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 helps more than one million businesses of all types and sizes, primarily in North America, as well as Latin America, Europe and Asia, get Ready™ to open their doors with confidence every day by providing a wide range of products and services that enhance our customers’ image and help keep their facilities and employees clean, safe and looking their best. With products and services including uniforms, floor care, restroom supplies, first aid and safety products, fire extinguishers and testing, and safety and compliance training, Cintas helps customers get Ready for the Workday™.
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 cleaning services and supplies, carpet and tile cleaning services, first aid and safety services and fire protection products and services.
Cintas' principal objective is "to exceed customers' expectations in order to maximize the long-term value of Cintas for shareholders and working partners," and it provides the framework and focus for Cintas' business strategy. This 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 we have 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 several ways. Cintas has a national sales organization introducing all of our products and services to prospects in all business segments. Our broad 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 first aid and safety and fire protection businesses. Finally, we evaluate strategic acquisitions as opportunities arise.
Results of Operations
On March 21, 2017, Cintas completed the acquisition of G&K Services, Inc. (G&K) for consideration of approximately $2.1 billion. G&K is now a wholly-owned subsidiary of Cintas that will operate within the Uniform Rental and Facility Services operating segment. To finance the G&K acquisition, Cintas used a combination of new senior notes, a term loan, other borrowings under its existing credit facility and cash on hand. G&K's results of operations are included in Cintas' consolidated financial statements as of and from the date of acquisition.
U. S. GAAP requires companies to evaluate their reportable operating segments periodically and when certain events occur. As a result of our evaluation in fiscal 2016, effective June 1, 2015, Cintas realigned its organizational structure and updated its reportable operating segments in light of certain changes in its business, including the acquisition of ZEE Medical Inc. (ZEE) in the first quarter of fiscal 2016. Cintas’ updated reportable operating segments are Uniform Rental and Facility Services and First Aid and Safety Services. The Uniform Rental and Facility Services reportable operating segment, which includes G&K, consists of the rental and servicing of uniforms and other garments including flame resistant clothing, mats, mops and shop towels and other ancillary items. In addition to these rental items, restroom cleaning services and supplies, carpet and tile cleaning services and the sale of items from our catalogs to our customers on route are included within this reportable operating segment. The First Aid and Safety Services reportable operating segment, which includes ZEE, consists of first aid and safety products and services. The remainder of Cintas’ business, which consists of Fire Protection Services and its Uniform Direct Sale business, is included in All Other. Cintas evaluates operating segment performance based on revenue and income before income taxes. Revenue and income before income taxes for each of these reportable operating segments for the years ended May 31, 2017, 2016 and 2015 are presented in Note 14 entitled Operating Segment Information of "Notes to Consolidated Financial Statements." The Company regularly reviews its operating segments for reporting purposes based on the information its chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance and makes changes when appropriate.
At May 31, 2017, Cintas has classified a significant business, referred to as Discontinued Services, as held for sale. Prior to meeting the held for sale criteria, Discontinued Services was primarily included in All Other. In fiscal 2014, Cintas completed its partnership transaction with the shareholders of Shred-it International Inc. to combine Shredding with the shredding business of Shred-it International Inc. Pursuant to the Shredding Transaction, the Shred-it Partnership was owned 42% by Cintas and 58% by the shareholders of Shred-it International Inc. Cintas' investment in Shred-it and the results of Shredding are classified as discontinued operations for all periods presented as a result of selling the investment during fiscal 2016. During fiscal 2015, Cintas sold Storage and, as a result, its operations are also classified as discontinued operations for all periods presented. In accordance with the applicable accounting guidance for the disposal of long-lived assets and discontinued operations, the results of Discontinued Services, Shredding and Storage have been excluded from both continuing operations and operating segment results for all periods presented. Please see Note 16 entitled Discontinued Operations of "Notes to Consolidated Financial Statements" for additional information.
The following table sets forth certain consolidated statements of income data as a percent of revenue by reportable operating segment, All Other and in total for the fiscal years ended May 31:
| 2017(1) | 2016(1) | 2015(1) | ||||||
| Revenue: | ||||||||
| Uniform Rental and Facility Services | 79.0 | % | 78.4 | % | 80.5 | % | ||
| First Aid and Safety Services | 9.5 | % | 9.6 | % | 7.5 | % | ||
| All Other | 11.5 | % | 12.0 | % | 12.0 | % | ||
| Total revenue | 100.0 | % | 100.0 | % | 100.0 | % | ||
| Cost of sales: | ||||||||
| Uniform Rental and Facility Services | 54.9 | % | 55.7 | % | 56.6 | % | ||
| First Aid and Safety Services | 54.7 | % | 57.3 | % | 53.4 | % | ||
| All Other | 58.3 | % | 58.6 | % | 59.1 | % | ||
| Total cost of sales | 55.3 | % | 56.2 | % | 56.6 | % | ||
| Gross margin: | ||||||||
| Uniform Rental and Facility Services | 45.1 | % | 44.3 | % | 43.4 | % | ||
| First Aid and Safety Services | 45.3 | % | 42.7 | % | 46.6 | % | ||
| All Other | 41.7 | % | 41.4 | % | 40.9 | % | ||
| Total gross margin | 44.7 | % | 43.8 | % | 43.4 | % | ||
| Selling and administrative expenses: | ||||||||
| Uniform Rental and Facility Services | 27.1 | % | 26.5 | % | 26.2 | % | ||
| First Aid and Safety Services | 34.9 | % | 31.9 | % | 32.8 | % | ||
| All Other | 34.5 | % | 33.1 | % | 34.3 | % | ||
| Total selling and administrative expenses | 28.7 | % | 27.8 | % | 27.7 | % | ||
| G&K Services, Inc. transaction and integration expenses | 1.5 | % | — | % | — | % | ||
| Gain on sale of stock of an equity method investment | — | % | — | % | 0.5 | % | ||
| Interest expense, net | 1.6 | % | 1.3 | % | 1.5 | % | ||
| Income from continuing operations before income taxes | 12.9 | % | 14.7 | % | 14.7 | % |
| (1) | The figures presented reflect the change in classification of Discontinued Services, Shredding and Storage to discontinued operations within the Consolidated Statements of Income. See Note 16 entitled Discontinued Operations of "Notes to Consolidated Financial Statements." |
Fiscal 2017 Compared to Fiscal 2016
Fiscal 2017 total revenue was $5.3 billion, an increase of 11.0% over the prior fiscal year. Revenue increased organically by 6.7% as a result of increased sales volume. Organic growth adjusts for the impact of acquisitions, divestitures, workday differences and foreign currency exchange rate fluctuations. Total revenue was positively impacted by 4.8% due to acquisitions, primarily through the acquisition of G&K. Revenue growth was negatively impacted by 0.1% due to foreign currency exchange rate fluctuations and 0.4% due to one less workday in fiscal 2017 compared to fiscal 2016.
Organic growth by quarter is shown in the table below.
| Organic Growth | |
| First Quarter Ending August 31, 2016 | 6.0% |
| Second Quarter Ending November 30, 2016 | 6.0% |
| Third Quarter Ending February 28, 2017 | 6.6% |
| Fourth Quarter Ending May 31, 2017 | 8.1% |
| For the Fiscal Year Ending May 31, 2017 | 6.7% |
Uniform Rental and Facility Services reportable operating segment revenue consists predominantly of revenue derived from the rental of corporate identity uniforms and other garments, including flame resistant clothing, and the rental and/or sale of mats, mops, shop towels, restroom supplies and other rental services. Revenue from the Uniform Rental and Facility Services reportable operating segment increased 11.8% compared to fiscal 2016. The increase resulted from an organic growth increase in revenue of 6.9%. The amount of new business grew, resulting from an increase in the number and productivity of sales representatives. Generally, sales productivity improvements are the result of increased tenure and improved training, which result in a higher number of products and services sold. Revenue growth was negatively impacted by 0.1% due to foreign currency exchange rate fluctuations and 0.4% due to one less workday in fiscal 2017 compared to the same period in the prior fiscal year. Revenue was positively impacted by 5.4% due to acquisitions, primarily G&K.
Other revenue, consisting of revenue from the First Aid and Safety Services reportable operating segment and All Other, increased 8.2% compared to fiscal 2016. Revenue increased organically by 6.1% due primarily to improved sales representative productivity. Revenue growth was negatively impacted by 0.1% due to foreign currency exchange rate fluctuations and 0.4% due to one less workday in fiscal 2017 compared to fiscal 2016. Acquisitions positively impacted revenue by 2.6%.
Cost of uniform rental and facility services increased 10.3% compared to fiscal 2016. Cost of uniform rental and facility services consists primarily of production expenses, delivery expenses and the amortization of in service inventory, including uniforms, mats, shop towels and other ancillary items. The cost of uniform rental and facility services increase compared to fiscal 2016 was due to increased Uniform Rental and Facility Services reportable operating segment sales volume from internal growth and the acquired G&K sales volume.
Cost of other consists primarily of cost of goods sold (predominantly first aid and safety products, uniforms and fire protection products), delivery expenses and distribution expenses in the First Aid and Safety Services reportable operating segment and All Other. Cost of other increased 5.6% in fiscal 2017 compared to fiscal 2016. The increase was primarily related to the increased sales volumes in the First Aid and Safety Services reportable operating segment and All Other.
Selling and administrative expenses increased $195.0 million, or 14.6%, compared to fiscal 2016 due primarily to increases in labor and other employee-partner related expenses. As a result of the acquisition of G&K in fiscal 2017, the Company incurred various transaction and integration expenses which relate primarily to asset impairment charges, legal and professional fees, employee termination expenses, the write-off of excess inventory and other miscellaneous expenses. In fiscal 2017, G&K transaction and integration expenses were $79.2 million or 1.5% of total revenue.
Net interest expense (interest expense less interest income) was $86.3 million in fiscal 2017 compared to $63.6 million in fiscal 2016. The increase in net interest expense is primarily due to the additional debt issued to finance the G&K acquisition and $17.1 million of short-term debt financing fees incurred in connection with the acquisition.
Income before income taxes was $687.4 million, a decrease of $17.9 million, or 2.5%, compared to fiscal 2016. The decrease in income before income taxes was due to the G&K transaction and integration expenses and the increase in interest expense previously mentioned. These impacts were partially offset by the increase in gross margin.
Cintas' effective tax rate on continuing operations was 33.5% for fiscal 2017 compared to 36.4% in fiscal 2016. The decrease was primarily due to the adoption of Accounting Standard Update (ASU) 2016-09, "Improvements to Employee Share-Based Payment Accounting." The effective tax rate in fiscal 2017 included a benefit of $29.4 million as a result of the adoption of ASU 2016-09. This benefit was partially offset by the election to recognize forfeitures as they occur, which resulted in additional stock compensation expense of $8.3 million when compared to our historical practice of estimating forfeiture for expense purposes. The adoption of ASU 2016-09 also resulted in an increase in the effect of dilutive securities in fiscal 2017 of 0.8 million shares. For fiscal 2017, the net impact on diluted earnings per share from the adoption of ASU 2016-09 was an increase of $0.19 per share over what diluted earnings per share would have been if ASU 2016-09 was not adopted in the current year.
Net income from continuing operations for fiscal 2017 of $457.3 million was a 1.9% increase compared to fiscal 2016. Diluted earnings per share from continuing operations of $4.17 was a 3.7% increase compared to fiscal 2016. Diluted earnings per share from continuing operations increased due to the lower effective tax rate combined with the decrease in weighted average common shares outstanding. The decrease in weighted average common shares outstanding resulted from purchasing 8.8 million shares of common stock under the January 13, 2015 and August 4, 2015 share buyback programs since the beginning of fiscal 2016.
Uniform Rental and Facility Services Reportable Operating Segment
Uniform Rental and Facility Services reportable operating segment revenue increased $443.0 million, or 11.8%, and the cost of uniform rental and facility services increased $214.9 million, or 10.3%, as previously discussed. The reportable operating segment's fiscal 2017 gross margin was 45.1% of revenue compared to 44.3% in fiscal 2016. The 80 basis point improvement was driven by many factors, including new business sold by sales representatives, penetration of additional products and services into existing customers and continuously improving the efficiency of internal processes.
Selling and administrative expenses for the Uniform Rental and Facility Services reportable operating segment increased $143.8 million in fiscal 2017 compared to fiscal 2016. Selling and administrative expense as a percent of revenue for fiscal 2017 was 27.1% compared to 26.5% in fiscal 2016. The increase in selling and administrative expenses for the Uniform Rental and Facility Services reportable operating segment is primarily related to the G&K acquisition.
As a result of the G&K acquisition, the Uniform Rental and Facility Services reportable operating segment incurred $79.2 million of transaction and integration expenses. These expenses consisted of the following: asset impairment charges of $23.3 million, legal and professional fees directly related to the acquisition of $17.4 million, employee termination expenses recognized under ASC Topic 712, "Compensation - Nonretirement Postemployment Benefits" of $31.0 million, write-off of excess inventory of $5.5 million and $2.0 million of other miscellaneous integration expenses.
Income before income taxes increased $5.0 million to $677.1 million for fiscal 2017 compared to fiscal 2016. Income before income taxes as a percent of revenue, at 16.1%, decreased 180 basis points from 17.9% in fiscal 2016. The decrease is primarily due to the G&K transaction and integration expenses mentioned above.
First Aid and Safety Services Reportable Operating Segment
First Aid and Safety Services reportable operating segment revenue increased $46.5 million in fiscal 2017, a 10.1% increase compared to fiscal 2016. Revenue increased organically by 5.9% as a result of increased sales volume. Revenue growth was positively impacted by 4.6% due to acquisitions. One less workday in fiscal 2017 compared to the prior year negatively impacted growth by 0.4%.
Cost of first aid and safety services increased $13.3 million, or 5.0%, in fiscal 2017, due primarily to increased First Aid and Safety Services reportable operating segment volume. Gross margin for the First Aid and Safety Services reportable operating segment is defined as revenue less cost of goods, warehouse expenses, service expenses and training expenses. The gross margin as a percent of revenue was 45.3% for fiscal 2017 compared to 42.7% in fiscal 2016. The increase in gross margin was due to the benefits realized as a result of the integration of ZEE. These benefits included improved delivery efficiencies and improved sourcing of goods.
Selling and administrative expenses for the First Aid and Safety Services reportable operating segment increased by $29.9 million, or 20.3%, in fiscal 2017 compared to fiscal 2016. Selling and administrative expenses as a percent of
revenue were 34.9% in fiscal 2017 compared to 31.9% in fiscal 2016. The increase in selling and administrative expenses is primarily the result of the investment in selling resources to grow the acquired ZEE customer base and increases in various employee-partner related expenses.
Income before income taxes was $52.8 million in fiscal 2017, an increase of $3.3 million, or 6.6%, compared to fiscal 2016. Income before income taxes as a percent of revenue, at 10.4%, decreased from 10.7% in fiscal 2016, due primarily to the investment in selling resources mentioned above.
Fiscal 2016 Compared to Fiscal 2015
Fiscal 2016 total revenue was $4.8 billion, an increase of 9.8% over the prior fiscal year. Revenue increased organically by 6.8% as a result of increased sales volume. Organic growth excludes the impact of acquisitions, divestitures, foreign currency exchange rate fluctuations and workday differences. Total revenue was positively impacted by 2.9% due to acquisitions and 0.8% due to two more workdays in fiscal 2016 compared to fiscal 2015. Revenue growth was negatively impacted by 0.7% due to foreign currency exchange rate fluctuations.
Organic growth by quarter is shown in the table below.
| Organic Growth | |
| First Quarter Ending August 31, 2015 | 6.9% |
| Second Quarter Ending November 30, 2015 | 6.6% |
| Third Quarter Ending February 28, 2016 | 7.1% |
| Fourth Quarter Ending May 31, 2016 | 6.8% |
| For the Fiscal Year Ending May 31, 2016 | 6.8% |
Uniform Rental and Facility Services reportable operating segment revenue consists predominantly of revenue derived from the rental of corporate identity uniforms and other garments, including flame resistant clothing, and the rental and/or sale of mats, mops, shop towels, restroom supplies and other rental services. Revenue from the Uniform Rental and Facility Services reportable operating segment increased 6.8% compared to fiscal 2015. The increase resulted from an organic growth increase in revenue of 6.5%. The amount of new business grew, resulting from an increase in the number and productivity of sales representatives. Generally, sales productivity improvements are the result of increased tenure and improved training, which result in a higher number of products and services sold. Revenue was positively impacted by 0.3% due to acquisitions, 0.8% due to two more workdays in fiscal 2016 compared to 2015 and negatively impacted by 0.8% due to foreign currency exchange rate fluctuations.
Other revenue, consisting of revenue from the First Aid and Safety Services reportable operating segment and All Other, increased 21.8% compared to fiscal 2015. The increase primarily resulted from an organic growth increase of 8.3%, which was largely due to improved sales representative productivity. Revenue in fiscal 2016 was negatively impacted by 0.5% due to foreign currency exchange rate fluctuations. Acquisitions positively impacted the growth rate by 13.0%, and two more workdays in fiscal 2016 contributed an additional 1.0%.
Cost of uniform rental and facility services increased 5.0% compared to fiscal 2015. Cost of uniform rental and facility services consists primarily of production expenses, delivery expenses and the amortization of in service inventory, including uniforms, mats, shop towels and other ancillary items. The increase in the cost of uniform rental and facility services compared to fiscal 2015 was due to increased Uniform Rental and Facility Services reportable operating segment sales volume.
Cost of other increased 24.3% compared to fiscal 2015. Cost of other consists primarily of cost of goods sold (predominantly first aid and safety products, uniforms and fire protection products), delivery expenses and distribution expenses in the First Aid and Safety Services reportable operating segment and All Other. The increase from fiscal 2015 was primarily due to increased First Aid and Safety Services reportable operating segment sales volume.
Selling and administrative expenses increased $123.1 million, or 10.2%, compared to fiscal 2015 due primarily to increases in labor and other employee-partner related expenses.
During fiscal 2015, Cintas sold stock in an equity method investment. In conjunction with the sale of the equity method investment, the Company received a cash dividend. The sale resulted in the recording of a gain of $21.7 million in fiscal 2015.
Operating income of $768.9 million in fiscal 2016 increased $85.3 million, or 12.5%, compared to fiscal 2015.
Net interest expense (interest expense less interest income) was $63.6 million in fiscal 2016 compared to $64.8 million in fiscal 2015. The decrease in net interest expense is primarily due to the capitalization of $1.1 million of interest in fiscal year 2016 versus $0.6 million of interest capitalized in fiscal 2015.
Income before income taxes was $705.3 million, an increase of $64.8 million, or 10.1%, compared to fiscal 2015. The increase in income before income taxes was primarily due to revenue growing at a faster rate than expenses.
Cintas' effective tax rate in fiscal 2016 was 36.4%, which was comparable to the effective tax rate of 37.2% in fiscal 2015. See Note 8 entitled Income Taxes of "Notes to Consolidated Financial Statements" for more information on income taxes.
Net income from continuing operations for fiscal 2016 of $448.6 million was a 11.4% increase compared to fiscal 2015. Diluted earnings per share from continuing operations of $4.02 was a 18.6% increase compared to fiscal 2015. The increase in diluted earnings per share is higher than the increase in net income due to a decrease in weighted average common stock outstanding as a result of Cintas purchasing 8.7 million shares of common stock under the January 13, 2015 share buyback program since the beginning of fiscal 2016.
Uniform Rental and Facility Services Reportable Operating Segment
Uniform Rental and Facility Services reportable operating segment revenue increased $240.3 million, or 6.8%, and the cost of uniform rental and facility services increased $100.2 million, or 5.0%. Revenue in fiscal 2016 was negatively affected by 0.8% due to foreign currency exchange rate changes compared to fiscal 2015 and positively affected by 0.3% due to acquisitions and 0.8% due to two more workdays in fiscal 2016 compared to 2015. The reportable operating segment's fiscal 2016 gross margin was 44.3% of revenue compared to 43.4% in fiscal 2015. The increase in gross margin as a percent of revenue over fiscal 2015 was due to new business sold by sales representatives, penetration of additional products and services into existing customers, and continuously improving the efficiency of internal processes. In addition, lower energy-related expenses increased gross margin 50 basis points.
Selling and administrative expenses for the Uniform Rental and Facility Services reportable operating segment increased $72.0 million in fiscal 2016 compared to fiscal 2015 primarily due to increases in labor and other employee-partner related expenses. Selling and administrative expense as a percent of revenue for fiscal 2016 was 26.5% compared to 26.2% in fiscal 2015.
Income before income taxes increased $68.1 million to $672.1 million for fiscal 2016 compared to fiscal 2015. Income before income taxes as a percent of revenue, at 17.9%, increased from 17.2% in fiscal 2015. This increase is primarily due to the increase in gross margin.
First Aid and Safety Services Reportable Operating Segment
First Aid and Safety Services reportable operating segment revenue increased $135.2 million in fiscal 2016, a 41.4% increase compared to fiscal 2015. Revenue increased organically by 9.7% as a result of increased sales volume. Revenue growth was positively impacted by 1.1% due to two more workdays in fiscal 2016 compared to fiscal 2015. The remaining 30.6% increase in growth represents growth derived through acquisitions, primarily the ZEE acquisition.
Cost of first aid and safety services increased $90.5 million, or 51.9%, in fiscal 2016, due primarily to increased First Aid and Safety Services reportable operating segment volume. Gross margin for the First Aid and Safety Services reportable operating segment is defined as revenue less cost of goods, warehouse expenses, service expenses and training expenses. The gross margin as a percent of revenue was 42.7% for fiscal 2016 compared to 46.6% in fiscal 2015. ZEE integration costs and the lower efficiency of the acquired ZEE routes were primarily responsible for the decrease in gross margin.
Selling and administrative expenses increased by $40.3 million, or 37.6%, in fiscal 2016 compared to fiscal 2015 primarily due to an increase in labor and other employee-partner related expenses and costs associated with the integration of ZEE. Selling and administrative expenses as a percent of revenue, at 31.9%, decreased from 32.8% in fiscal 2015.
Income before income taxes was $49.5 million in fiscal 2016, an increase of $4.4 million, or 9.7%, compared to fiscal 2015. Income before income taxes as a percent of revenue, at 10.7%, decreased from 13.8% in fiscal 2015, due to the decrease in gross margin discussed above.
Liquidity and Capital Resources
The following is a summary of our cash flows and cash, cash equivalents and marketable securities as of and for the fiscal years ending May 31:
| (In thousands) | 2017 | 2016 | |||||
| Net cash provided by operating activities | $ | 763,887 | $ | 465,845 | |||
| Net cash (used in) provided by investing activities | $ | (2,310,349 | ) | $ | 128,381 | ||
| Net cash provided by (used in) financing activities | $ | 1,578,502 | $ | (866,724 | ) | ||
| Cash and cash equivalents at the end of the period | $ | 169,266 | $ | 139,357 | |||
| Marketable securities at the end of the period | $ | 22,219 | $ | 70,405 |
Cash, cash equivalents and marketable securities as of May 31, 2017 and 2016 include $125.5 million and $96.5 million, respectively, that is located outside of the United States. We expect to use these amounts to fund our international operations and international expansion activities.
Cash flows provided by operating activities have historically supplied us with a significant source of liquidity. We generally use these cash flows to fund most, if not all, of our operations and dividends on our common stock. We may also use cash flows provided by operating activities, as well as proceeds from long-term debt and short-term borrowings, to fund growth and expansion opportunities, as well as other cash requirements such as the repurchase of our common stock.
Net cash provided by operating activities was $763.9 million for fiscal 2017, which was an increase of $298.0 million compared to fiscal 2016. Net cash provided by operating activities in fiscal 2016 was negatively impacted by the $229.5 million payment of taxes due on the gain on the sale of Shred-it.
Net cash used in investing activities was $2,310.3 million in fiscal 2017, compared to $128.4 million of net cash provided by investing activities in fiscal 2016. Capital expenditures were $273.3 million and $275.4 million for fiscal 2017 and fiscal 2016, respectively. Capital expenditures for fiscal 2017 included $232.8 million for the Uniform Rental and Facility Services reportable operating segment and $26.9 million for the First Aid and Safety Services reportable operating segment. Cash paid for acquisitions of businesses, net of cash acquired was $2,102.4 million and $156.6 million for fiscal 2017 and fiscal 2016, respectively. The acquisitions in both fiscal 2017 and 2016 occurred in our Uniform Rental and Facility Services reportable operating segment, which includes G&K, our First Aid and Safety Services reportable operating segment and our Fire Protection business, which is included in All Other. Net cash provided by investing activities included proceeds related to the sale of Shred-it and Storage of $28.3 million and $616.2 million in fiscal 2017 and 2016, respectively. Net cash used in investing activities for fiscal 2017 also included net proceeds of $37.3 million from purchases and redemptions of marketable securities and investments compared to net purchases of $60.0 million in fiscal 2016.
Net cash provided by financing activities was $1,578.5 million for fiscal 2017, compared to net cash used in financing activities of $866.7 million for fiscal 2016. The increase from fiscal 2017 over fiscal 2016 is primarily due to the net issuance of $1,732.7 million of debt and the decrease in stock buybacks. To finance the G&K acquisition, Cintas issued various forms of debt, totaling $2,091.2 million, net. In addition, on June 1, 2016, Cintas paid the $250.0 million five-year senior notes that matured on that date with cash on hand and proceeds from the issuance of commercial paper.
On August 4, 2015, we announced that the Board of Directors authorized a $500.0 million share buyback program, which does not have an expiration date. During fiscal 2017, we purchased 0.1 million shares at an average price of $94.09 per share for a total purchase price of $3.7 million. This completed the August 4, 2015 program through which Cintas purchased a total of 5.7 million shares of Cintas common stock at an average price of $87.89 for a total purchase price of $500.0 million. During fiscal 2016, we purchased $759.2 million of common stock under previously authorized share buyback programs. On August 2, 2016, we announced that the Board of Directors authorized a new $500.0 million share buyback program, which does not have an expiration date. For the fiscal year ended May 31, 2017, Cintas acquired 0.2 million shares of Cintas common stock in satisfaction of employee payroll taxes due on restricted stock awards that vested during the fiscal year. These shares were acquired at an average price of $101.37 per share for a total purchase price of $17.0 million.
On October 18, 2016, Cintas declared an annual cash dividend of $1.33 per share on outstanding common stock, a
26.7% increase over the annual dividend paid in the prior year. The dividend was paid on December 2, 2016 to shareholders of record as of November 4, 2016. This marked the 34th consecutive year that Cintas has increased its annual dividend, every year since going public in 1983.
On March 21, 2017, the Company completed the acquisition of G&K. To finance the G&K acquisition, Cintas used a combination of new senior notes, a term loan, other borrowings under its existing credit facility and cash on hand.
The following table summarizes Cintas' outstanding debt at May 31:
| (In thousands) | Interest Rate | Fiscal Year Issued | Fiscal Year Maturity | 2017 | 2016 | |||||||||
| Debt due within one year | ||||||||||||||
| Senior notes | 2.85 | % | 2007 | 2017 | $ | — | $ | 250,000 | ||||||
| Senior notes | 6.13 | % | 2008 | 2018 | 300,000 | — | ||||||||
| Commercial paper | 1.24 | % | (1) | Various | Various | 50,500 | — | |||||||
| Current portion of term loan | 2.00 | % | (1) | 2017 | 2018 | 12,500 | — | |||||||
| Debt issuance costs | (100 | ) | — | |||||||||||
| Total debt due within one year | $ | 362,900 | $ | 250,000 | ||||||||||
| Debt due after one year | ||||||||||||||
| Senior notes | 6.13 | % | 2008 | 2018 | $ | — | $ | 300,000 | ||||||
| Senior notes | 4.30 | % | 2012 | 2022 | 250,000 | 250,000 | ||||||||
| Senior notes | 2.90 | % | 2017 | 2022 | 650,000 | — | ||||||||
| Senior notes | 3.25 | % | 2013 | 2023 | 300,000 | 250,000 | ||||||||
| Senior notes (2) | 2.78 | % | 2013 | 2023 | 52,554 | — | ||||||||
| Senior notes (3) | 3.11 | % | 2015 | 2025 | 52,645 | — | ||||||||
| Senior notes | 3.70 | % | 2017 | 2027 | 1,000,000 | — | ||||||||
| Senior notes | 6.15 | % | 2007 | 2037 | 250,000 | 250,000 | ||||||||
| Long-term portion of term loan | 2.00 | % | (1) | 2017 | 2022 | 237,500 | — | |||||||
| Debt issuance costs | (22,075 | ) | (5,578 | ) | ||||||||||
| Total debt due after one year | $ | 2,770,624 | $ | 1,044,422 |
(1) Variable rate debt instrument. The rate presented is the variable borrowing rate at May 31, 2017.
(2) Cintas assumed these senior notes with the acquisition of G&K, and they were recorded at fair value. The interest rate shown above is the effective interest rate. The principal amount of these notes is $50.0 million with a stated interest rate of 3.73%.
(3) Cintas assumed these senior notes with the acquisition of G&K, and they were recorded at fair value. The interest rate shown above is the effective interest rate. The principal amount of these notes is $50.0 million with a stated interest rate of 3.88%.
The credit agreement that supports our commercial paper program was amended on September 16, 2016. The amendment increased the capacity of the revolving credit facility from $450.0 million to $600.0 million and added a $250.0 million term loan facility. The $150.0 million increase in the revolving credit facility took effect upon the consummation of the merger (Merger) contemplated by the Merger Agreement among the Cintas, G&K and Bravo Merger Sub, Inc. (Merger Sub), a wholly-owned subsidiary of Cintas. The term loan was funded upon the consummation of the Merger. The credit agreement has an accordion feature that provides Cintas the ability to request increases to the borrowing commitments under either the revolving credit facility or the term loan of up to $250.0 million in the aggregate, subject to customary conditions. The maturity date of the agreement is September 15, 2021. As of May 31, 2017, there was $50.5 million of commercial paper outstanding with a weighted average interest rate of 1.24% and maturity dates less than 30 days and no borrowings on our revolving credit facility. No commercial paper or borrowings on our revolving credit facility were outstanding at May 31, 2016.
Cintas has certain covenants related to debt agreements. These covenants limit Cintas' ability to incur certain liens, to engage in sale-leaseback transactions and to merge, consolidate or sell all or substantially all of Cintas' assets. These covenants also require Cintas to maintain certain debt to consolidated earnings before interest, taxes, depreciation and amortization (EBITDA) and interest coverage ratios. Cross-default provisions exist between certain debt instruments. If a default of a significant covenant were to occur, the default could result in an acceleration of the
maturity of the indebtedness, impair liquidity and limit the ability to raise future capital. Cintas was in compliance with all of the debt covenants for all periods presented.
Our access to the commercial paper and long-term debt markets has historically provided us with sources of liquidity. We do not anticipate having difficulty in obtaining financing from those markets in the future in view of our favorable experiences in the debt markets in the recent past. Our ability to continue to access the commercial paper and long-term debt markets on favorable interest rate and other terms will depend, to a significant degree, on the ratings assigned by the credit rating agencies to our indebtedness. As of May 31, 2017, our ratings were as follows:
| Rating Agency | Outlook | Commercial Paper | Long-term Debt | |||
| Standard & Poor’s | Stable | A-2 | BBB+ | |||
| Moody’s Investors Service | Stable | P-2 | A3 |
In the event that the ratings of our commercial paper or our outstanding long-term debt issues were substantially lowered or withdrawn for any reason, or if the ratings assigned to any new issue of long-term debt securities were significantly lower than those noted above, particularly if we no longer had investment grade ratings, our ability to access the debt markets may be adversely affected. In addition, in such a case, our cost of funds for new issues of commercial paper and long-term debt would be higher than our cost of funds would have been had the ratings of those new issues been at or above the level of the ratings noted above. The rating agency ratings are not recommendations to buy, sell or hold our commercial paper or debt securities. Each rating may be subject to revision or withdrawal at any time by the assigning rating organization and should be evaluated independently of any other rating. Moreover, each credit rating is specific to the security to which it applies.
To monitor our credit rating and our capacity for long-term financing, we consider various qualitative and quantitative factors. One such factor is the ratio of our total debt to EBITDA. For the purpose of this calculation, debt is defined as the sum of short-term borrowings, long-term debt due within one year, obligations under capital leases due in one year, long-term debt and long-term obligations under capital leases.
Contractual Obligations
| Payments Due by Period | |||||||||||||||||||
| (In thousands) | Total | One year or less | Two to three years | Four to five years | After five years | ||||||||||||||
| Debt (1) | $ | 3,155,699 | $ | 363,000 | $ | 25,000 | $ | 1,112,500 | $ | 1,655,199 | |||||||||
| Operating leases (2) | 176,004 | 43,775 | 64,417 | 39,295 | 28,517 | ||||||||||||||
| Interest payments (3) | 936,383 | 119,547 | 199,498 | 196,841 | 420,497 | ||||||||||||||
| Unconditional purchase obligations | — | — | — | — | — | ||||||||||||||
| Total contractual cash obligations | $ | 4,268,086 | $ | 526,322 | $ | 288,915 | $ | 1,348,636 | $ | 2,104,213 |
Cintas also makes payments to defined contribution plans. The amount of contributions made to the defined contribution plans are at the discretion of the Board of Directors of Cintas. Future contributions are expected to be $51.7 million in the next year, $111.2 million in the next two to three years, and $122.6 million in the next four to five years. Cintas may make payments to defined benefit plans to satisfy minimum funding requirements. Currently, Cintas does not expect to make any such payments during the next five years.
| (1) | See Note 6 entitled Debt and Derivatives of "Notes to Consolidated Financial Statements" for a detailed presentation of Cintas' debt. |
| (2) | Operating leases consist primarily of operational facility leases. |
| (3) | Interest payments include interest on both fixed and variable rate debt. As of May 31, 2017, Cintas had approximately $300.5 million of variable rate debt outstanding, which consisted of $50.5 million of commercial paper and a $250.0 million term loan. The interest payments for variable rate debt were estimated using forecasted rates in future years. |
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) | $ | 549,399 | $ | — | $ | 549,399 | $ | — | $ | — | |||||||||
| Standby letters of credit and surety bonds (2) | 110,893 | 110,893 | — | — | — | ||||||||||||||
| Total other commitments | $ | 660,292 | $ | 110,893 | $ | 549,399 | $ | — | $ | — |
| (1) | Back-up facility for the commercial paper program (reference Note 6 entitled Debt and Derivatives of "Notes to Consolidated Financial Statements" for further discussion). |
| (2) | These standby letters of credit support certain outstanding debt (reference Note 6 entitled Debt and Derivatives of "Notes to Consolidated Financial Statements"), self-insured workers' compensation and general liability insurance programs. |
Inflation and Changing Prices
Changes in wages, benefits and energy costs have the potential to materially impact Cintas' consolidated financial results. Management believes inflation has not had a material impact on Cintas' consolidated financial condition or a negative impact on consolidated results of operations.
Litigation and Other Contingencies
Cintas is subject to legal proceedings, insurance receipts, legal settlements 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 consolidated financial position, consolidated results of operations or consolidated cash flows of Cintas.
New Accounting Standards
In April 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2014-08, “Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity,” which amended accounting guidance related to the reporting of discontinued operations and disclosures of disposals of components of an entity. The amended guidance changes the thresholds for disposals to qualify as discontinued operations and requires additional disclosures. This guidance is effective for reporting periods beginning after December 15, 2014 and is required to be applied prospectively. Cintas adopted ASU 2014-08 during the quarter ended August 31, 2015 and applied the amended accounting guidance to Shred-it and will apply it to future transactions, as appropriate.
In May 2014, the FASB issued ASU 2014-09, "Revenue from Contracts with Customers (Topic 606)," to clarify revenue recognition principles. This guidance is intended to improve disclosure requirements and enhance the comparability of revenue recognition practices. Improved disclosures under the amended guidance relate to the nature, amount, timing and uncertainty of revenue that is recognized from contracts with customers. This guidance will be effective for reporting periods beginning after December 15, 2017 and will be required to be applied retrospectively. Early application of the amendments in this update is not permitted. A cross-functional implementation team has been established consisting of representatives from all of our operating segments. The implementation team is working to analyze the impact of the standard on the Cintas' contract portfolio by reviewing current accounting policies and practices to identify potential differences that would result from applying the requirements of the new standard to revenue contracts. In addition, we are in the process of identifying and implementing the appropriate changes to business processes and controls to support recognition and disclosure under the new standard. Cintas plans to adopt the standard as of the first quarter of fiscal year 2019 using the modified retrospective approach and will record a cumulative adjustment to equity for open contracts as of June 1, 2018. Cintas is continuing to evaluate the impact of ASU 2014-09 and an estimate of the impact to the consolidated financial statements cannot be made at this time.
In April 2015, the FASB issued ASU 2015-17, “Balance Sheet Classifications of Deferred Taxes,” which amended accounting guidance related to the presentation of deferred tax liabilities and assets. The amended guidance requires that all deferred tax liabilities and assets be classified as noncurrent on the balance sheet. This guidance is effective for reporting periods beginning after December 15, 2016; however, early adoption is permitted. This guidance can also be applied either prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. Cintas adopted ASU 2015-17 during the quarter ended November 30, 2015 and has applied this amended accounting guidance to its deferred tax liabilities and assets for all periods presented.
In April 2015, the FASB issued ASU 2015-03, "Interest - Imputation of Interest (Subtopic 835-30), Simplifying the Presentation of Debt Issuance Costs." ASU 2015-03 requires that debt issuance costs related to a recognized debt liability be presented in the consolidated condensed balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This guidance is effective for annual and interim periods beginning after December 15, 2015. The guidance is applied retrospectively and early adoption is permitted. Cintas adopted ASU 2015-03 during the quarter ended August 31, 2016 and has applied this amended accounting guidance to its long-term debt and other assets for all periods presented. The impact of this change in accounting principle on balances previously reported as of May 31, 2016 was a reclassification of $5.6 million from other assets to debt due after one year within long-term liabilities.
In September 2015, the FASB issued ASU 2015-16, “Business Combinations (Topic 805), Simplifying the Accounting for Measurement-Period Adjustments.” This amendment eliminates the requirement to retrospectively account for adjustments made to provisional amounts recognized in a business combination. This amendment became effective for Cintas beginning June 1, 2016, and was adopted prospectively in accordance with the standard. The adoption of this amendment did not have an effect on our consolidated financial statements for the fiscal year ended May 31, 2017.
In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842),” which sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract (i.e. lessees and lessors). The new standard requires lessees to apply a dual approach, classifying leases as either finance or operating leases based on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight line basis over the term of the lease, respectively. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases today. Topic 842 supersedes the previous leases standard, ASC 840, Leases. This guidance is effective for reporting periods beginning after December 15, 2018; however, early adoption is permitted. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. Cintas is currently evaluating the impact that ASU 2016-02 will have on its consolidated financial statements.
In March 2016, the FASB issued ASU 2016-09, "Improvements to Employee Share-Based Payment Accounting." ASU 2016-09 is intended to simplify accounting for share-based payments. Upon adoption, ASU 2016-09 requires that excess tax benefits for share-based payments be recorded as a reduction of income tax expense and reflected within operating cash flows rather than being recorded within equity and reflected within financing cash flows. The standard also permits the repurchase of more of an employee’s shares for tax withholding purposes without triggering liability accounting, clarifies that all cash payments made on an employee’s behalf for withheld shares should be presented as a financing activity on our cash flows statement, and provides an accounting policy election to account for forfeitures as they occur. This update is effective for interim and annual periods beginning after December 15, 2016; however, early adoption is permitted. Cintas adopted ASU 2016-09 during the quarter ended August 31, 2016 and elected to make an accounting policy change to recognize forfeitures as they occur. The adoption impact on the consolidated balance sheet was a cumulative-effect adjustment of $26.7 million, increasing opening retained earnings and decreasing paid-in capital.
In March 2017, the FASB issued ASU 2017-07, “Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Costs.” ASU 2017-07 continues to require the service component of pension and other postretirement benefit costs to be presented in the same line item as other employee compensation costs on the consolidated statement of income and changes the presentation of other components of net benefit cost so that these items will be presented outside of operating income within the consolidated statements of income. Cintas plans to adopt ASU 2017-07 in fiscal 2018 and apply it prospectively. Cintas does not expect the adoption of ASU 2017-07 to have a material impact on its consolidated financial statements.
No other new accounting pronouncement recently issued or newly effective had or is expected to have a material impact on the consolidated financial statements.
Critical Accounting Policies and Estimates
The preparation of Cintas' consolidated financial statements in conformity with U. S. GAAP 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 Uniform Rental and Facility Services reportable operating segment, is recognized when services are performed. Other revenue, which is recorded in the First Aid and Safety Services reportable operating segments and All Other, is recognized when either services are performed or when products are shipped and the title and risks of ownership pass to the customer.
Inventories
Inventories are valued at the lower of cost (first-in, first-out) or market. Cintas applies a commonly accepted practice of using inventory turns to apply variances between actual and 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 the Company's 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 clothing) are amortized over their useful life of 18 months. Uniforms acquired in the G&K acquisition will be amortized over 12 months. Other rental items, including shop towels, mats, mops, cleanroom garments, flame resistant clothing, linens and restroom dispensers, are amortized over their useful lives, which range from 8 to 60 months. The amortization rates used are based on industry experience, Cintas' specific experience and wear tests performed by Cintas. These factors are critical to determining the amount of in service inventory and related cost of uniforms and ancillary products that are 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 based on industry and Cintas specific experience, 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 15 years for leasehold improvements. When events or circumstances indicate that the carrying amount of long-lived assets may not be recoverable, the estimated undiscounted future cash flows are compared to the carrying amount of the assets. If the estimated undiscounted future cash flows are less than the carrying amount of the assets, an impairment loss is recorded based on the excess of the carrying amount of the assets over their respective fair values. Fair value is generally determined by discounted cash flows or based on prices of similar assets, as appropriate. As a result of the identification of certain G&K plants and branches for future closure, an indicator of potential impairment was identified. Cintas recognized an impairment loss of $23.3 million during the year ended May 31, 2017, based on the excess of the carrying amount of asset over their respective fair values. The undiscounted cash flows were estimated, using Level 2 inputs based on both the cost and market approaches, at the lowest discernible level, which is at the location level. Cintas did not identify any indicators of impairment for the years ended May 31, 2016 and 2015.
Goodwill
Goodwill, obtained through acquisitions of businesses, is valued at cost less any impairment. Cintas completes an annual impairment test, which may include an assessment of qualitative factors including, but not limited to, macroeconomic conditions, industry and market conditions, and entity specific factors such as strategies and financial performance. The test may also include the determination of the estimated fair value of Cintas' reporting units via comparisons to current market values, where available, and discounted cash flow analyses. Significant assumptions may include growth rates based on historical trends and margin improvement leveraged from such growth, as well as discount rates. We determine discount rates separately for each reporting unit using the weighted average cost of capital, which includes a calculation of cost of equity, which is developed using the capital asset pricing model and comparable company betas (a measure of systemic risk), and cost of debt. We also use comparable market earnings
multiple data and our market capitalization to corroborate our reporting unit valuations. We test for goodwill impairment at the reporting unit level. As a result of Cintas’ operating segment realignment in fiscal 2016 and the acquisition of G&K in fiscal 2017, the composition of Cintas’ reporting units for the evaluation of goodwill impairment has changed. Cintas has identified six reporting units for purposes of evaluating goodwill impairment: Uniform Rental and Facility Services, G&K Services Uniform Rental and Facility Services, First Aid and Safety Services, and three reporting units within All Other. Given the proximity of the G&K acquisition date to the consolidated balance sheet date, the Company performed a high level qualitative analysis for its G&K reporting unit, which considered indicators of impairment to evaluate whether the fair value was more-likely-than-not in excess of its carrying value. The key indicators considered include macroeconomic conditions, industry/market considerations, financial performance, cash flow, changes in management, and composition of net assets. Based on the results of the annual impairment tests, Cintas was not required to recognize an impairment of goodwill for the fiscal years ended May 31, 2017, 2016 or 2015. Cintas will continue to perform impairment tests as of March 1 in future years and when indicators of impairment exist.
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. The G&K service contract asset will be amortized over a period of 15 years, which represents the estimated life of the economic benefit and the asset amortization is based on the annual economic value of the underlying asset which generally decreases over the 15-year term. 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 accomplished through specific identification. No impairment has been recognized by Cintas for the fiscal years ended May 31, 2017, 2016 or 2015.
Business Combinations
Accounting for acquisitions requires us to recognize separately from goodwill the assets acquired and the liabilities assumed at their acquisition date fair values. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of the assets acquired and the liabilities assumed. While we use our best estimates and assumptions to accurately value assets acquired and liabilities assumed at the acquisition date as well as contingent consideration, where applicable, our estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, we record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period or final determination of the values of assets acquired or liabilities assumed, whichever comes first, any subsequent adjustments are recorded to our consolidated statements of income. See Note 9 entitled Acquisitions and Divestitures of the "Notes to Consolidated Financial Statements" for a discussion of the G&K and ZEE Acquisitions.
General insurance liabilities
General insurance liabilities represent the estimated ultimate cost of all asserted and unasserted claims incurred, primarily related to worker's compensation, auto liability and other general liability exposure through the consolidated balance sheet dates. Our reserves are estimated through actuarial procedures of the insurance industry and by using industry assumptions, adjusted for specific expectations based on our claims history. Cintas records an increase or decrease in selling and administrative expenses related to development of prior claims, higher claims activity and other environmental factors in the period in which it becomes known. These changes in estimates may be material to the consolidated financial statements.
Stock-based compensation
Compensation expense is recognized for all share-based payments to employees, including stock options and restricted stock awards, 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 12 entitled Stock-Based Compensation of "Notes to Consolidated Financial Statements" for further information.
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. U.S. GAAP requires 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.
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. See Note 8 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. 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. Although realization is not assured, management believes it is more likely than not that the recorded deferred tax assets, as adjusted for valuation allowances, will be realized.
Accounting for uncertain tax positions requires the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the consolidated financial statements. Companies may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement.
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 tax related accruals are appropriate.
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