filings.toolsItem 7. Management’s Discussion and Analysis
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Item 7. Management’s Discussion and Analysis
of Financial Condition and Results of Operations
Business Strategy
Cintas provides highly specialized products and services to businesses of all types throughout the United States and Canada. We refer to ourselves as “The Service Professionals.” We bring value to our customers by helping them provide a cleaner, safer, more pleasant atmosphere for their customers and employees. Our products and services are designed to improve our customers’ images. We also help our customers protect their employees and their company by enhancing workplace safety and helping to ensure legal compliance in key areas of their business.
We are North America's leading provider of corporate identity uniforms through rental and sales programs, as well as a significant provider of related business services, including entrance mats, restroom products and services, first aid, safety and fire protection products and services, document management services and branded promotional products.
Our business strategy is to achieve revenue growth for all of our products and services by increasing our penetration at existing customers and by broadening our customer base to include business segments to which Cintas has not historically served. We will also continue to identify additional product and service opportunities for our current and future customers.
To pursue the strategy of increasing penetration, we have a highly talented and diverse team of service professionals visiting our customers on a regular basis. This frequent contact with our customers enables us to develop close personal relationships. The combination of our distribution system and these strong customer relationships provides a platform from which we launch additional products and services.
We pursue the strategy of broadening our customer base in a few ways. Cintas has a national sales organization introducing all of our products and services to prospects in all business segments. Our ever expanding range of products and services allows our sales organization to consider any type of business a prospect. We also broaden our customer base through geographic expansion, especially in our emerging businesses of first aid and safety, fire protection and document management. Finally, we will continue to evaluate strategic acquisitions as opportunities arise.
Results of Operations
Fiscal 2008 marked the 39th consecutive year of uninterrupted growth in sales and profits for Cintas. This milestone was achieved despite challenging economic conditions, including significant increases in energy costs. Additionally, we increased our dividends paid to shareholders by 17.9%.
Cintas historically classified its businesses into two operating segments, Rentals and Other Services. The Rentals operating segment reflects the rental and servicing of uniforms and other garments, mats, mops and shop towels. In addition to these rental items, restroom and hygiene products and services are also provided within this operating segment. Effective June 1, 2007, this operating segment was renamed Rental Uniforms and Ancillary Products.
The Other Services operating segment historically consisted of the direct sale of uniforms and related items, first aid, safety and fire protection products and services, document management services and branded promotional products. Effective June 1, 2007, the Other Services operating segment was separated into three reportable operating segments – Uniform Direct Sales operating segment, First Aid, Safety and Fire Protection Services operating segment and Document Management Services operating segment. This change provides more visibility to these operating segments as they continue to grow and have a larger impact on Cintas’ consolidated results. The Uniform Direct Sales operating segment consists of the direct sale of uniforms and related items and branded promotional products. The First Aid, Safety and Fire Protection Services operating segment consists of first aid, safety and fire protection products and services. The Document Management Services operating segment consists of document shredding and document storage services. Revenue and income before income taxes for each of these operating segments for fiscal 2008, fiscal 2007 and fiscal 2006 are presented in Note 13 entitled Segment Information of “Notes to Consolidated Financial Statements.”
The following table sets forth certain consolidated statements of income data as a percentage of revenue by operating segment and in total for the periods indicated. Fiscal 2007 and fiscal 2006 amounts have been restated to reflect the change to the reportable operating segments made effective June 1, 2007.
| 2008 | 2007 | 2006 | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Revenue: | ||||||||||||
| Rental Uniforms and Ancillary Products | 72.0% | 73.8% | 75.5% | |||||||||
| Uniform Direct Sales | 13.1% | 13.5% | 14.2% | |||||||||
| First Aid, Safety and Fire Protection Services | 10.3% | 9.8% | 8.4% | |||||||||
| Document Management Services | 4.6% | 2.9% | 1.9% | |||||||||
| Total revenue | 100.0% | 100.0% | 100.0% | |||||||||
| Cost of sales: | ||||||||||||
| Rental Uniforms and Ancillary Products | 55.8% | 55.4% | 54.8% | |||||||||
| Uniform Direct Sales | 67.5% | 68.0% | 69.9% | |||||||||
| First Aid, Safety and Fire Protection Services | 60.1% | 60.1% | 60.3% | |||||||||
| Document Management Services | 45.4% | 47.6% | 47.5% | |||||||||
| Total cost of sales | 57.3% | 57.3% | 57.3% | |||||||||
| Gross margin: | ||||||||||||
| Rental Uniforms and Ancillary Products | 44.2% | 44.6% | 45.2% | |||||||||
| Uniform Direct Sales | 32.5% | 32.0% | 30.1% | |||||||||
| First Aid, Safety and Fire Protection Services | 39.9% | 39.9% | 39.7% | |||||||||
| Document Management Services | 54.6% | 52.4% | 52.5% | |||||||||
| Total gross margin | 42.7% | 42.7% | 42.7% | |||||||||
| Selling and administrative expenses | 28.0% | 27.1% | 26.8% | |||||||||
| Interest income | -0.1% | -0.2% | -0.2% | |||||||||
| Interest expense | 1.3% | 1.4% | 0.9% | |||||||||
| Income before income taxes | 13.5% | 14.4% | 15.2% |
As shown above, our First Aid, Safety and Fire Protection Services operating segment revenue and Document Management Services operating segment revenue have grown as a percentage of our total revenue over the last two fiscal years. This shift was driven by acquisitions of first aid, safety and fire protection businesses and document management businesses. Information related to acquisitions is discussed in Note 8 entitled Acquisitions of “Notes to Consolidated Financial Statements.” In addition, the continued development of our sales efforts in the First Aid, Safety and Fire Protection Services operating segment and the Document Management Services operating segment have contributed to higher revenue growth in these two operating segments compared to the Rental Uniforms and Ancillary Products operating segment and the Uniform Direct Sales operating segment.
Selling and administrative expenses as a percentage of revenue have increased over the last two fiscal years primarily due to a reorganization of our sales efforts which began in fiscal 2007. The financial impact of this reorganization effort continued into fiscal 2008. The reorganization has been completed, and we expect to see improved leverage in fiscal 2009.
Fiscal 2008 Compared to Fiscal 2007
Fiscal 2008 total revenue was $3.9 billion, an increase of 6.2% over fiscal 2007. Internal growth was 4.6% in fiscal 2008, compared to 5.3% in fiscal 2007. The deterioration in the North American economy created a challenging environment throughout fiscal 2008. The rising unemployment in the U.S. put pressure on our ability to grow rental uniform wearers, particularly in the latter half of fiscal 2008, as many of our customers reduced their workforces. In addition, our fire protection services business within the First Aid, Safety and Fire Protection
Services operating segment suffered due to pressure on fire installation system revenue and lower than anticipated recurring service revenue. Our internal growth was generated primarily through the sale of document management services to new and existing customers, continued penetration of our ancillary products and services such as mats, hygiene supplies and restroom cleaning services to existing customers, and first aid and safety products and services to new and existing customers. The remaining growth in total revenue was generated predominantly through acquisitions of rental, first aid, safety and fire protection service businesses and document management businesses. Information related to acquisitions is discussed in Note 8 entitled Acquisitions of “Notes to Consolidated Financial Statements.”
Rental Uniforms and Ancillary Products operating segment revenue consists predominantly of revenue derived from the rental of corporate identity uniforms and other garments, and the rental and/or sale of mats, mops, shop towels, restroom supplies and other rental services. Revenue from the Rental Uniforms and Ancillary Products operating segment increased 3.7% over fiscal 2007. Internal growth for the Rental Uniforms and Ancillary Products operating segment was 3.4% in fiscal 2008. The increase in the Rental Uniforms and Ancillary Products operating segment revenue was primarily due to growth in the customer base as well as the continued penetration of ancillary products into our existing customer base. New business remained the main driver of our internal growth as we continued to sell rental programs to new customers. We also continued to expand our rental market, with over half of our new business being comprised of customers who were first time users of uniform rental programs. The remaining growth of 0.3% in fiscal 2008 resulted from the acquisition of rental businesses.
Other Services revenue, consisting of revenue from the reportable operating segments of Uniform Direct Sales, First Aid, Safety and Fire Protection Services and Document Management Services, increased 13.5% over fiscal 2007. Internal growth accounted for 8.2% of this increase. This internal growth was generated primarily through the increased sales of first aid, safety and fire protection products and services and document management services to customers. The remaining revenue growth of 5.3% was generated through a combination of acquisitions of first aid, safety and fire protection businesses and document management businesses.
Cost of rental uniforms and ancillary products increased 4.4% over fiscal 2007. Cost of rental uniforms and ancillary products consists primarily of production expenses, delivery expenses and the amortization of in service inventory, including uniforms, mats, shop towels and other rental items. The cost increase over fiscal 2007 was primarily driven by the growth in the Rental Uniforms and Ancillary Products operating segment revenue. In addition, rising energy costs, especially in the second half of the fiscal year, contributed to this increase. Energy costs increased 11.1% in fiscal 2008, from $104.6 million in fiscal 2007 to $116.2 million in fiscal 2008.
Cost of other services increased 10.5% over fiscal 2007. Cost of other services consists primarily of cost of goods sold (predominantly uniforms and first aid products), delivery expenses and distribution expenses in the Uniform Direct Sales operating segment, the First Aid, Safety and Fire Protection Services operating segment and the Document Management Services operating segment. The increase over fiscal 2007 was due to the growth in other services revenue, derived through a combination of internal growth and acquisitions. Rising energy costs also impacted the cost of other services. Other services energy costs increased 35.4% from $18.1 million in fiscal 2007 to $24.5 million in fiscal 2008. Improved leverage and various cost containment programs in our Uniform Direct Sales, First Aid, Safety and Fire Protection Services and Document Management Services operating segments helped to partially offset the increases in energy costs.
Selling and administrative expenses increased 10.0% over fiscal 2007. Selling and administrative expenses increased mainly due to higher selling expenses. In fiscal 2007, we reorganized our sales efforts to become more efficient and productive in the long-term. This reorganization, as well as increased marketing plans and sales promotions, combined to increase our selling costs by $53.1 million over the prior fiscal year. In addition, administrative expenses increased by $10.4 million due to an increase in legal and other professional services.
Operating income of $577.5 million in fiscal 2008, was relatively flat over fiscal 2007. Gross margin increased by $100.2 million, but was offset by the increase of $100.2 million in selling and administrative expenses.
Net interest expense (interest expense less interest income) increased $2.9 million from the prior fiscal year. This increase was primarily a result of increased interest expense from additional debt added in fiscal 2008 used to buyback shares under our share buyback program.
Income before income tax was $530.7 million, a 0.5% decrease over fiscal 2007. This change reflects the relatively flat operating income being reduced by the higher net interest expense.
Cintas' effective tax rate was 36.8% for fiscal 2008 as compared to 37.3% for fiscal 2007 (see also Note 7 entitled Income Taxes of “Notes to Consolidated Financial Statements”).
Net income for fiscal 2008 of $335.4 million was a 0.3% increase over fiscal 2007, and diluted earnings per share of $2.15 was a 2.9% increase over fiscal 2007. The increase in diluted earnings per share was greater than the increase in net income due to the impact of the share buyback program, which is discussed in more detail in the Liquidity and Capital Resources section below.
Rental Uniforms and Ancillary Products Operating Segment
As discussed above, Rental Uniforms and Ancillary Products operating segment revenue increased $99.9 million, or 3.7%, and the cost of rental uniforms and ancillary products increased $66.4 million, or 4.4%. The operating segment’s gross margin was $1,253.0 million, or 44.2% of revenue. This gross margin percent of revenue of 44.2% decreased from the 44.6% in fiscal 2007, primarily as a result of an 11.1% increase in energy costs.
Selling and administrative expenses for the Rental Uniforms and Ancillary Products operating segment as a percent to sales, at 28.3%, increased 60 basis points from the 27.7% in the prior fiscal year. This increase was due to the increased investment in our sales organization and increases in our marketing efforts and sales promotions as described above.
Income before income taxes decreased $11.1 million to $451.3 million for the Rental Uniforms and Ancillary Products operating segment for fiscal 2008 compared to the prior fiscal year. Income before income taxes was 15.9% of this operating segment’s revenue, which is a 100 basis point decrease compared to fiscal 2007 primarily as a result of the increased energy costs and the increased investment in our sales organization and increases in our marketing efforts and sales promotions.
Uniform Direct Sales Operating Segment
Uniform Direct Sales operating segment revenue increased $16.0 million for fiscal 2008, a 3.2% increase over fiscal 2007. There were no acquisitions in the Uniform Direct Sales operating segment during fiscal 2008.
Cost of uniform direct sales increased $8.5 million, or 2.5%, for fiscal 2008 due to increased Uniform Direct Sales volume. The gross margin as a percent to revenue was 32.5% for fiscal 2008, which was a 50 basis point improvement over the prior fiscal year. This improvement is due to both sourcing improvements for catalog products as well as the increased sales volume.
Selling and administrative expenses as a percent to revenue, at 20.0%, increased 60 basis points compared to fiscal 2007. This increase is in part due to the catalog costs associated with the introduction of the new “Uniform Book” and new healthcare catalog.
Income before income taxes increased $1.5 million to $64.8 million for the Uniform Direct Sales operating segment for fiscal 2008 compared to the prior fiscal year. Income before income taxes was 12.5% of the operating segment’s revenue, which is a 10 basis point decrease compared to fiscal 2007. This decrease is primarily due to the increased catalog costs noted above, offset by the gross margin improvements due to sourcing improvements and increased sales volume.
First Aid, Safety and Fire Protection Services Operating Segment
First Aid, Safety and Fire Protection Services operating segment revenue increased $41.1 million for fiscal 2008, an 11.4% increase over fiscal 2007. This operating segment’s internal growth for fiscal 2008 was 6.1% over the prior fiscal year. The operating segment’s internal growth was negatively impacted by lower than anticipated fire suppression system installation revenue and lower than anticipated recurring service revenue within the fire protection services business. Internal growth was generated primarily by the sale of first aid and safety products and services to new customers. The remaining growth was generated through the acquisition of first aid, safety and fire protection businesses.
Cost of first aid, safety and fire protection services increased $24.8 million, or 11.4%, for fiscal 2008, due to increased First Aid, Safety and Fire Protection Services volume. Gross margin for the First Aid, Safety and Fire Protection Services operating segment is defined as revenue less cost of goods, warehouse expenses, service expenses and training expenses. The gross margin as a percent to revenue was 39.9% for fiscal 2008, which is consistent with the prior fiscal year.
Selling and administrative expenses as a percent to revenue, at 31.0%, increased 170 basis points compared to fiscal 2007. This increase was due to the increased investment in our sales organization and increases in our marketing efforts and sales promotions as described above.
Income before income taxes for the First Aid, Safety and Fire Protection Services operating segment decreased by $2.6 million in fiscal 2008 compared to the prior fiscal year. Income before income taxes was 8.8% of the operating segment’s revenue, which is a 180 basis point decrease compared to last fiscal year primarily as a result of the increased investment in our sales organization and increases in our marketing efforts and sales promotions.
Document Management Services Operating Segment
Document Management Services operating segment revenue increased $73.9 million for fiscal 2008, or 68.1% over the prior fiscal year. This operating segment’s internal growth for fiscal 2008 was 38.2% over fiscal 2007. The internal growth is primarily due to the sale of shredding services to new customers. The remaining growth was generated through the acquisition of document management businesses.
Cost of document management services increased $31.1 million, or 60.2%, for fiscal 2008, due to increased Document Management Services volume. Gross margin for the Document Management Services operating segment is defined as revenue less production and service costs. The gross margin as a percent to revenue was 54.6% for fiscal 2008, which is a 220 basis point improvement over the gross margin percentage in fiscal 2007. This improvement is primarily due to the operating segment’s increased sales volume and favorable recycled paper prices relative to the prior fiscal year.
Selling and administrative expenses as a percent to revenue was 40.5% compared to 45.7% in fiscal 2007. This decrease is due to better leveraging of administrative functions resulting from the operating segment’s increased sales volume, partially offset by the increased investment in our sales organization and increases in our marketing efforts and sales promotions.
Income before income taxes for the Document Management Services operating segment increased $18.6 million for fiscal 2008 compared to the prior fiscal year. Income before income taxes was 14.1% of the operating segment’s revenue compared to 6.6% in fiscal 2007 primarily as a result of the operating segment’s increased sales volume.
Fiscal 2007 Compared to Fiscal 2006
Fiscal 2007 total revenue was $3.7 billion, an increase of 8.9% over fiscal 2006. Internal growth was 5.3% in fiscal 2007, compared to 7.8% in fiscal 2006. This decline in internal growth is due to economic pressure experienced throughout the year from the continued off-shoring of manufacturing jobs as well as the ripple effect felt at other customers that serve these manufacturing businesses. In addition, the reorganization of our sales force has taken longer in the current year than we anticipated. Our internal growth continues to be generated mainly through the sale of uniform rental programs to new customers and the increased penetration of ancillary products to our existing customer base. The remaining growth in total revenue was generated predominantly through acquisitions of rental, first aid, safety and fire protection service businesses and document management businesses. Information related to acquisitions is discussed in Note 8 entitled Acquisitions of “Notes to Consolidated Financial Statements.”
Rental Uniforms and Ancillary Products operating segment revenue consists predominantly of revenue derived from the rental of corporate identity uniforms and other garments, and the rental and/or sale of mats, mops, shop towels, restroom supplies and other rental services. This operating segment’s revenue increased 6.5% over fiscal 2006. Internal growth for the Rental Uniforms and Ancillary Products operating segment was 4.2% in fiscal 2007. The increase in revenue was primarily due to growth in the customer base as well as the continued penetration of ancillary products into our existing customer base. New business remained the main driver of our internal growth as we continued to sell rental programs to new customers. We also continued to expand our rental market, with over half of our new business being comprised of customers who were first time users of uniform rental programs. The remaining growth of 2.3% in fiscal 2007 resulted from the acquisition of rental businesses.
Other Services revenue, consisting of revenue from the reportable operating segments of Uniform Direct Sales, First Aid, Safety and Fire Protection Services and Document Management Services, increased 16.5% over fiscal 2006. Internal growth accounted for 8.6% of this increase. This internal growth was mainly due to an increase in the customer base and through further penetration of first aid, safety and fire protection products and services and document management services into our existing customer base. The remaining revenue growth of 7.9% was generated through a combination of acquisitions of first aid, safety and fire protection businesses and document management businesses.
Cost of rental uniforms and ancillary products increased 7.7% over fiscal 2006. Cost of rental uniforms and ancillary products consists primarily of production expenses, delivery expenses and the amortization of in service inventory, including uniforms, mats, shop towels and other rental items. The cost increase over fiscal 2006 was primarily driven by the growth in Rental Uniforms and Ancillary Products operating segment revenue. In addition, delivery labor increased $34.1 million due to increased Rental Uniforms and Ancillary Products operating segment revenue and the introduction of our restroom cleaning service. As a result, cost of rental uniforms and ancillary products as a percent of Rental Uniforms and Ancillary Products operating segment revenue increased to 55.4% in fiscal 2007 compared to 54.8% in fiscal 2006.
Cost of other services increased 12.6% over fiscal 2006. Cost of other services consists primarily of cost of goods sold (predominantly uniforms and first aid products), delivery expenses and distribution expenses in the Uniform Direct Sales operating segment, the First Aid, Safety and Fire Protection Services operating segment and the Document Management Services operating segment. The increase over fiscal 2006 was due to the growth in Other Services revenue, derived through a combination of internal growth and acquisitions.
Selling and administrative expenses increased 10.1% over fiscal 2006. Selling and administrative expenses increased mainly due to higher selling expenses. In fiscal 2007, we reorganized our sales efforts to become more efficient and productive in the long-term. This reorganization, as well as increased marketing plans and sales promotions, combined to increase our selling costs by $32.6 million over the prior fiscal year. The cost of providing medical and retirement benefits to our employees increased $21.8 million, representing a 15.7% increase over the prior fiscal year. In addition, administrative expenses increased by $7.1 million due to the amortization of intangibles generated by new acquisitions and $6.2 million as a result of an increase in professional services relating to legal and the outsourcing of certain human resource functions. During the third quarter of fiscal 2006, Cintas entered into a forward starting swap to protect forecasted interest payments from interest rate movement in anticipation of a $200.0 million, 30-year debt issuance in early fiscal 2008. During the fourth quarter of fiscal 2007, Cintas changed its intent on issuing this 30-year debt. This decision was based on current market conditions and the interest rate environment as well as the additional payment flexibility provided to Cintas under its commercial paper program. As a result of this decision, Cintas terminated the forward starting swap and recorded the resulting $6.2 million gain in fiscal 2007 as a reduction of administrative expenses.
Operating income was $577.4 million in fiscal 2007, an increase of $34.4 million, or 6.3%, over fiscal 2006. Gross margin increased by $126.6 million, offset by the increase of $92.2 million in selling and administrative expenses.
Net interest expense (interest expense less interest income) increased $18.8 million from the prior fiscal year. This increase was primarily a result of increased interest expense from higher debt outstanding as a result of our share buybacks.
Income before income tax was $533.6 million, a 3.0% increase over fiscal 2006. This change reflects the increased operating income being reduced by the higher net interest expense.
Cintas' effective tax rate was 37.3% for fiscal 2007, as compared to 37.6% for fiscal 2006 (see also Note 7 entitled Income Taxes of “Notes to Consolidated Financial Statements”).
Net income for fiscal 2007 of $334.5 million was a 3.4% increase over fiscal 2006, and diluted earnings per share of $2.09 was an 8.9% increase over fiscal 2006. The increase in diluted earnings per share was greater than the increase in net income due to the impact of the share buyback program, which is discussed in more detail in the Liquidity and Capital Resources section below.
Rental Uniforms and Ancillary Products Operating Segment
As discussed above, Rental Uniforms and Ancillary Products operating segment revenue increased $165.9 million, or 6.5%, and the cost of rental uniforms and ancillary products increased $108.4 million, or 7.7%. The operating segment’s gross margin was $1,219.4 million, or 44.6% of revenue. The gross margin as a percent of revenue of 44.6% decreased compared to the 45.2% in fiscal 2006. This decrease is in part due to increased delivery labor associated with the introduction of our restroom cleaning service.
Selling and administrative expenses for the Rental Uniforms and Ancillary Products operating segment as a percent to revenue, at 27.7%, increased 70 basis points compared the prior fiscal year. This increase was due to the increased investment in our sales organization and increases in our marketing efforts and sales promotions as described above.
Income before income taxes decreased $6.0 million to $462.4 million for the Rental Uniforms and Ancillary Products operating segment for fiscal 2007 compared to the prior fiscal year. Income before income taxes was 16.9% of this operating segment’s revenue, which is a 130 basis point decrease compared to fiscal 2006 primarily as a result of the increase in delivery labor and the increased investment in our sales organization and increases in our marketing efforts and sales promotions.
Uniform Direct Sales Operating Segment
Uniform Direct Sales operating segment revenue increased $16.5 million for fiscal 2007, or 3.4% over fiscal 2006. There were no acquisitions in the Uniform Direct Sales operating segment during fiscal 2007.
Cost of uniform direct sales increased $1.7 million, or 0.5%, for fiscal 2007 due to increased Uniform Direct Sales volume. The gross margin as a percent to revenue was 32.0% for fiscal 2007, which was a 190 basis point improvement over the prior fiscal year. This improvement is due to both sourcing improvements for direct sales apparel as well as the increased sales volume.
Selling and administrative expenses as a percent to revenue, at 19.4%, decreased 220 basis points compared to fiscal 2006. This decrease is primarily due to cost containment initiatives and improved leverage due to higher sales volumes.
Income before income taxes increased $22.2 million to $63.3 million for the Uniform Direct Sales operating segment for fiscal 2007 compared to the prior fiscal year. Income before income taxes was 12.6% of the operating segment’s revenue, which is a 410 basis point increase compared to fiscal 2006. This increase is primarily due to the gross margin improvements and cost containment initiatives discussed above.
First Aid, Safety and Fire Protection Services Operating Segment
First Aid, Safety and Fire Protection Services operating segment revenue increased $77.1 million for fiscal 2007, or 27.0% over fiscal 2006. This operating segment’s internal growth for fiscal 2007 was 12.5% over the prior fiscal year. The operating segment’s internal growth was mainly due to an increase in the customer base and through further penetration of first aid, safety and fire protection products and services. The remaining growth was generated through the acquisition of first aid, safety and fire protection businesses.
Cost of first aid, safety and fire protection services increased $45.8 million, or 26.6%, for fiscal 2007, due to increased First Aid, Safety and Fire Protection Services operating segment volume. Gross margin for the First Aid, Safety and Fire Protection Services operating segment is defined as revenue less cost of goods, warehouse expenses, service expenses and training expenses. The gross margin as a percent to revenue was 39.9% for fiscal 2007, which is a 20 basis point increase over the gross margin percentage in fiscal 2006. This improvement came in both the first aid and fire protection businesses and is primarily due the operating segment’s increased sales volume.
Selling and administrative expenses as a percent to revenue, at 29.3%, increased 50 basis points compared to fiscal 2006. This increase was due to the increased investment in our sales organization and increases in our marketing efforts and sales promotions as described above.
Income before income taxes increased $7.4 million to $38.3 million for the First Aid, Safety and Fire Protection Services operating segment for fiscal 2007 compared to the prior fiscal year. Income before income taxes was 10.6% of the operating segment’s revenue, which is a 20 basis point decrease compared to the prior fiscal year primarily as a result of the increased investment in our sales organization and increases in our marketing efforts and sales promotions.
Document Management Services Operating Segment
Document Management Services operating segment revenue increased $43.9 million for fiscal 2007, or 67.9% over the prior fiscal year. This operating segment’s internal growth for fiscal 2007 was 34.2% over fiscal 2006. The internal growth is primarily due to the sale of shredding services to new customers. The remaining growth was generated through the acquisition of document management businesses.
Cost of document management services increased $20.9 million, or 68.2%, for fiscal 2007, due to increased Document Management Services volume. Gross margin for the Document Management Services operating segment is defined as revenue less production and service costs. The gross margin as a percent to revenue was 52.4% for fiscal 2007, which is comparable to the gross margin percentage in fiscal 2006.
Selling and administrative expenses as a percent to revenue, at 45.7%, decreased 270 basis points compared to fiscal 2006. This decrease is due to better leveraging of administrative functions resulting from the operating segment’s increased sales volume, offset by the increased investment in our sales organization and increases in our marketing efforts and sales promotions.
Income before income taxes for the Document Management Services operating segment increased $4.6 million for fiscal 2007 compared to the prior fiscal year. Income before income taxes was 6.6% of the operating segment’s revenue, which is a 250 basis point increase compared to fiscal 2006 primarily as a result of the operating segment’s increased sales volume.
Liquidity and Capital Resources
At May 31, 2008, Cintas had $191.7 million in cash, cash equivalents and marketable securities, representing an increase of $36.3 million from May 31, 2007, or 23.3%. This cash amount includes $26.8 million in bank overdrafts with no right of offset. In prior fiscal years, we have netted these bank overdrafts against daily cash holdings at our depository bank. However, we have transferred these cash holdings in fiscal 2008 to a different bank and, as a result, no longer have right of offset. Therefore, the bank overdraft balance was reclassified as an increase to cash and accounts payable in accordance with FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts. The remaining increase is primarily due to the improvement in net working capital (defined as current assets less current liabilities), which increased by $161.4 million in fiscal 2008 compared to fiscal 2007. Cash generated from operations was $544.5 million in fiscal 2008 as compared to $449.4 million generated in fiscal 2007. This $95.1 million increase was primarily due to an increase in accounts payable and accrued liabilities and an increase in income taxes payable. Significant uses of cash in fiscal 2008 were capital expenditures of $190.3 million, acquisitions of $111.5 million (net of cash acquired), repurchases of common stock of $191.5 million and dividends of $70.8 million. Cash, cash equivalents and marketable securities will be used to finance future acquisitions, capital expenditures and share buybacks.
Marketable securities consist primarily of Canadian federal government securities. Cintas' investment policy pertaining to marketable securities is conservative. The criterion used in making investment decisions is the preservation of principal, while earning an attractive yield.
Accounts receivable increased $21.2 million, primarily due to increased revenue. The average collection period in fiscal 2008 remained comparable with fiscal 2007.
Inventories increased $6.9 million, or 3.0%, primarily due to inventory requirements for the rollout of our direct sale catalog and for the opening of a new facility services distribution center. This new distribution center is designed to improve logistics and enhance the cost structure of our ancillary products within our Rental Uniforms and Ancillary Products operating segment.
Working capital increased $161.4 million to $915.1 million in fiscal 2008. This increase is primarily due to an increase in accounts payable due to a reclassification of cash and accounts payable as described above.
Net property and equipment increased by $54.3 million due to continued investment in rental facilities and equipment and real estate purchased in conjunction with the acquisitions of rental, first aid, safety and fire protection and document management businesses. Capital expenditures for fiscal 2008 totaled $190.3 million, including $140.8 million for the Rental Uniforms and Ancillary Products operating segment and $31.0 million for the Document Management Services operating segment, exceeding depreciation expense by approximately
$41.8 million. Cintas continues to reinvest in land, buildings and equipment in an effort to expand capacity for future growth. During fiscal 2008, Cintas completed construction of four new uniform rental facilities and one new distribution center and has an additional five uniform rental facilities in various stages of construction to accommodate growth in rental operations. Cintas anticipates that capital expenditures for fiscal 2009 will be between $180.0 million and $200.0 million.
Long-term debt totaled $942.7 million at May 31, 2008. This amount includes $225.0 million of 10-year senior notes at a rate of 6.0% issued in fiscal 2002, $250.0 million of 30-year senior notes issued in August 2006 at a rate of 6.15% and $300.0 million of 10-year senior notes issued in the third quarter of fiscal 2008 at a rate of 6.125%. Proceeds from issuances of the August 2006 30-year senior notes and the fiscal 2008 third quarter 10-year senior notes were both used to extinguish outstanding commercial paper at the time of their respective debt issuances. Cintas has earned credit ratings on these notes of “A” from Standard & Poor’s and “A2” from Moody’s. In addition, long-term debt also includes $163.0 million in commercial paper. Cintas utilizes a $600.0 million commercial paper program, on which it has earned credit ratings of “A-1” from Standard & Poor’s and “Prime-1” from Moody’s. We believe these ratings are reflective of our commitment to conservative financial policies, strong financial management and a disciplined integration strategy for acquisitions. The commercial paper program is fully supported by a long-term credit facility that matures in fiscal 2011.
Cintas’ total debt to capitalization ratio has increased from 28.9% at May 31, 2007, to 29.5% at May 31, 2008. Total debt increased $62.6 million in fiscal 2008 through the net activity of the debt issuance noted above (see Note 5 entitled Long-Term Debt of “Notes to Consolidated Financial Statements”). This additional indebtedness was used to execute the share buyback program. During fiscal 2008, Cintas bought back $191.5 million of Cintas common stock.
During fiscal 2008, Cintas paid dividends of $70.8 million, or $0.46 per share. On a per share basis, this dividend is an increase of 17.9% over the dividend paid in fiscal 2007. This marks the 25th consecutive year that Cintas has increased its annual dividend, every year since going public in 1983.
On May 2, 2005, Cintas announced that the Board of Directors authorized a $500.0 million share buyback program at market prices. In July 2006, Cintas announced that the Board of Directors approved the expansion of its share buyback program by an additional $500.0 million. During fiscal 2008, Cintas purchased 5.2 million shares of Cintas stock at an average price of $36.86 per share, for a total purchase price of $191.5 million. From the inception of the share buyback program through July 25, 2008, Cintas has purchased 19.4 million shares of Cintas stock at an average price of $39.81 per share for a total purchase price of $772.0 million. The Board of Directors did not specify an expiration date for this program.
Following is information regarding Cintas' long-term contractual obligations and other commitments outstanding as of May 31, 2008:
Long-Term Contractual Obligations
| Payments Due by Period | ||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (In thousands) | Total | One year or less | Two to three years | Four to five years | After five years | |||||||||||||||
| Long-term debt (1) | $ | 942,657 | $ | 535 | $ | 164,177 | $ | 226,278 | $ | 551,667 | ||||||||||
| Capital lease obligations (2) | 1,149 | 535 | 255 | 240 | 119 | |||||||||||||||
| Operating leases (3) | 91,228 | 24,241 | 35,239 | 18,034 | 13,714 | |||||||||||||||
| Interest payments (4) | 711,152 | 53,339 | 105,373 | 84,540 | 467,900 | |||||||||||||||
| Interest swap agreements (5) | — | — | — | — | — | |||||||||||||||
| Unconditional purchase obligations | — | — | — | — | — | |||||||||||||||
| Total contractual cash obligations | $ | 1,746,186 | $ | 78,650 | $ | 305,044 | $ | 329,092 | $ | 1,033,400 |
Cintas also makes payments to defined contribution plans. The amounts of contributions made to the defined contribution plans are made at the discretion of Cintas. Future contributions are expected to increase 10% annually. Assuming this 10% increase, payments due in one year or less would be $33,220, two to three years would be $76,738 and four to five years would be $92,853. Payments for years thereafter are expected to continue increasing by 10% each year.
| (1) | Long-term debt primarily consists of $775,000 in long-term notes and $163,000 in commercial paper. Reference Note 5 entitled Long-Term Debt of “Notes to Consolidated Financial Statements” for a detailed discussion of long-term debt. |
|---|---|
| (2) | Capital lease obligations are included in long-term debt detailed in Note 5 entitled Long-Term Debt of “Notes to Consolidated Financial Statements.” |
| (3) | Operating leases consist primarily of building leases and a synthetic lease on a corporate aircraft. |
| (4) | Interest payments include interest on both fixed and variable rate debt. Rates have been assumed to remain constant in fiscal 2009, increase 25 basis points for both fiscal 2010 and fiscal 2011, and an additional 50 basis points in each future year. |
| (5) | Reference Note 5 entitled Long-Term Debt of “Notes to Consolidated Financial Statements” for a detailed discussion of interest swap agreements. |
Other Commitments
| Amount of Commitment Expiration per Period | ||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (In thousands) | Total | One year or less | Two to three years | Four to five years | After five years | |||||||||||||||
| Lines of credit (1) | $ | 600,000 | $ | — | $ | 600,000 | $ | — | $ | — | ||||||||||
| Standby letters of credit (2) | 74,764 | 45,728 | 29,036 | — | — | |||||||||||||||
| Guarantees | — | — | — | — | — | |||||||||||||||
| Standby repurchase obligations | — | — | — | — | — | |||||||||||||||
| Other commercial commitments | — | — | — | — | — | |||||||||||||||
| Total commercial commitments | $ | 674,764 | $ | 45,728 | $ | 629,036 | $ | — | $ | — |
| (1) | Back-up facility for the commercial paper program (reference Note 5 entitled Long-Term Debt of “Notes to Consolidated Financial Statements” for further discussion). |
|---|
| (2) | Support certain outstanding debt (reference Note 5 entitled Long-Term Debt of “Notes to Consolidated Financial Statements”), self-insured workers' compensation and general liability insurance programs. |
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Cintas has no off-balance sheet arrangements other than the synthetic lease on a corporate aircraft. The synthetic lease on the aircraft does not currently have, and is not reasonably likely to have, a current or future material effect on Cintas’ financial condition, changes in Cintas’ financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.
Inflation and Changing Prices
Changes in wages, benefits and energy costs have the potential to materially impact Cintas’ financial results. Energy costs, in particular, continue to rise. Energy costs were 3.6% of total revenue in fiscal 2008 and 3.3% of total revenue in fiscal 2007. Medical benefit costs have decreased as a percent to revenue due to better claims experience and a one-time benefit from a switch to a new provider. Medical benefits were 3.1% of total revenue in fiscal 2008 and 3.4% of total revenue in fiscal 2007. Although difficult to predict, we do not expect that medical benefit expense will continue to decrease. Management believes inflation has not had a material impact on Cintas' financial condition or a negative impact on operations.
Litigation and Other Contingencies
Cintas is subject to legal proceedings and claims arising from the ordinary course of its business, including personal injury, customer contract, environmental and employment claims. In the opinion of management, the aggregate liability, if any, with respect to such ordinary course of business actions, will not have a material adverse effect on the financial position or results of operations of Cintas. Cintas is party to additional litigation not considered in the ordinary course of business, including the litigation discussed below.
Cintas is a defendant in a purported class action lawsuit, Paul Veliz, et al. v. Cintas Corporation, filed on March 19, 2003, in the United States District Court, Northern District of California, Oakland Division, alleging that Cintas violated certain federal and state wage and hour laws applicable to its service sales representatives, whom Cintas considers exempt employees, and asserting additional related ERISA claims. On August 23, 2005, an amended complaint was filed alleging additional state law wage and hour claims under the following state laws: Arkansas, Kansas, Kentucky, Maine, Maryland, Massachusetts, Minnesota, New Mexico, Ohio, Oregon, Pennsylvania, Rhode Island, Washington,
West Virginia and Wisconsin. The plaintiffs are seeking unspecified monetary damages, injunctive relief or both. Cintas denies these claims and is defending the plaintiffs’ allegations. On February 14, 2006, the court ordered a majority of the opt-in plaintiffs to arbitrate their claims in accordance with the terms of their Cintas employment agreement. On February 14, 2006, the court also permitted plaintiffs to file a second amended complaint alleging state law claims in the 15 states listed above only with respect to the putative class members that may litigate their claims in court. No determination has been made by the court or an arbitrator regarding class certification. There can be no assurance as to whether a class will be certified or, if a class is certified, as to the geographic or other scope of such class. If a court or arbitrator certifies a class in this action and there is an adverse verdict on the merits, or in the event of a negotiated settlement of the action, the resulting liability and/or any increased costs of operations on an ongoing basis could be material to Cintas. Any estimated liability relating to this lawsuit is not determinable at this time.
Cintas also is a defendant in a purported class action lawsuit, Mirna E. Serrano, et al. v. Cintas Corporation (Serrano), filed on May 10, 2004, and pending in the United States District Court, Eastern District of Michigan, Southern Division. The Serrano plaintiffs allege that Cintas discriminated against women in hiring into various service sales representative positions across all divisions of Cintas. On November 15, 2005, the Equal Employment Opportunity Commission (EEOC) intervened in the Serrano lawsuit. The Serrano plaintiffs seek injunctive relief, compensatory damages, punitive damages, attorneys’ fees and other remedies. Cintas is a defendant in another purported class action lawsuit, Blanca Nelly Avalos, et al. v. Cintas Corporation (Avalos), currently pending in the United States District Court, Eastern District of Michigan, Southern Division. Ms. Avalos’ claims have been dismissed, but her putative class complaint remains pending. The Avalos plaintiffs allege that Cintas discriminated against women, African-Americans and Hispanics in hiring into various service sales representative positions in Cintas’ Rental division only throughout the United States. The Avalos plaintiffs seek injunctive relief, compensatory damages, punitive damages, attorneys’ fees and other remedies. The claims in Avalos originally were brought in the previously disclosed lawsuit captioned Robert Ramirez, et al. v. Cintas Corporation (Ramirez), filed on January 20, 2004, in the United States District Court, Northern District of California, San Francisco Division. On April 27, 2005, the EEOC intervened in the claims asserted in Ramirez. On May 11, 2006, the Ramirez and Avalos African-American, Hispanic and female failure to hire into service sales representative positions claims and the EEOC's intervention were consolidated for pretrial purposes with the Serrano case and transferred to the United States District Court for the Eastern District of Michigan, Southern Division. The consolidated case is known as Mirna E. Serrano/Blanca Nelly Avalos, et al. v. Cintas Corporation (Serrano/Avalos), and remains pending in the United States District Court, Eastern District of Michigan, Southern Division. No filings or determinations have been made in Serrano/Avalos as to class certification. There can be no assurance as to whether a class will be certified or, if a class is certified, as to the geographic or other scope of such class. The non-service sales representative hiring claims in the previously disclosed Ramirez case that have not been dismissed remain pending in the Northern District of California, San Francisco Division, but were ordered to arbitration and stayed pending the completion of arbitration. The Ramirez purported class action claims currently in arbitration include allegations that Cintas failed to promote Hispanics into supervisory positions, discriminated against African-Americans and Hispanics in service sales representative route assignments and discriminated against African-Americans in hourly pay in Cintas’ Rental division only throughout the United States. The Ramirez plaintiffs seek injunctive relief, compensatory damages, punitive damages, attorneys’ fees and other remedies. No filings or determinations have been made in Ramirez as to class certification. There can be no assurance as to whether a class will be certified or, if a class is certified, as to the geographic or other scope of such class. On February 24, 2006, a motion to intervene in Serrano was filed by intervening plaintiffs Colleen Grindle, et al., on behalf of a subclass of female employees at Cintas’ Perrysburg, Ohio rental location who allegedly were denied hire, promotion or transfer to service sales representative positions. On March 24, 2006, the plaintiffs Colleen Grindle, et al., withdrew their motion to intervene without prejudice. On February 20, 2007, the plaintiffs Colleen Grindle, et al., filed a separate lawsuit in the Court of Common Pleas, Wood County, Ohio, captioned Colleen Grindle, et al. v. Cintas Corporation (Grindle), on behalf of a class of female employees at Cintas’ Perrysburg, Ohio location who allegedly were denied hire, promotion or transfer to service sales representative positions on the basis of their gender. The Grindle plaintiffs seek injunctive relief, compensatory damages, punitive damages, attorneys’ fees and other remedies. The Grindle case is stayed pending the class certification proceedings in Serrano. No filings or determinations have been made in Grindle as to class certification. There can be no assurance as to whether a class will be certified or, if a class is certified, as to the geographic or other scope of such class. In addition, a class action lawsuit, Larry Houston, et al. v. Cintas Corporation (Houston), was filed on August 3, 2005, in the United States District Court for the Northern District of California on behalf of African-American managers alleging racial discrimination. On November 22, 2005, the court entered an order requiring the named plaintiffs in the Houston lawsuit to arbitrate all of their claims for monetary damages.
On July 17, 2008, Manville Personal Injury Settlement Trust filed a purported shareholder derivative lawsuit in the Court of Common Pleas, Hamilton County, Ohio, captioned Manville Personal Injury Settlement Trust v. Richard T. Farmer, et. al., A0806822 against certain directors and officers, alleging that they breached their fiduciary duties to the Company by consciously failing to cause Cintas to comply with worker safety and employment-related laws and regulations. The Company is named as a nominal defendant in the case. The complaint contends that, as a consequence of such alleged breach of duty, the Company suffered substantial monetary losses and other injuries and seeks, among other things, an award of compensatory damages, other non-monetary remedies and expenses.
The litigation discussed above, if decided or settled adversely to Cintas, may, individually or in the aggregate, result in liability material to Cintas’ financial condition or results of operations and could increase costs of operations on an on-going basis. Any estimated liability relating to these proceedings is not determinable at this time. Cintas may enter into discussions regarding settlement of these and other lawsuits, and may enter into settlement agreements if it believes such settlement is in the best interest of Cintas’ shareholders.
Cintas is subject to various environmental laws and regulations, as are other companies in the uniform rental industry. While environmental compliance is not a material component of our costs, Cintas must incur capital expenditures and associated operating costs, primarily for water treatment and waste removal, on a regular basis. Environmental spending related to water treatment and waste removal was approximately $17 million in fiscal 2008 and approximately $16 million in fiscal 2007. Capital expenditures to limit or monitor hazardous substances were approximately $4 million in fiscal 2008 and approximately $2 million in fiscal 2007. Cintas does not expect a material change in the cost of environmental compliance on a percent to revenue basis and is not aware of any material non-compliance with environmental laws.
New Accounting Standards
As of June 1, 2007, Cintas adopted Financial Accounting Standards Board (FASB) Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FAS 109), which clarifies the accounting for uncertainty in income taxes recognized in the consolidated financial statements in accordance with FAS 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. As a result of the implementation of FIN 48, Cintas recorded a decrease to retained earnings as of June 1, 2007, of $13,731. Cintas’ adoption of FIN 48 is more fully described in Note 7 entitled Income Taxes of “Notes to Consolidated Financial Statements.”
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (FAS 157), which defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosure requirements about fair value measurements. Cintas will adopt FAS 157 in the first quarter of fiscal 2009. In February 2008, the FASB released a FASB Staff Position (FSP FAS 157-2, Effective Date of FASB Statement No. 157) which delayed the effective date of FAS 157 for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The adoption of FAS 157 for our financial assets and liabilities will not have a material impact upon adoption.
In December 2007, the FASB issued Statement No. 141 (revised 2007), Business Combinations (FAS 141(R)). Under FAS 141(R), an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs are recognized separately from the acquisition and expensed as incurred, restructuring costs generally are expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense. For Cintas, FAS 141(R) is effective for acquisitions and adjustments to an acquired entity’s deferred tax asset and liability balances occurring after May 31, 2009. Cintas is currently evaluating the future impact and disclosures under FAS 141(R).
Critical Accounting Policies
The preparation of Cintas' consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and judgments that have a significant effect on the amounts reported in the consolidated financial statements and accompanying notes. These critical accounting policies should be read in conjunction with Note 1 entitled Significant Accounting Policies of “Notes to Consolidated Financial Statements.” Significant changes, estimates or assumptions related to any of the following critical accounting policies could possibly have a material impact on the consolidated financial statements.
Revenue recognition
Rental revenue, which is recorded in the Rentals Uniforms and Ancillary Products operating segment, is recognized when services are performed. Other services revenue, which is recorded in the Uniform Direct Sales, First Aid, Safety and Fire Protection Services and Document Management Services operating segments, is recognized when either services are performed or when products are shipped and the title and risks of ownership pass to the customer.
Allowance for doubtful accounts
Cintas establishes an allowance for doubtful accounts. This allowance is an estimate based on historical rates of collectibility. An allowance for doubtful accounts is recorded for overdue amounts, beginning with a nominal percentage and increasing substantially as the account ages. The amount provided as the account ages will differ slightly between the Rental Uniforms and Ancillary Products operating segment and the three other operating segments because of differences in customers served and the nature of each segment.
Inventories
Inventories are valued at the lower of cost (first-in, first-out) or market. Substantially all inventories represent finished goods. Cintas applies a commonly accepted practice of using inventory turns to apply variances between actual to standard costs to the inventory balances. The judgments and estimates used to calculate inventory turns will have an impact on the valuation of inventories at the lower of cost or market. An inventory obsolescence reserve is determined by specific identification, as well as an estimate based on historical rates of obsolescence.
Uniforms and other rental items in service
Uniforms and other rental items in service are valued at cost less amortization, calculated using the straight-line method. Uniforms in service (other than cleanroom and flame resistant garments) are amortized over their useful life of 18 months. Other rental items including shop towels, mats, cleanroom garments, flame resistant garments, linens and restroom dispensers are amortized over their useful lives which range from 8 to 48 months. The amortization rates used are based on industry experience, Cintas' experience and wear tests performed by Cintas. These factors are critical to determining the amount of in service inventory that is presented in the consolidated financial statements.
Property and equipment
Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, which is typically 30 to 40 years for buildings, 5 to 20 years for building improvements, 3 to 10 years for equipment and 2 to 5 years for leasehold improvements. When events or circumstances indicate that the carrying amount of long-lived assets may not be recoverable, the estimated future cash flows (undiscounted) are compared to the carrying amount of the assets. If the estimated future cash flows are less than the carrying amount of the assets, an impairment loss is recorded. The impairment loss is measured by comparing the fair value of the assets with their carrying amounts. Fair value is determined by discounted cash flows or appraised values, as appropriate. Long-lived assets that are held for disposal are reported at the lower of the carrying amount or the fair value, less estimated costs related to disposition.
Goodwill and impairment
Goodwill, obtained through acquisitions of businesses, is valued at cost less any impairment. Cintas performs annual impairment tests by operating segment. These tests include comparisons to current market values, where available, and discounted cash flow analyses. Significant assumptions include growth rates based on historical trends and margin improvement leveraged from such growth. Based on the results of the impairment tests, Cintas has not recognized an impairment of goodwill for the years ended May 31, 2008, 2007 or 2006.
Service contracts and other assets
Service contracts and other assets, which consist primarily of noncompete and consulting agreements obtained through acquisitions of businesses, are amortized by use of the straight-line method over the estimated lives of the agreements, which are generally 5 to 10 years. Certain noncompete agreements, as well as all service contracts, require that a valuation be determined using a discounted cash flow model. The assumptions and judgments used in these models involve estimates of cash flows and discount rates, among other factors. Because of the assumptions used to value these intangible assets, actual results over time could vary from original estimates. Impairment of service contracts and other assets is through specific identification. No impairment has been recognized by Cintas for the years ended May 31, 2008, 2007 or 2006.
Stock-based compensation
As required under FASB Statement No. 123(R), Share-Based Payment, compensation expense is recognized for all share-based payments to employees, including stock options, in the consolidated statements of income based on the fair value of the awards that are granted. The fair value of stock options is estimated at the date of grant using the Black-Scholes option-pricing model. Measured compensation cost, net of estimated forfeitures, is recognized on a straight line basis over the vesting period of the related share-based compensation award.
See Note 11 entitled Stock-Based Compensation of “Notes to Consolidated Financial Statements” for further information.
Litigation and environmental matters
Cintas is subject to legal proceedings and claims related to environmental matters arising from the ordinary course of business. U.S. generally accepted accounting principles require that a liability for contingencies be recorded when it is probable that a liability has occurred and the amount of the liability can be reasonably estimated. Significant judgment is required to determine the existence of a liability, as well as the amount to be recorded. While a significant change in assumptions and judgments could have a material impact on the amounts recorded for contingent liabilities, Cintas does not believe that they will result in a material adverse effect on the consolidated financial statements.
A detailed discussion of litigation matters is discussed above in the section entitled Litigation and Other Contingencies.
Income taxes
Deferred tax assets and liabilities are determined by the differences between the consolidated financial statement carrying amounts and the tax basis of assets and liabilities. Please reference Note 7 entitled Income Taxes of “Notes to Consolidated Financial Statements” for the types of items that give rise to significant deferred income tax assets and liabilities. Deferred income taxes are classified as assets or liabilities based on the classification of the related asset or liability for financial reporting purposes. Deferred income taxes that are not related to an asset or liability for financial reporting are classified according to the expected reversal date. Cintas regularly reviews deferred tax assets for recoverability based upon projected future taxable income and the expected timing of the reversals of existing temporary differences. As a result of this review, Cintas has not established a valuation allowance against the deferred tax assets.
Cintas is periodically reviewed by domestic and foreign tax authorities regarding the amount of taxes due. These reviews include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various filing positions, Cintas records reserves as deemed appropriate. Based on Cintas' evaluation of current tax positions, Cintas believes its accruals are appropriate.
Outlook
While it is our view that economic conditions will remain sluggish, we believe we can achieve continued growth in sales and profits. We will pursue our strategy of achieving revenue growth for all of our products and services by increasing our penetration at existing customers and by broadening our customer base to include business segments and markets to which Cintas has not historically served. When appropriate opportunities arise, we will also supplement our internal growth with strategic acquisitions.
We believe that the high level of customer service provided by our employee-partners and supported by our infrastructure, quality products, financial resources and corporate culture will provide for continued business success. As such, we see upside revenue potential for all of our business units. However, we do not expect that economic and competitive pressures will diminish, and these pressures will continue creating a difficult pricing environment.
Like many other companies, we anticipate upward pressures on energy costs to remain in fiscal 2009. This pressure may make gross margin improvements as a percentage of revenue difficult. However, we expect productivity improvements brought on by cost containment initiatives, technological advances and continued leverage of our infrastructure to soften the adverse energy impact.
Although difficult to predict, we expect to make improvements to our selling and administrative expenses as a percentage of revenue in fiscal 2009. The reorganization of our sales efforts has been completed, and we expect to gain improved leverage from this organization in fiscal 2009. We also expect cost containment initiatives will offset anticipated increases to wages and benefits, including medical expenses.
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