the rate of future sales adjustments is less than the historical rate, then the sales allowance will be in excess of actual sales adjustments.

 

Deferred Income Tax Asset and Valuation Allowance.  Deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and such amounts recognized for tax purposes. These deferred taxes are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. If the enacted rates in future years differ from the rates expected to apply, an adjustment of the net deferred tax assets will be required. Additionally, if management determines it is more likely than not that a

portion of the net deferred tax asset will not be realized, a valuation allowance is recorded. At October 31, 2007, the net deferred tax asset was $83.7 million, net of a $1.7 million valuation allowance related to state net operating loss carryforwards. Should future income be less than anticipated, the net deferred tax asset may not be fully recoverable.

 

Other Intangible Assets Other Than Goodwill.  The Company performs valuations of intangible assets acquired in business acquisitions. Acquired customer relationship intangible assets are being amortized using the sum-of-the-years-digits method over their useful lives consistent with the estimated useful life considerations used in the determination of their fair values. The accelerated method of amortization reflects the pattern in which the economic benefits of the customer relationship intangible asset are expected to be realized. Trademarks and trade names are being amortized over their useful lives using the straight-line method. Other intangible assets, consisting principally of contract rights, are being amortized over the contract periods using the straight-line method. At least annually, in the fourth quarter, the Company evaluates the remaining useful lives of its intangible assets to determine whether events and circumstances warrant a revision to the remaining period of amortization. If the estimate of an asset’s remaining useful life changes, the remaining carrying amount of the intangible asset would be amortized over the revised remaining useful life. In addition, the remaining unamortized book value of intangibles is reviewed for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-lived Assets” (“SFAS No. 144”). The first step of an impairment test under SFAS No. 144 is a comparison of the future cash flows, undiscounted, to the remaining book value of the intangible. If the future cash flows are insufficient to recover the remaining book value, a fair value of the asset, depending on its size, will be independently or internally determined and compared to the book value to determine if an impairment exists.

 

Goodwill.  In accordance with SFAS No. 142, “Goodwill and Other Intangibles” (“SFAS No. 142”), goodwill is not amortized. The Company performs goodwill impairment tests on at least an annual basis, in the fourth quarter, using the two-step process prescribed in SFAS No. 142. The first step is to evaluate for potential impairment by comparing the reporting unit’s fair value with its book value. If the first step indicates potential impairment, the required second step allocates the fair value of the reporting unit to its assets and liabilities, including recognized and unrecognized intangibles. If the implied fair value of the reporting unit’s goodwill is lower than its carrying amount, goodwill is impaired and written down to its implied fair value. Throughout the year, the Company monitors goodwill impairment by assessing projections of future performance for each segment and considers the effect of significant events that may impair goodwill. As of October 31, 2007, there was no indication that the Company’s goodwill carrying value was impaired.

 

Contingencies and Litigation.  ABM and certain of its subsidiaries have been named defendants in certain proceedings arising in the ordinary course of business, including certain environmental matters and wage and hour claims. Litigation outcomes are often difficult to predict and often are resolved over long periods of time. Estimating probable losses requires the analysis of multiple possible outcomes that often depend on judgments about potential actions by third parties. Loss contingencies are recorded as liabilities in the consolidated financial statements when it is both: (1) probable or known that a liability has been incurred and (2) the amount of the loss is reasonably estimable. If the reasonable estimate of the loss is a range and no amount within the range is a better estimate, the minimum amount of the range is recorded as a liability. So long as the Company believes that a loss in litigation is not probable, then no liability will be recorded unless the parties agree upon a settlement, which may occur because the Company wishes to avoid the costs of litigation.

 

 

The Company does not issue or invest in financial instruments or their derivatives for trading or speculative purposes. Included within its investment portfolio at October 31, 2007 were $25.0 million of auction rate securities that had long-term ratings in the highest classification by recognized rating agencies. These investments failed to trade at recent auctions due to insufficient bids from buyers. As such, the outstanding auction rate securities were subsequently reset at the default rate of LIBOR plus 125 or 350 basis points. While the Company now earns a premium interest rate, the investments cannot be quickly converted into cash and were considered illiquid as of October 31, 2007. If the issuers are unable to successfully close future auctions and their credit ratings deteriorate, the Company may be required to adjust the carrying value of these investments through an impairment charge. At October 31, 2007, the fair value of these instruments was estimated at par value by standard pricing models.

 

Based on the Company’s ability to access its cash and other short-term investments, its expected operating cash flows, and its other sources of cash, the Company does not anticipate the lack of liquidity of these investments will affect the Company’s ability to operate its businesses in the ordinary course.

 

With respect to the Company’s $136.2 million in cash and cash equivalents at October 31, 2007, market rate risk associated with changing interest rates in the United States was not material.

 

Substantially all of the operations of the Company are conducted in the United States, and, as such, are not subject to material foreign currency exchange rate risk. At October 31, 2007, the Company had no outstanding long-term debt.

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

ABM Industries Incorporated:

 

We have audited the accompanying consolidated balance sheets of ABM Industries Incorporated and subsidiaries as of October 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended October 31, 2007. In connection with our audits of the consolidated financial statements, we also have audited the related financial statement schedule II. 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 the standards of the Public Company Accounting Oversight Board (United States). 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 ABM Industries Incorporated and subsidiaries as of October 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended October 31, 2007, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule II, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

As discussed in Note 1 of the Notes to the Consolidated Financial Statements, effective October 31, 2007, the Company adopted the provisions of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R) and effective November 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payments.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), ABM Industries Incorporated’s internal control over financial reporting as of October 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated December 21, 2007 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting

 

KPMG LLP

 

San Francisco, California

December 21, 2007

 

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

ABM Industries Incorporated:

 

We have audited ABM Industries Incorporated’s internal control over financial reporting as of October 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). ABM Industries Incorporated’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting (Item 9A(b)). Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, ABM Industries Incorporated maintained, in all material respects, effective internal control over financial reporting as of October 31, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of ABM Industries Incorporated and subsidiaries as of October 31, 2007 and 2006, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended October 31, 2007, and our report dated December 21, 2007 expressed an unqualified opinion on those consolidated financial statements.

 

KPMG LLP

 

San Francisco, California

December 21, 2007

 

ABM Industries Incorporated and Subsidiaries

 

CONSOLIDATED BALANCE SHEETS

 

     The accompanying notes are an integral part of the consolidated financial statements.

ABM Industries Incorporated and Subsidiaries

 

CONSOLIDATED STATEMENTS OF INCOME

 

     The accompanying notes are an integral part of the consolidated financial statements.

ABM Industries Incorporated and Subsidiaries

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME