UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ____________ Commission file number 1-4422 ROLLINS, INC. (Exact name of registrant as specified in its charter) Delaware 51-0068479 (State or other jurisdiction of incorporation (I.R.S. Employer or organization) Identification No.) 2170 Piedmont Road, N.E., Atlanta, Georgia (Address of principal executive offices) 30324 (Zip Code) (404) 888-2000 (Registrant's telephone number, including area code) -------------------------------- Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Exchange Act). Yes [X] No [ ] Rollins, Inc. had 45,651,470 shares of its $1 Par Value Common Stock outstanding as of July 15, 2004.
ROLLINS, INC. AND SUBSIDIARIES INDEX PART I FINANCIAL INFORMATION Page No. -------------- Item 1. Financial Statements. Consolidated Statements of Financial Position as of June 30, 2004 and December 31, 2003 2 Consolidated Statements of Income for the Three and Six Months Ended June 30, 2004 and 2003 3 Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2004 and 2003 4 Notes to Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk. 17 Item 4. Controls and Procedures. 17 PART II OTHER INFORMATION Item 1. Legal Proceedings. 18 Item 4. Submission of Matters to a Vote of Security Holders. 18 Item 6. Exhibits and Reports on Form 8-K. 18 SIGNATURES 20
PART I FINANCIAL INFORMATION Item 1. Financial Statements.
ROLLINS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (In thousands except share and per share data) June 30, December 31, 2004 2003 -------------------- ------------------ (Unaudited) ASSETS Cash and Short-Term Investments $ 21,865 $ 59,540 Marketable Securities 0 21,866 Trade Receivables, Net of Allowance for Doubtful Accounts of $5,300 and $4,616, respectively 62,765 48,471 Materials and Supplies 12,157 9,837 Deferred Income Taxes 21,633 23,243 Other Current Assets 10,441 7,414 -------------------- ------------------ Current Assets 128,861 170,371 Equipment and Property, Net 45,313 35,836 Goodwill 113,853 72,498 Customer Contracts and Other Intangible Assets 82,166 30,333 Deferred Income Taxes 8,860 15,902 Other Assets 30,908 24,964 -------------------- ------------------ Total Assets $ 409,961 $ 349,904 ==================== ================== LIABILITIES Accounts Payable $ 14,756 $ 12,290 Accrued Insurance 13,050 13,050 Accrued Payroll 33,313 31,019 Unearned Revenue 58,511 46,007 Accrual for Termite Contracts 21,704 21,500 Other Current Liabilities 30,306 21,156 -------------------- ------------------ Current Liabilities 171,640 145,022 Accrued Insurance, Less Current Portion 26,641 26,024 Accrual for Termite Contracts, Less Current Portion 23,621 22,373 Long-Term Accrued Liabilities 18,482 17,711 -------------------- ------------------ Total Liabilities 240,384 211,130 -------------------- ------------------ Commitments and Contingencies STOCKHOLDERS' EQUITY Common Stock, par value $1 per share; 99,500,000 shares authorized; 45,638,134 and 45,156,674 shares issued and outstanding, respectively 45,638 45,157 Additional Paid-In Capital 7,491 4,408 Accumulated Other Comprehensive Loss (414) (314) Unearned Compensation (3,792) (239) Retained Earnings 120,654 89,762 -------------------- ------------------ Total Stockholders' Equity 169,577 138,774 -------------------- ------------------ Total Liabilities and Stockholders' $ $ 349,904 Equity 409,961 ==================== ================== The accompanying notes are an integral part of these consolidated financial statements.
2 ROLLINS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands except per share data) (Unaudited)
Three Months Ended Six Months Ended June 30, June 30, ---------------------------------- ------------------------------------ 2004 2003 2004 2003 ---------------- ---------------- ---------------- ----------------- REVENUES Customer Services $ 207,698 $ 185,105 $ 366,390 $ 340,227 ---------------- ---------------- ---------------- ----------------- COSTS AND EXPENSES Cost of Services Provided 105,442 95,558 190,799 179,484 Depreciation and Amortization 5,764 5,037 10,421 10,193 Sales, General & Administrative 69,155 62,312 123,330 116,688 Gain on Sale of Assets (14,143) (67) (14,142) (69) Interest Income (47) (94) (197) (160) ---------------- ---------------- ---------------- ----------------- 166,171 162,746 310,211 306,136 ---------------- ---------------- ---------------- ----------------- INCOME BEFORE INCOME TAXES 41,527 22,359 56,179 34,091 ---------------- ---------------- ---------------- ----------------- PROVISION FOR INCOME TAXES Current 10,250 7,290 14,911 10,753 Deferred 7,467 1,207 8,740 2,202 ---------------- ---------------- ---------------- ----------------- 17,717 8,497 23,651 12,955 ---------------- ---------------- ---------------- ----------------- NET INCOME $ 23,810 $ 13,862 $ 32,528 $ 21,136 ================ ================ ================ ================= EARNINGS PER SHARE - BASIC $ 0.52 $ 0.31 $ 0.72 $ 0.47 ================ ================ ================ ================= EARNINGS PER SHARE - DILUTED $ 0.51 $ 0.30 $ 0.70 $ 0.46 ================ ================ ================ ================= Average Shares Outstanding---Basic 45,552 45,117 45,425 45,015 Average Shares Outstanding---Diluted 46,753 46,404 46,698 46,258 DIVIDENDS PER SHARE $ 0.06 $ 0.05 $ 0.12 $ 0.10 ================ ================ ================ ================= The accompanying notes are an integral part of these consolidated financial statements.
3 ROLLINS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
Six Months Ended June 30, ---------------------------------------- 2004 2003 ------------------ ----------------- OPERATING ACTIVITIES Net Income $ 32,528 $ 21,136 Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities: Depreciation and Amortization 10,421 10,193 Deferred Income Taxes 8,740 2,364 Other, Net 202 163 Gain on Sale of Assets (14,142) 0 (Increase) Decrease in Assets, Net of Businesses Acquired: Trade Receivables (7,390) (6,517) Materials and Supplies (655) (358) Other Current Assets (2,578) (1,566) Other Non-Current Assets (2,235) (60) Increase (Decrease) in Liabilities, Net of Businesses Acquired: Accounts Payable and Accrued Expenses 10,172 11,874 Unearned Revenue 5,668 1,799 Accrued Insurance (1,643) 177 Accrual for Termite Contracts 1,076 (466) Long-Term Accrued Liabilities (4,393) (5,864) ------------------ ----------------- Net Cash Provided by Operating Activities 35,771 32,875 ------------------ ----------------- INVESTING ACTIVITIES Sale of Marketable Securities, Net 21,866 0 Purchases of Equipment and Property (3,751) (2,332) Acquisitions (103,155) (1,508) Proceeds From Sale of Assets, Net of Deferred Gain 15,468 0 ------------------ ----------------- Net Cash Used in Investing Activities (69,572) (3,840) ------------------ ----------------- FINANCING ACTIVITIES Dividends Paid (5,451) (4,500) Other 1,577 2,015 ------------------ ----------------- Net Cash Used in Financing Activities (3,874) (2,485) ------------------ ----------------- Net (Decrease) Increase in Cash and Short-Term Investments (37,675) 26,550 Cash and Short-Term Investments At Beginning of Period 59,540 38,315 ------------------ ----------------- Cash and Short-Term Investments At End of Period $ 21,865 $ 64,865 ================== ================= The accompanying notes are an integral part of these consolidated financial statements.
4 ROLLINS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1. BASIS OF PREPARATION AND OTHER Basis of Preparation - The consolidated financial statements included herein have been prepared by Rollins, Inc. (the "Company"), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission applicable to quarterly reporting on Form 10-Q. These consolidated financial statements have been prepared in accordance with Statement of Financial Accounting Standard No. 94, Consolidation of All Majority-Owned Subsidiaries ("SFAS 94") and Rule 3A-02(a) of Regulation S-X. In accordance with SFAS 94 and with Rule 3A-02(a) of Regulation S-X, the Company's policy is to consolidate all subsidiaries and investees where it has voting control. The Company does not have any subsidiaries or investees where it has less than a 100% equity interest or less than 100% voting control, nor does it have any interest in other investees, joint ventures, or other entities that require consolidation. Footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted as permitted by such rules and regulations. These consolidated financial statements should be read in conjunction with the financial statements and related notes contained in the Company's annual report on Form 10-K for the year ended December 31, 2003. In the opinion of management, the consolidated financial statements included herein contain all adjustments, consisting of a normal recurring nature, necessary to present fairly the financial position of the Company as of June 30, 2004 and December 31, 2003, and the results of its operations and cash flows for the three and six months ended June 30, 2004 and 2003. Operating results for the three and six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. The Company has only one reportable segment, its pest and termite control business. The Company's results of operations and its financial condition are not reliant upon any single customer or a few customers or the Company's foreign operations. Estimates Used in the Preparation of Consolidated Financial Statements - The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires Management to make estimates and assumptions that affect the amounts reported in the accompanying notes and financial statements. Actual results could differ from those estimates. Cash and Short-Term Investments - The Company considers all investments with a maturity of three months or less to be cash equivalents. Short-term investments, all of which are cash equivalents, are stated at cost, which approximates fair market value. Marketable Securities - From time to time, the Company maintains investments held by several large, well-capitalized financial institutions. The Company's investment policy does not allow investment in any securities rated less than "investment grade" by national rating services. Management determines the appropriate classification of debt securities at the time of purchase and re-evaluates such designations as of each balance sheet date. Debt securities are classified as available-for-sale because the Company does not have the intent to hold the securities to maturity. Available-for-sale securities are stated at their fair values, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders' equity. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest income. In the first quarter of 2004, the Company sold the balance of its marketable securities, the proceeds of which were used to pay the primary portion of the Western Industries, Inc. acquisition completed in the second quarter of 2004. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in interest income. The Company's marketable securities generally consist of United States government, corporate and municipal debt securities. Comprehensive Income (Loss) - Other Comprehensive Income (Loss) results from foreign currency translations and unrealized gain/losses on marketable securities. New Accounting Standards - In December 2002, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"). The Interpretation requires that a variable interest entity be consolidated 5 by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation requirements of FIN 46 were effective in 2003 for all variable interest entities created or acquired after January 31, 2003. In December 2003, the Financial Accounting Standards Board issued a revision to FIN 46 referred to as Interpretation No. 46 (R). Among other provisions, the revision extended the adoption date of FIN 46 (R) to the first quarter of 2004 for variable interest entities created prior to February 1, 2003. The Company adopted FIN 46 (R) in the first quarter of 2004 for variable interest entities created prior to February 1, 2003. The adoption did not have a significant effect on the Company's financial position or results of operations. Franchising Program - Orkin had 46 franchises as of June 30, 2004, including international franchises in Mexico, established in 2000, and Panama, established in 2003. Transactions with franchises involve sales of customer contracts to establish new franchises, initial franchise fees and royalties. The customer contracts and initial franchise fees are typically sold for a combination of cash and notes due over periods ranging up to 5 years. As of June 30, 2004 and December 31, 2003, notes receivable from franchises aggregated $4.7 million and $3.9 million, respectively. The Company recognizes gains from the sale of customer contracts at the time they are sold to franchises and collection on the notes is reasonably assured. The gain amounted to approximately $41,000 in the second quarter of 2004 compared to $481,000 in second quarter of 2003, and is included as revenues in the accompanying Consolidated Statements of Income. The Company has recognized gains from the sale of customer contracts of approximately $0.9 million for the six months ended June 30, 2004, as compared to approximately $2.1 million for the six months ended June 30, 2003. Initial franchise fees are deferred for the duration of the initial contract period and are included as unearned revenue in the Consolidated Statements of Financial Position. Deferred franchise fees amounted to $1.5 million and $1.4 million at June 30, 2004 and December 31, 2003, respectively. Royalties from franchises are accrued and recognized as revenues as earned on a monthly basis. Revenues from royalties were $464,000 in the second quarter of 2004 compared to $419,000 in the second quarter of 2003 and were $811,000 and $656,000 for the six months ended June 30, 2004 and 2003, respectively. The Company's maximum exposure to loss relating to the franchises aggregated $3.2 million and $2.5 million at June 30, 2004 and December 31, 2003, respectively. Fair Value of Financial Instruments - The Company's financial instruments consist of cash, short-term investments, marketable securities, trade and notes receivables, accounts payable and other short-term liabilities. The carrying amounts of these financial instruments approximate their fair values. Seasonality - The revenues of the Company are affected by the seasonal nature of the Company's pest and termite control services as evidenced by the following chart. Total Net Revenues ------------------------------------------ 2004 2003 2002 - ------------------------------------------------------------------------------ First Quarter $158,692 $155,122 $153,302 Second Quarter 207,698 185,105 184,189 Third Quarter N/A 178,262 174,063 Fourth Quarter N/A 158,524 153,871 - ------------------------------------------------------------------------------ NOTE 2. EARNINGS PER SHARE In accordance with SFAS No. 128, Earnings Per Share ("EPS"), the Company presents basic EPS and diluted EPS. Basic EPS is computed on the basis of weighted-average shares outstanding. Diluted EPS is computed on the basis of weighted-average shares outstanding plus common stock options outstanding during the year which, if exercised, would have a dilutive effect on EPS. A reconciliation of the number of weighted-average shares used in computing basic and diluted EPS is as follows: 6
Three Months Ended Six Months Ended --------------------------- -------------------------- June 30, June 30, --------------------------- -------------------------- (In thousands except per share data amounts) 2004 2003 2004 2003 - -------------------------------------------------------------------------------------------------- -------------------------- Basic and diluted earnings available to stockholders (numerator): $23,810 $13,862 $32,528 $21,136 Shares (denominator): Weighted-average shares outstanding 45,552 45,117 45,425 45,015 Effect of Dilutive securities: Employee Stock Options 1,201 1,287 1,273 1,243 --------------------------- -------------------------- Adjusted Weighted-Average Shares and Assumed Exercises 46,753 46,404 46,698 46,258 Per share amounts: Basic earnings per common share $0.52 $0.31 $0.72 $0.47 Diluted earnings per common share $0.51 $0.30 $0.70 $0.46 - -------------------------------------------------------------------------------------------------- --------------------------
NOTE 3. LEGAL PROCEEDINGS Orkin, one of the Company's subsidiaries, is a named defendant in Helen Cutler and Mary Lewin v. Orkin Exterminating Company, Inc. et al. pending in the District Court of Houston County, Alabama. The plaintiffs in the above mentioned case filed suit in March of 1996 and are seeking monetary damages and injunctive relief for alleged breach of contract arising out of alleged missed or inadequate reinspections. The attorneys for the plaintiffs contend that the case is suitable for a class action and the court has ruled that the plaintiffs would be permitted to pursue a class action lawsuit against Orkin. Orkin believes this case to be without merit and intends to defend itself vigorously at trial. The trial has been continued and a new date has not been set. At this time, the final outcome of the litigation cannot be determined. However, in the opinion of Management, the ultimate resolution of this action will not have a material adverse effect on the Company's financial position, results of operations or liquidity. Orkin is also a named defendant in Butland et al. v. Orkin Exterminating Company, Inc. et al. pending in the Circuit Court of Hillsborough County, Tampa, Florida. The plaintiffs filed suit in March of 1999 and are seeking monetary damages and injunctive relief. The Court ruled in early April 2002, certifying the class action lawsuit against Orkin. Orkin appealed this ruling to the Florida Second District Court of Appeals which remanded the case back to the trial court for further findings. Orkin believes this case to be without merit and intends to defend itself vigorously through trial, if necessary. At this time, the final outcome of the litigation cannot be determined. However, in the opinion of Management, the ultimate resolution of this action will not have a material adverse effect on the Company's financial position, results of operations or liquidity. Orkin is involved in certain environmental matters primarily arising in the normal course of business. In the opinion of Management, the Company's liability under any of these matters would not materially affect its financial condition or results of operations. Orkin has received from the Office of the Florida Attorney General a subpoena for documents relating to the company's termite work in the state of Florida. Orkin is cooperating fully with the Office of the Attorney General. Additionally, in the normal course of business, Orkin is a defendant in a number of lawsuits, which allege that plaintiffs have been damaged as a result of the rendering of services by Orkin personnel and equipment. Orkin is actively contesting these actions. Certain of these lawsuits have been filed (Ernest W. Warren and Dolores G. Warren et al. v. Orkin Exterminating Company, Inc., et al.; Francis D. Petsch, et al. v. Orkin Exterminating Company, Inc. et al.; and Bob J. Stevens v. Orkin Exterminating Company, Inc. and Rollins, Inc.) in which the Plaintiffs are seeking certification of a class. The cases originate in Georgia, Florida, and Texas. Furthermore, the Company has been named a defendant in Larry Hanna, et. al. v. Rollins, Inc. dba Rollins Service Bureau pending in the District Court for the Northern District of Indiana (Hammond Division) in which the Plaintiffs are seeking certification of a class. The Company does not believe that any of these actions, individually, is material to the Company. The action alleges violation of the Fair Debt Collection Practices Act. The Company believes all of these cases to be without merit and intends to vigorously contest certification and defend itself through trial, if necessary. In the opinion of Management, the outcome of these actions will not have a material adverse effect on the Company's financial position, results of operations or liquidity. 7 NOTE 4. STOCKHOLDERS' EQUITY During the second quarter and six months ended June 30, 2004, approximately 125,000 and 374,000 shares of common stock were issued upon exercise of stock options by employees. As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, the Company accounts for employee stock compensation plans using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. No stock-based employee compensation cost is reflected in net income, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
Three Months Ended Six Months Ended June 30, June 30, --------------------------------------------------- (In thousands, except per share data) 2004 2003 2004 2003 --------------------------------------------------- Net income, as reported $23,810 $13,862 $32,528 $21,136 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (202) (483) (404) (966) -------------------------- ------------------------ Pro forma net income $23,608 $13,379 $32,124 $20,170 -------------------------- ------------------------ Earnings per share: Basic-as reported $0.52 $0.31 $0.72 $0.47 Basic-pro forma $0.52 $0.30 $0.71 $0.45 Diluted-as reported $0.51 $0.30 $0.70 $0.46 Diluted-pro forma $0.50 $0.29 $0.69 $0.44
NOTE 5. ACCUMULATED OTHER COMPREHENSIVE LOSS Accumulated other comprehensive loss consists of the following (in thousands):
Unrealized Minimum Foreign Loss on Pension Currency Marketable Liability Transaltion Securities Total - ---------------------------------------------------------------------------------------------------------------- Balance at January 1, 2003 $ (16,182) $ (765) $ 0 $ (16,947) Change during 2003: Before-tax amount.. 26,079 842 (108) 26,813 Tax benefit (expense) (9,897) (324) 41 (10,180) --------------------------------------------------------------- 16,182 518 (67) 16,633 Balance at December 31, 2003 $ 0 $ (247) $ (67) $ (314) Change during first six months of 2004: Before-tax amount.. 0 (281) 108 (173) Tax benefit (expense) 0 114 (41) 73 --------------------------------------------------------------- 0 (167) 67 (100) --------------------------------------------------------------- Balance at June 30, 2004 $ 0 $ (414) $ 0 $ (414) - ----------------------------------------------------------------------------------------------------------------
8 NOTE 6. ACCRUAL FOR TERMITE CONTRACTS The Company maintains an accrual for termite contracts representing the estimated costs of reapplications, repair claims and associated labor, chemicals, and other costs relative to termite control services performed prior to the balance sheet date. A reconciliation of the beginning and ending balances of the accrual for termite contracts is as follows: Six Months Ended June 30, ------------------------------- (In thousands) 2004 2003 ----------------------------------------------------------------------------- Beginning Balance $43,873 $46,446 Current Period Provision 9,793 12,592 Settlements, Claims and Expenditures Made During the Period (8,734) (13,058) Western 393 0 ------------------------------- Ending Balance $45,325 $45,980 ----------------------------------------------------------------------------- NOTE 7. PENSION AND POST-RETIREMENT BENEFIT PLANS The following represents the net periodic pension benefit costs and related components in accordance with SFAS 132 ( R ): Components of Net Pension Benefit Cost
Three Months Ended Six Months Ended June 30, June 30, ----------------------------------------------------------- (in thousands) 2004 2003 2004 2003 -------------------------------------------------------------------------------------------------------- Service Cost $1,297 $1,171 $2,594 $2,342 Interest Cost 2,074 1,950 4,148 3,900 Expected Return on Plan Assets (2,394) (2,123) (4,788) (4,246) Amortization of: Prior Service Benefit (217) (217) (434) (434) Unrecognized Net Loss 845 506 1,690 1,012 ----------------------------------------------------------- Net Periodic Benefit Cost $1,605 $1,287 $3,210 $2,574 --------------------------------------------------------------------------------------------------------
A contribution of $3.0 million was made to the pension plan in April 2004. The Company expects to contribute an additional amount up to $3.0 million to the pension plan in 2004. NOTE 8. RELATED PARTY TRANSACTIONS On April 28, 2004, the Company sold real estate in Okeechobee County, Florida to LOR, Inc., a company controlled by R. Randall Rollins, Chairman of the Board of Rollins, Inc. and Gary W. Rollins, Chief Executive Officer, President and Chief Operating Officer of Rollins, Inc. for $16.6 million in cash. The sale resulted in a net gain after tax of $8.1 million or $0.17 per share since the real estate had appreciated over approximately 30 years it had been owned by the Company. The Company deferred a portion of the gain pending the completion of a survey that may result in the return of a portion of the proceeds. The real estate was under a lease agreement with annual rentals of $131,939 that expired June 30, 2007. On May 28, 2004, the Company sold real estate in Sussex County, Delaware to LOR, Inc. for $111,000 in cash. The sale resulted in an immaterial net gain after tax. The Board of Directors, at its quarterly meeting on January 27, 2004, approved the formation of a committee (the "Committee") made up of Messrs. Bill J. Dismuke and James B. Williams, who are independent directors, to evaluate the transactions. The Committee was furnished with full disclosure of the transactions, including independent appraisals, and determined that the terms of the transactions were reasonable and fair to the Company. The Company is also contemplating the sale of an additional piece of real estate in Sussex County, Delaware to LOR, Inc. or an entity wholly owned by LOR, Inc. In addition, the Company is contemplating the purchase of real estate located at 2158 Piedmont Road, N.E., Atlanta, Georgia 30324, adjacent to the Company's headquarters, from LOR, Inc. 9 NOTE 9. ACQUISITIONS On April 30, 2004, the Company acquired substantially all of the assets and assumed certain liabilities of Western Pest Services ("Western"), and the Company's consolidated financial statements include the operating results of Western from the date of the acquisition. Neither Western nor its principals had any prior relationship with the Company or its affiliates. Western was engaged in the provision of pest control services and the Company intends to continue this business. The acquisition was made pursuant to an Asset Purchase Agreement (the "Western Agreement") dated March 8, 2004, between Rollins, Inc. and Western Industries, Inc. and affiliates. The consideration for the assets and certain noncompetition agreements (the "Purchase Price") was approximately $106.6 million, including approximately $7.0 million of assumed liabilities and excluding all consideration of Residex Corporation. The Purchase Price was funded with cash on hand, the sale of property located in Okeechobee County, Florida and a $15.0 million senior unsecured revolving credit facility. Pursuant to the Western Agreement, the Company acquired substantially all of Western's property and assets, including accounts receivable, real property leases, seller contracts, governmental authorizations, data and records, intangible rights and property and insurance benefits. As described in the Western Agreement, the Company assumed only specified liabilities of Western, including current balance sheet liabilities of the seller and obligations under disclosed assigned contracts. The Company engaged an independent valuation firm to determine the allocation of the purchase price to Goodwill and identifiable Intangible assets. Such valuation resulted in the allocation of $41.3 million to Goodwill and $55.2 million to other intangible assets, principally customer contracts. The finite-lived intangible assets, principally customer contracts, are being amortized over periods principally ranging from 8 to 12.5 years on a straight-lined basis. On April 30, 2004, in a transaction ancillary to the Western acquisition, the Company acquired Residex Corporation ("Residex"), a company that distributes chemicals and other products to pest management professionals, pursuant to an Asset Purchase Agreement (the "Residex Agreement") dated March 8, 2004, between Rollins, Inc. and Western Industries, Inc., JBD Incorporated and Residex Corporation. Subsequently on April 30, 2004, the Company sold Residex to an industry distribution group. The amounts involved were not material and no gain or loss was recognized on the transaction. Prior to the acquisition, Western Pest Services was recognized as a premier pest control business and ranked as the 8th largest company in the industry. Based in Parsippany, NJ, the Company provides pest elimination and prevention to homes and businesses to over 130,000 customers from New York to Virginia with additional operations in Georgia and Florida. Western is primarily a commercial pest control service company and its existing businesses complement most of the services that Orkin offers, in an area of the country in which Orkin has not been particularly strong, the Northeast. The Company's consolidated statements of income include the results of operations of Western for the period beginning May 1, 2004 through June 30, 2004. NOTE 10. PRO FORMA FINANCIAL INFORMATION The pro forma financial information presented below gives effect to the Western acquisition as if it had occurred as of the beginning of our fiscal year 2004 and 2003, respectively. The information presented below is for illustrative purposes only and is not necessarily indicative of results that would have been achieved if the acquisition actually had occurred as of the beginning of such years or results which may be achieved in the future. 10
Three Months Ended Six Months Ended June 30, June 30, ---------------------------------- ------------------------------------ 2004 2003 2004 2003 ---------------- ---------------- ---------------- ----------------- REVENUES Customer Services $ 215,240 $ 204,982 $ 393,068 $ 377,817 ================ ================ ================ ================= INCOME BEFORE INCOME TAXES 41,071 21,049 56,137 32,103 ================ ================ ================ ================= NET INCOME $ 23,549 $ 13,050 $ 32,513 $ 19,904 ================ ================ ================ ================= EARNINGS PER SHARE - BASIC $ 0.52 $ 0.29 $ 0.72 $ 0.44 ================ ================ ================ ================= EARNINGS PER SHARE - DILUTED $ 0.50 $ 0.28 $ 0.70 $ 0.43 ================ ================ ================ ================= Average Shares Outstanding---Basic 45,552 45,117 45,425 45,015 Average Shares Outstanding---Diluted 46,753 46,404 46,698 46,258
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Overview The Company's investment in its new marketing and sales initiatives and continued emphasis on customer retention as well as the acquisition of Western, resulted in revenue growth of 12.2% in the second quarter of 2004 compared to the second quarter of 2003. For the second quarter of 2004, the Company had net income of $23.8 million compared to net income of $13.9 million in the second quarter of 2003, which represents a 71.8% increase. Included in second quarter's net income was a one-time gain from the sale of assets of $8.1 million, net of tax, or $0.17 per share. In addition to the revenue increase of 12.2%, the Company's Cost of Services Provided decreased 0.8 percentage points, as a percentage of revenues, and the Company achieved an improvement in Sales, General and Administrative expenses of 0.4 percentage point, as a percentage of revenues. The financial results for the second quarter of 2004 were positively impacted by the continued benefit of our recent service and sales and marketing initiatives, which included every-other-month residential pest control service, Gold Medal premium commercial pest control services, the investment in Business Development Managers for every Orkin division, the Commercial Pest Control Quality Assurance Program, termite directed liquid and baiting treatment, and the creation of or enhancement of regional call centers, which have enabled better accountability over leads and better coordination of scheduling starts for new customers. The Company finalized the acquisition of Western on April 30, 2004 and reported an additional $13.7 million in revenues for the second quarter of 2004. Western also contributed approximately $3.0 million to the Company's cash flow for the second quarter of 2004 however, it did not contribute to the Company's earnings, due to goodwill amortization and some post acquisition related expenses. The Company was able to fund all but $15.0 million of the $110.0 million that it paid for Western primarily with cash on-hand. The Company's strong cash flow allowed it to end the second quarter of 2004 with zero debt from the acquisition, and $21.9 million in cash and short-term investments. The improving results that the Company reported for both the quarter and first six months of 2004 are primarily attributable to the success it is having in implementing its 2004 initiatives. The Company set the bar high for Orkin this year, as it does each year, and is on track to improve its performance in sales, customer and employee retention and profitability. Residential pest control growth is being driven by service improvements, primarily in lead generation. The "market segmentation" work that the Company had done previously, in which it identified the ideal customer groups for Orkin is contributing to the financials and quality of phone leads. The three segments the Company is targeting are 1) Big Branders, those who want the best and are willing to pay for it; 2) Relationship Seekers, prospects concerned about pest prevention and driven by reputation, responsiveness and trust, 3) and Safety First customers, those seeking a pest control company with the most professional, best 11 trained and knowledgeable technicians. These characteristics are all attributes that Orkin delivers every day and the Company believes its advertising is hitting these objectives. This year the Company is also attracting more prospective customers to its Orkin.com web site. In the first quarter of 2002, the Company had 25 leads on its site. This year it generated approximately 3,600 leads. Having a user friendly web site, at a time where people are using the Internet more and more to manage their active lives, shall prove to be an important channel for generating leads and improving sales in the future. The Company has also achieved greater efficiency in the handling and capturing of phone inquiries from prospective customers. It has moved more of its branch telephone calls to regional centers. The use of these centers means fewer dropped leads, and the ability to route calls when demand peaks to a "backup" call center that can take the call. The Company has also upgraded the phone equipment and skill set of the people who handle these calls. As a result of these two actions, the Company is experiencing an improved rate of closure at these locations and positive increases in leads in part because it can better control their documentation and handling. This improved accountability should enable the Company to build a better database for future direct mail solicitation or telemarketing. The Company continues to invest in its commercial business area, where its strategy has moved from building awareness to industry specific targeted programs. The Company continues to see increased interest in its Gold Medal initiative, which was introduced last year and addresses the food processing industry. The Company is also enjoying favorable revenue momentum as a result of its national account business. On July 1, 2004, the Company announced that Orkin will formally work with the U.S. Centers for Disease Control and Prevention ("CDC") on educational projects targeting pest-related health risks. Over the next 12 months the Company will collaborate with the CDC on three major shared efforts. o First, the Company will be co-developing materials for Orkin training and customer service, which will assist Orkin's pest management professionals in providing more comprehensive information to their customers. Included in this information will be prevention guidance on vector-borne and zoonotic diseases. These are diseases that are transmitted to humans by fleas and ticks. o Second, together with the CDC, it will develop and distribute public information regarding pests and prevention of associated infectious diseases. o And at the same time, the Company will be expanding health-related information on Orkins' web site www.orkin.com. With increased concern over pest-related diseases over the past few years, the Company and the CDC recognize the importance to do a better job informing the public. The Company believes that this collaboration will enhance its ability to share important information with the public about health risks from certain pests and allow it to enhance its award-winning training and customer service while further distinguishing Orkin as the pest control leader. The Company continues to expand its growth through the Orkin franchise program. This program is primarily used in smaller markets where it is currently not economically feasible to locate a conventional Orkin branch. There is a contractual buyback provision at the Company's option with a pre-determined purchase price using a formula applied to revenues of the franchise. There were 46 Company franchises at the end of the first quarter of 2004 compared to 44 at December 31, 2003. Results of Operations
% Better/ % Better/ Three Months Ended Worse as Six Months Ended Worse as June 30, Compared to June 30, Compared to Prior Year Prior Year ------------------------------------------------------------------------------------ (in thousands) 2004 2003 2004 2004 2003 2004 ------------------------------------------------------------------------------------ Revenues $207,698 $185,105 12.2% $366,390 $340,227 7.7% Cost of Services Provided 105,442 95,558 (10.3) 190,799 179,484 (6.3) Depreciation and Amortization 5,764 5,037 (14.4) 10,421 10,193 (2.2) Sales, General and Administrative 69,155 62,312 (11.0) 123,330 116,688 (5.7) Gain on Sale of Assets (14,143) (67) N/M (14,142) (69) N/M Interest Income (47) (94) (50.0) (197) (160) 23.1 ------------------------------------------------------------------------------------ Income Before Income Taxes 41,527 22,359 85.7 56,179 34,091 64.8 Provision for Income Taxes 17,717 8,497 (108.5) 23,651 12,955 (82.6) ------------------------------------------------------------------------------------ Net Income $23,810 $ 13,862 71.8% $ 32,528 $ 21,136 53.9%
12 Revenues for the quarter ended June 30, 2004 increased to $207.7 million, an increase of $22.6 million or 12.2%, inclusive of the Western acquisition completed on April 30, 2004 and the additional termite renewals deferred from the first quarter of 2004 and recognized in the second quarter of 2004, from last year's second quarter revenues of $185.1 million. For the second quarter of 2004 the primary revenue driver was the acquisition of Western as well as the residential pest control business, which grew at 6.8%. The Company's movement over the last year to regional incoming call centers has led to greater efficiency in the handling and capturing of calls and with the improved closure, greater sales and revenue. Every-other-month service, our primary residential pest control service offering, continues to grow in importance, comprising 55.3% of our residential pest control customer base at June 30, 2004. Revenues for the six month period ended June 30, 2004 increased to $366.4 million, an increase of $26.2 million or 7.7% from last year's first six month period revenues of $340.2 million. The Company's foreign operations accounted for approximately 6% of total second quarter revenues of 2004 compared to approximately 6% in the second quarter of 2003. The revenues of the Company are affected by the seasonal nature of the Company's pest and termite control services as evidenced by the following chart. Total Net Revenues ------------------------------------------ 2004 2003 2002 - ------------------------------------------------------------------------------ First Quarter $158,692 $155,122 $153,302 Second Quarter 207,698 185,105 184,189 Third Quarter N/A 178,262 174,063 Fourth Quarter N/A 158,524 153,871 - ------------------------------------------------------------------------------ Cost of Services Provided for the second quarter ended June 30, 2004 increased $9.9 million or 10.3%, although the expense expressed as a percentage of revenues decreased by 0.8 percentage points, representing 50.8% of revenues for the second quarter 2004 compared to 51.6% of revenues in the prior year second quarter. For the first six months of 2004, Cost of Services Provided increased $11.3 million or 6.3%, while margins improved by 0.7 percentage points, representing 52.1% of revenues for the first six months of 2004 compared to 52.8% of revenues in the prior year. Cost of Services Provided as a percentage of revenues decreased primarily due to continuing improvements in insurance and claims, as well as continued employee productivity improvements at Orkin. These were partially offset by Western's higher Cost of Services Provided as a percentage of revenues. One area in which the Company experienced some minor expense increases was fleet, which was the result of higher lease, fuel and the cost of the Western fleet. Sales, General and Administrative for the second quarter ended June 30, 2004 increased $6.8 million or 11.0% and, as a percentage of revenues, improved by 0.4 percentage points or 0.9%, representing 33.3% of total revenues compared to 33.7% for the prior year quarter. For the first six months of 2004, Sales, General and Administrative increased $6.6 million or 5.7%, while margins improved by 0.6 percentage points, representing 33.7% of revenues for the first six months of 2004 compared to 34.3% of revenues in the prior year. The decrease in Sales, General and Administrative as a percentage of revenue was mainly attributable to the absence of an ineffective advertising campaign that was conducted in Canada in 2003. The savings were partially offset by the higher Sales, General and Administrative costs of Western. Depreciation and Amortization expenses for the quarter ended June 30, 2004 were $727,000, or 14.4%, higher than the prior year quarter. For the first six months of 2004, Depreciation and Amortization expenses were approximately $228,000, or 2.2%, higher than the prior year. The increase was due to the addition of depreciation and amortization from the acquisition of Western partially offset by lower capital spending and certain technology assets becoming fully depreciated in the last twelve months. As part of the Western acquisition, $55.2 million of finite-lived intangible assets, principally customer contracts, were acquired. They will be amortized over periods principally ranging from 8 to 12.5 years. This represents a non-cash charge and will increase our amortization by approximately $6.0 million to approximately $12.8 million per year. The Company's tax provision of $17.7 million for the second quarter ended June 30, 2004 reflects increased pre-tax income over the prior year period and an increase in the effective tax rate. The effective tax rate was 42.7% for the second quarter ended June 30, 2004, up from 38.0% for the second quarter ended June 30, 2003. The increase reflects increases in the Company's effective state income tax rate, a "true-up" adjustment to deferred income taxes, as well as the impact of permanent differences associated with the Company's Canadian operations. Critical Accounting Policies We view critical accounting policies to be those policies that are very important to the portrayal of our financial condition and results of operations, and that require Management's most difficult, complex or subjective judgments. The circumstances that 13 make these judgments difficult or complex relate to the need for Management to make estimates about the effect of matters that are inherently uncertain. We believe our critical accounting policies to be as follows: Accrual for Termite Contracts--The Company maintains an accrual for termite contracts representing the estimated costs of reapplications, repair claims, associated labor and chemicals, settlements, awards and other costs relative to termite control services performed prior to the balance sheet date. The Company contracts an independent third party actuary on an annual basis to provide the Company an estimate of the liability based upon historical claims information for the largest portion of the accrual. In addition, Management estimates and accrues for costs outside the scope of the actuarial study including the estimated costs of retreatments, representing costs to be incurred that are estimatable at the balance sheet date, as well as liability and costs associated with claims in litigation. The actuarial study and historical experience are major considerations in determining the accrual balance, along with Management's knowledge of changes in business practices, contract changes, ongoing claims, and termite remediation trends. The accrual is established based on all these factors. Management makes judgments utilizing these operational and other factors but recognizes that they are inherently subjective due to the difficulty in predicting settlements and awards. Other factors that may impact future cost include chemical life expectancy and government regulation. It is significant that the actual number of claims has decreased in recent years due to changes in the Company's business practices. However, it is not possible to accurately predict future significant claims. Positive changes to our business practices include revisions made to our contracts, more effective treatment methods that include a directed-liquid baiting program, more effective termiticides, and expanded training methods and techniques. Accrued Insurance--The Company self-insures, up to specified limits, certain risks related to general liability, workers' compensation and vehicle liability. The estimated costs of existing and future claims under the self-insurance program are accrued based upon historical trends as incidents occur, whether reported or unreported (although actual settlement of the claims may not be made until future periods) and may be subsequently revised based on developments relating to such claims. The Company contracts an independent third party actuary on an annual basis to provide the Company an estimated liability based upon historical claims information. The actuarial study is a major consideration, along with Management's knowledge of changes in business practices and existing claims compared to current balances. The reserve is established based on all these factors. Management's judgment is inherently subjective and a number of factors are outside Management's knowledge and control. Additionally, historical information is not always an accurate indication of future events. It should be noted that the number of claims has been decreasing due to the Company's proactive risk management to develop and maintain ongoing programs. However, it is not possible to accurately predict future significant claims. Initiatives that have been implemented include pre-employment screening and an annual motor vehicle report required on all its drivers, utilization of a Global Positioning System that has been fully deployed to our Company vehicles, post-offer physicals for new employees, and pre-hire, random and post-accident drug testing. The Company has improved the time required to report a claim by utilizing a "Red Alert" program that provides serious accident assessment twenty four hours a day and seven days a week and has instituted a modified duty program that enables employees to go back to work on a limited-duty basis. Revenue Recognition--The Company's revenue recognition policies are designed to recognize revenues at the time services are performed. For certain revenue types, because of the timing of billing and the receipt of cash versus the timing of performing services, certain accounting estimates are utilized. Residential and commercial pest control services are primarily recurring in nature on a monthly or bi-monthly basis, while certain types of commercial customers may receive multiple treatments within a given month. In general, pest control customers sign an initial one-year contract, and revenues are recognized at the time services are performed. For pest control customers, the Company offers a discount for those customers who prepay for a full year of services. The Company defers recognition of these advance payments and recognizes the revenue as the services are rendered. The Company classifies the discounts related to the advance payments as a reduction in revenues. Termite baiting revenues are recognized based on the delivery of the individual units of accounting. At the inception of a new baiting services contract upon quality control review of the installation, the Company recognizes revenue for the delivery of the monitoring stations, initial directed liquid termiticide treatment and installation of the monitoring services. The amount deferred is the fair value of monitoring services to be rendered after the initial service. The amount deferred for the undelivered monitoring element is then recognized as income on a straight-line basis over the remaining contract term, which results in recognition of revenue in a pattern that approximates the timing of performing monitoring visits. Baiting renewal revenue is deferred and recognized over the annual contract period on a straight-line basis that approximates the timing of performing the required monitoring visits. Traditional termite treatments are recognized as revenue at the time services are performed. Traditional termite contract renewals are recognized as revenues at the renewal date in order to match the revenue with the approximate timing of the corresponding service provided. Interest income on installment receivables is accrued monthly based on actual loan balances and stated interest rates. Franchise fees are treated as unearned revenue in the Statement of Financial Position for the duration of the initial contract period. Royalties from Orkin franchises are accrued and recognized as revenues as earned on a monthly basis. Gains on sales of pest control customer accounts to franchises are recognized at the time of sale and when collection of the proceeds under notes are reasonably assured. Contingency Accruals--The Company is a party to legal proceedings with respect to matters in the ordinary course of business. In accordance with Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, the Company estimates and accrues for its liability and costs associated with the litigation. Estimates and accruals are determined in 14 consultation with outside counsel. It is not possible to accurately predict the ultimate result of the litigation. However, in the opinion of Management, the outcome of the litigation will not have a material adverse impact on the Company's financial condition or results of operations. Liquidity and Capital Resources Cash and Cash Flow Six Months Ended June 30, ----------------------------------------------------------------------- (in thousands) 2004 2003 ----------------------------------------------------------------------- Net Cash Provided by Operating Activities $ 35,771 $ 32,875 Net Cash Used in Investing Activities (69,572) (3,840) Net Cash Used in Financing Activities (3,874) (2,485) --------- -------- Net Increase in Cash and Short-Term Investments $ (37,675) $ 26,550 ----------------------------------------------------------------------- The Company believes its current cash and short-term investments balances, future cash flows from operating activities and available borrowings under its $70.0 million credit facilities will be sufficient to finance its current operations and obligations, and fund expansion of the business for the foreseeable future and the acquisition of other select pest control businesses. The Company's operating activities generated cash of $35.8 million for the first six months ended June 30, 2004, compared with cash provided by operating activities of $32.9 million for the same period in 2003. Cash flows from operating activities in 2004 were consistent with 2003 due primarily to higher net income and provision for deferred income taxes offset by increased gains on sale of assets. The Company invested approximately $3.8 million in capital expenditures during the first six months ended June 30, 2004, compared to $2.3 million during the same period in 2003, and expects to invest between $4.0 million and $7.0 million for the remainder of 2004. Capital expenditures for the first six months consisted primarily of the purchase of equipment replacements and upgrades and improvements to the Company's management information systems. During the first six months, the Company made acquisitions totaling $103.2 million, compared to $1.5 million during the same period in 2003. Acquisitions were primarily funded by cash on hand, sales of marketable securities of approximately $21.9 million, proceeds from sale of assets and borrowings under a senior unsecured revolving credit facility (See below for further discussion). A total of $5.5 million was paid in cash dividends ($0.12 per share) during the first six months of 2004, compared to $4.5 million or $0.10 per share during the same period in 2003. The Company did not repurchase any shares of Common Stock in the first six months of 2004 and there remain 649,684 shares authorized to be repurchased. The capital expenditures and cash dividends were funded entirely through existing cash balances and operating activities. The Company maintains $70.0 million credit facilities with commercial banks, of which no borrowings were outstanding as of June 30, 2004 or July 15, 2004. The Company maintains approximately $33.6 million in Letters of Credit. On April 28, 2004, the Company entered into a $15.0 million senior unsecured revolving credit facility. The entire amount of the credit facility was used to fund a portion of the Western Industries, Inc. acquisition that the Company closed on April 30, 2004. The Company repaid the full amount of the credit facility in May 2004. On April 28, 2004, the Company sold real estate in Okeechobee County, Florida to LOR, Inc., a company controlled by R. Randall Rollins, Chairman of the Board of Rollins, Inc. and Gary W. Rollins, Chief Executive Officer, President and Chief Operating Officer of Rollins, Inc. for $16.6 million in cash. The sale resulted in a net gain after tax of $8.1 million or $0.17 per share since the real estate had appreciated over approximately 30 years it had been owned by the Company. The Company deferred a portion of the gain pending the completion of a survey that may result in the return of a portion of the proceeds. The real estate was under a lease agreement with annual rentals of $131,939 that expired June 30, 2007. On May 28, 2004, the Company sold real estate in Sussex County, Delaware to LOR, Inc. for $111,000 in cash. The sale resulted in an immaterial net gain after tax. The Board of Directors, at its quarterly meeting on January 27, 2004, approved the formation of a committee (the "Committee") made up of Messrs. Bill J. Dismuke and James B. Williams, who are independent directors, to evaluate the transactions. The Committee was furnished with full disclosure of the transactions, including independent appraisals, and determined that the terms of the transactions were reasonable and fair to the Company. The Company is also contemplating the sale of an additional piece of real estate in Sussex County, Delaware to LOR, Inc. or an entity wholly owned by LOR, Inc. In addition, the Company is contemplating the purchase of real estate located at 2158 Piedmont Road, N.E., Atlanta, Georgia 30324, adjacent to the Company's headquarters, from LOR, Inc. On April 30, 2004, the Company acquired substantially all of the assets and assumed certain liabilities of Western Pest Services ("Western"), and the Company's consolidated financial statements include the operating results of Western from the date of the acquisition. Neither Western nor its principals had any prior relationship with the Company or its affiliates. Western was engaged in the provision of pest control services and the Company intends to continue this business. The 15 acquisition was made pursuant to an Asset Purchase Agreement (the "Western Agreement") dated March 8, 2004, between Rollins, Inc. and Western Industries, Inc. and affiliates. The consideration for the assets and certain noncompetition agreements (the "Purchase Price") was approximately $106.6 million, including approximately $7.0 million of assumed liabilities and excluding all consideration of Residex Corporation. The Purchase Price was funded with cash on hand, the sale of property located in Okeechobee County, Florida and a $15.0 million senior unsecured revolving credit facility. Pursuant to the Western Agreement, the Company acquired substantially all of Western's property and assets, including accounts receivable, real property leases, seller contracts, governmental authorizations, data and records, intangible rights and property and insurance benefits. As described in the Western Agreement, the Company assumed only specified liabilities of Western, including current balance sheet liabilities of the seller and obligations under disclosed assigned contracts. The Company engaged an independent valuation firm to determine the allocation of the purchase price to Goodwill and identifiable Intangible assets. Such valuation resulted in the allocation of $41.3 million to Goodwill and $55.2 million to other intangible assets, principally customer contracts. The finite-lived intangible assets, principally customer contracts, are being amortized over periods principally ranging from 8 to 12.5 years on a straight-lined basis. On April 30, 2004, in a transaction ancillary to the Western acquisition, the Company acquired Residex Corporation ("Residex"), a company that distributes chemicals and other products to pest management professionals, pursuant to an Asset Purchase Agreement (the "Residex Agreement") dated March 8, 2004, between Rollins, Inc. and Western Industries, Inc., JBD Incorporated and Residex Corporation. Subsequently on April 30, 2004, the Company sold Residex to an industry distribution group. The amounts involved were not material and no gain or loss was recognized on the transaction. Prior to the acquisition, Western Pest Services was recognized as a premier pest control business and ranked as the 8th largest company in the industry. Based in Parsippany, NJ, the Company provides pest elimination and prevention to homes and businesses to over 130,000 customers from New York to Virginia with additional operations in Georgia and Florida. Western is primarily a commercial pest control service company and its existing businesses complement most of the services that Orkin offers, in an area of the country in which Orkin has not been particularly strong, the Northeast. The Company's consolidated statements of income include the results of operations of Western for the period beginning May 1, 2004 through June 30, 2004. Orkin, one of the Company's subsidiaries, is aggressively defending a class action lawsuit filed in Hillsborough County, Tampa, Florida. In early April 2002, the Circuit Court of Hillsborough County certified the class action status of Butland et al. v. Orkin Exterminating Company, Inc. et al. Orkin is also a defendant in Helen Cutler and Mary Lewin v. Orkin Exterminating Company, Inc. et al pending in the District Court of Houston County, Alabama. Other lawsuits against Orkin, and in some instances the Company, are also being vigorously defended, including the Warren, Petsch, and Stevens cases. The Company has been named a defendant in Larry Hanna, et. al. v. Rollins, Inc. dba Rollins Service Bureau pending in the District Court for the Northern District of Indiana (Hammond Division) in which the Plaintiffs are seeking certification of a class. For further discussion, see Note 3 to the accompanying financial statements. A contribution of $3.0 million was made to the pension plan in April 2004. The Company expects to contribute an additional amount up to $3.0 million to the pension plan in 2004. In the opinion of Management, additional Plan contributions will not have a material effect on the Company's financial position, results of operations or liquidity. Impact of Recent Accounting Pronouncements In December 2002, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"). The Interpretation requires that a variable interest entity be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation requirements of FIN 46 were in 2003 effective for all variable interest entities created or acquired after January 31, 2003. In December 2003, the Financial Accounting Standards Board issued a revision to FIN 46 referred to as Interpretation No. 46 (R). Among other provisions, the revision extended the adoption date of FIN 46 (R) to the first quarter of 2004 for variable interest entities created prior to February 1, 2003. The Company adopted FIN 46 (R) in the first quarter of 2004 for variable interest entities created prior to February 1, 2003. The adoption did not have a significant effect on the Company's financial position or results of operations (see Note 1 to the accompanying financial statements). Forward-Looking Statements This Quarterly Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements include statements regarding the expected amount and impact of potential future pension plan contributions, the expected impact of related party transactions, the outcome of litigation arising in the ordinary course of business and the outcome of the Helen Cutler and Mary Lewin v. Orkin Exterminating Company, Inc. et al. 16 ("Cutler") and the Butland et al. v. Orkin Exterminating Company, Inc. et al. ("Butland") litigation on the Company's financial position, results of operations and liquidity; the adequacy of the Company's resources to fund operations and obligations; the Company's projected 2004 capital expenditures; the expected performance of the commercial business, franchise growth; and the impact of recent accounting pronouncements. The actual results of the Company could differ materially from those indicated by the forward-looking statements because of various risks, timing and uncertainties including, without limitation, the possibility of an adverse ruling against the Company in the Cutler, Butland or other litigation; general economic conditions; market risk; changes in industry practices or technologies; the degree of success of the Company's termite process reforms and pest control selling and treatment methods; the Company's ability to identify potential acquisitions; climate and weather trends; competitive factors and pricing practices; potential increases in labor costs; and changes in various government laws and regulations, including environmental regulations and additional risks discussed in the Company's Form 10-K for 2003. All of the foregoing risks and uncertainties are beyond the ability of the Company to control, and in many cases the Company cannot predict the risks and uncertainties that could cause its actual results to differ materially from those indicated by the forward-looking statements. Item 3. Quantitative and Qualitative Disclosures About Market Risk. As of June 30, 2004, the Company maintained an investment portfolio subject to short-term interest rate risk exposure. The Company has been affected by the impact of lower interest rates on interest income from its short-term investments. The Company is also subject to interest rate risk exposure through borrowings on its $70.0 million credit facilities. Due to the absence of such borrowings as of June 30, 2004, this risk was not significant in the first six months of 2004 and is not expected to have a material effect upon the Company's results of operations or financial position going forward. The Company is also exposed to market risks arising from changes in foreign exchange rates. The Company believes that this foreign exchange rate risk will not have a material effect upon the Company's results of operations or financial position going forward. Item 4. Controls and Procedures. Under the supervision and with the participation of our Management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operations of our disclosure controls and procedures, as defined in rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of June 30, 2004. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level such that the material information required to be included in our Securities and Exchange Commission ("SEC") reports is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms relating to Rollins, Inc., including our consolidated subsidiaries, and was made known to them by others within those entities, particularly during the period when this report was being prepared. In addition, there were no significant changes in our internal control over financial reporting during the quarter that could significantly affect these controls. As of June 30, 2004, we did not identify any significant deficiency or material weaknesses in our internal controls, and therefore no corrective actions were taken. 17 PART II OTHER INFORMATION Item 1. Legal Proceedings. See Note 3 to Part I, Item 1 for discussion of certain litigation. Item 4. Submission of Matters to a Vote of Security Holders. Because the Company's directors have staggered three-year terms, Mr. R. Randall Rollins, Mr. James B. Williams, Mr. Gary W. Rollins and Mr. Henry B. Tippie continue to serve as directors of the Company but were not up for reelection at the Company's Annual Meeting of Stockholders on April 27, 2004. The Company's Annual Meeting of Stockholders was held on April 27, 2004. At the meeting, stockholders voted on the following proposal: 1. To elect two Class III Directors for the three-year term expiring in 2007. Each nominee for Class III Director was elected by a vote of the stockholders as follows: Election of Class III Directors: For Withheld --------------------------------------------------------------------- Wilton Looney 42,576,086 1,104,078 Bill J. Dismuke 43,168,460 511,704 Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits (2) (i) Asset Purchase Agreement by and among Orkin, Inc. (as assigned to Rollins, Inc.) and Western Industries, Inc., Western Exterminating Company, Inc. et al. dated March 8, 2004 incorporated herein by reference to Exhibit (2) (i) as filed with its Form 10-Q for the quarter ended March 31, 2004, as amended. (2) (ii) Purchase and Sale Agreement by and among Rollins Continental, Inc. et al. dated April 28, 2004. (3) (i) Restated Certificate of Incorporation of Rollins, Inc. is incorporated herein by reference to Exhibit (3) (i) as filed with its Form 10-K for the year ended December 31, 1997. (ii) Amended and Restated By-laws of Rollins, Inc. is incorporated herein by reference to Exhibit (3) (ii) as filed with its Form 10-Q for the quarterly period ended March 31, 2004. (4) Form of Common Stock Certificate of Rollins, Inc. is incorporated herein by reference to Exhibit (4) as filed with its Form 10-K for the year ended December 31, 1998. (31.1) Certification of Chief Executive Officer Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (31.2) Certification of Chief Financial Officer Pursuant to Item 601(b)(31) of Regulation S-K, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (32.1) Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 18 (b) Reports on Form 8-K. On April 28, 2004, the Company furnished a report on Form 8-K, which reported under Items 7 and 9 financial results for its first quarter ended March 31, 2004. On April 28, 2004, the Company furnished a report on Form 8-K, which reported under Items 7 and 9 that the Board of Directors on April 27, 2004 declared a regular quarterly dividend of $0.06 per share payable June 10, 2004 to stockholders of record at the close of business May 10, 2004. On May 5, 2004, the Company filed a report on Form 8-K, which reported under Items 5 and 7 that on May 3, 2004, Rollins, Inc. had completed its acquisition of Western Pest Services and affiliates for a cash payment of approximately $110.0 million. On May 17, 2004, the Company filed a report on Form 8-K, which reported under Items 2 and 7 that on April 30, 2004, Rollins, Inc. had acquired substantially all of the assets and assumed certain liabilities of Western Pest Services. 19 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ROLLINS, INC. (Registrant) Date: July 30, 2004 By: /s/ Gary W. Rollins ------------------------------------------- Gary W. Rollins Chief Executive Officer, President and Chief Operating Officer (Member of the Board of Directors) Date: July 30, 2004 By: /s/ Harry J. Cynkus ------------------------------------------- Harry J. Cynkus Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer) 20