e10vq
Table of Contents

(G&K SERVICES LOGO)
 
 
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended April 1, 2006
Commission file number 0-4063
G&K SERVICES, INC.
(Exact name of registrant as specified in its charter)
         
         MINNESOTA       41-0449530
         
(State or other jurisdiction of       (I.R.S. Employer
incorporation or organization)       Identification No.)
5995 OPUS PARKWAY
MINNETONKA, MINNESOTA 55343
(Address of principal executive offices and zip code)
(952) 912-5500
(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 þ   NO o    
          Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):
          Large Accelerated Filer þ       Accelerated Filer o       Non-Accelerated Filer o
          Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
             
    YES o   NO þ    
          Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.
Common Stock, par value $0.50 per share, outstanding
May 1, 2006 was 21,271,489 shares.
 
 

 


Table of Contents

G&K Services, Inc.
Form 10-Q
Table of Contents
             
        PAGE
           
  Financial Statements        
 
           
 
  Consolidated Condensed Balance Sheets as of April 1, 2006 and July 2, 2005     3  
 
           
 
  Consolidated Statements of Operations for the three and nine months ended April 1, 2006 and April 2, 2005     4  
 
           
 
  Consolidated Condensed Statements of Cash Flows for the nine months ended April 1, 2006 and April 2, 2005     5  
 
           
 
  Notes to Consolidated Condensed Financial Statements     6  
 
           
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     14  
 
           
  Quantitative and Qualitative Disclosure About Market Risk     23  
 
           
  Controls and Procedures     23  
 
           
           
  Unregistered Sales of Equity Securities and Use of Proceeds     24  
  Exhibits     24  
        25  
 Chief Executive Officer to Sec. 302 Certification
 Chief Financial Officer to Sec. 302 Certification
 Chief Executive Officer to Sec. 906 Certification
 Chief Financial Officer to Sec. 906 Certification

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PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED CONDENSED BALANCE SHEETS
G&K Services, Inc. and Subsidiaries
                 
    April 1,     July 2,  
    2006     2005  
(In thousands)   (Unaudited)     (Restated)  
 
ASSETS
               
Current Assets
               
Cash and cash equivalents
  $ 21,960     $ 15,345  
Accounts receivable, less allowance for doubtful accounts of $3,146 and $2,890
    95,426       83,459  
Inventories
    137,290       121,120  
Prepaid expenses
    14,630       16,587  
 
Total current assets
    269,306       236,511  
 
 
               
Property, Plant and Equipment, net
    249,896       243,307  
Goodwill
    344,642       338,701  
Other Assets
    84,336       84,650  
 
 
  $ 948,180     $ 903,169  
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities
               
Accounts payable
  $ 32,874     $ 25,695  
Accrued expenses
    66,877       71,483  
Deferred income taxes
    9,201       8,971  
Current maturities of long-term debt
    17,925       26,537  
 
Total current liabilities
    126,877       132,686  
 
 
               
Long-Term Debt, net of Current Maturities
    212,066       210,462  
Deferred Income Taxes
    30,756       30,887  
Other Noncurrent Liabilities
    54,427       47,691  
Stockholders’ Equity
    524,054       481,443  
 
 
  $ 948,180     $ 903,169  
 
The accompanying notes are an integral part of these consolidated condensed financial statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS
G&K Services, Inc. and Subsidiaries
(Unaudited)
                                 
    For the Three Months Ended     For the Nine Months Ended  
            April 2,             April 2,  
    April 1,     2005     April 1,     2005  
(In thousands, except per share data)   2006     (Restated)     2006     (Restated)  
 
Revenues
                               
Rental operations
  $ 201,562     $ 188,064     $ 594,985     $ 547,465  
Direct sales
    24,579       15,746       58,452       33,912  
 
Total revenues
    226,141       203,810       653,437       581,377  
 
Operating Expenses
                               
Cost of rental operations
    131,387       119,139       383,565       346,563  
Cost of direct sales
    17,659       12,011       42,015       25,348  
Selling and administrative
    49,619       43,283       141,219       124,577  
Depreciation and amortization
    10,883       10,407       32,126       30,726  
 
Total operating expenses
    209,548       184,840       598,925       527,214  
 
Income from Operations
    16,593       18,970       54,512       54,163  
Interest expense
    3,395       2,891       9,712       8,080  
 
Income before Income Taxes
    13,198       16,079       44,800       46,083  
Provision for income taxes
    2,840       6,129       13,837       17,338  
 
Net Income
  $ 10,358     $ 9,950     $ 30,963     $ 28,745  
 
Basic weighted average number of shares outstanding
    21,132       20,994       21,069       20,910  
Basic Earnings per Common Share
  $ 0.49     $ 0.47     $ 1.47     $ 1.37  
 
Diluted weighted average number of shares outstanding
    21,311       21,322       21,228       21,362  
Diluted Earnings per Common Share
  $ 0.49     $ 0.47     $ 1.46     $ 1.35  
 
 
                               
Dividends per share
  $ 0.0175     $ 0.0175     $ 0.0525     $ 0.0525  
 
The accompanying notes are an integral part of these consolidated condensed financial statements.

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CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
G&K Services, Inc. and Subsidiaries
(Unaudited)
                 
    For the Nine Months Ended  
            April 2,  
    April 1,     2005  
(In thousands)   2006     (Restated)  
 
Operating Activities:
               
Net income
  $ 30,963     $ 28,745  
Adjustments to reconcile net income to net cash provided by operating activities —
               
Depreciation and amortization
    32,126       30,726  
Stock-based compensation
    3,060       2,891  
Deferred income taxes
    354       1,095  
Changes in current operating items, exclusive of acquisitions
    (17,320 )     (20,253 )
Other assets and liabilities
    829       1,159  
 
Net cash provided by operating activities
    50,012       44,363  
 
Investing Activities:
               
Property, plant and equipment additions, net
    (26,414 )     (10,194 )
Acquisitions of business assets and other
    (13,020 )     (74,895 )
 
Net cash used for investing activities
    (39,434 )     (85,089 )
 
Financing Activities:
               
Repayments of long-term debt
    (7,661 )     (21,317 )
Proceeds from short-term borrowings, net
    2,050       41,200  
Cash dividends paid
    (1,112 )     (1,100 )
Sale of common stock
    2,395       4,268  
 
Net cash (used for) provided by financing activities
    (4,328 )     23,051  
 
Increase (Decrease) in Cash and Cash Equivalents
    6,250       (17,675 )
Effect of Exchange Rates on Cash
    365       1,608  
 
               
Cash and Cash Equivalents:
               
Beginning of period
    15,345       26,931  
 
End of period
  $ 21,960     $ 10,864  
 
 
               
Supplemental Cash Flow Information:
               
Non-Cash Transactions —
               
Debt issued in connection with business acquisitions
  $ (1,419 )   $ 11,890  
 
The accompanying notes are an integral part of these consolidated condensed financial statements.

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G&K SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
(Amounts in thousands, except per share data)
Three and nine month periods ended April 1, 2006 and April 2, 2005
(Unaudited)
    The consolidated condensed financial statements included herein, except for the July 2, 2005 balance sheet which was derived from the audited consolidated financial statements for the fiscal year ended July 2, 2005, have been prepared by G&K Services, Inc. (the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of the Company, the accompanying unaudited consolidated condensed financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position of the Company as of April 1, 2006, and the results of its operations for the three and nine months ended and its cash flows for the nine months ended April 1, 2006 and April 2, 2005. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures herein are adequate to make the information presented not misleading. It is suggested that these consolidated condensed financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s latest report on Form 10-K.
 
    The results of operations for the three and nine month periods ended April 1, 2006 and April 2, 2005 are not necessarily indicative of the results to be expected for the full year.
1.   Summary of Significant Accounting Policies
    Accounting policies followed by the Company are set forth in Note 1 in the Company’s Annual Report on Form 10-K for the fiscal year ended July 2, 2005.
 
    Nature of Business
 
    G&K Services, Inc. (the “Company”) is a market leader in providing branded identity apparel and facility services programs that enhance image and safety in the workplace. The Company serves a wide variety of industrial, service and high-technology companies providing them with rented uniforms or purchase options as well as facility services products such as floor mats, dust mops, wiping towels, selected linen items and several restroom products. The Company also manufactures certain uniform garments that it uses to support its garment rental programs. The Company has two operating segments, United States and Canada, which have been identified as components of the Company that are reviewed by the Company’s Chief Executive Officer to determine resource allocation and evaluate performance.
 
    Principles of Consolidation
 
    The accompanying consolidated condensed financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned. Significant intercompany balances and transactions have been eliminated in consolidation.
 
    Revenue Recognition
 
    The Company’s rental operations business is largely based on written service agreements whereby it agrees to collect, launder and deliver uniforms and other related products. The service agreements provide for weekly billing upon completion of the laundering process and delivery to the customer. Accordingly, the Company recognizes revenue from rental operations in the period in which the services are provided. Revenue from rental operations also includes billings to customers for lost or abused merchandise. Direct sale revenue is recognized in the period in which the product is shipped.

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    Derivative Financial Instruments
 
    The Company uses derivative financial instruments to manage the risk that changes in interest rates will affect the amount of its future interest payments. Interest rate swap contracts are used to balance the proportion of total debt that is subject to variable and fixed interest rates. The interest rate swap contracts are reflected at fair value in the consolidated condensed balance sheets and the related gains or losses on these contracts are recorded in other comprehensive income, which is a component of stockholders’ equity. Amounts to be paid or received under the contracts are accrued as interest rates change and are recognized over the life of the contracts as an adjustment to interest expense. The net effect of this accounting is that interest expense on the portion of variable rate debt being hedged is generally recorded based on fixed interest rates.
 
    The Company also uses derivative financial instruments to manage the risk that changes in gasoline cost will affect the future financial results of the Company. The Company purchases futures contracts to effectively hedge a portion of anticipated actual gasoline purchases. The futures contracts are reflected at fair value in the consolidated condensed balance sheet and the related gains or losses on these contracts are recorded in other comprehensive income, which is a component of stockholders’ equity or in the statements of operations depending on the effectiveness of the hedge. Upon settlement of each contract, the actual gain or loss is reflected in gasoline expense.
 
    The Company may periodically hedge firm commitments with its foreign subsidiary, generally with foreign currency contracts. These agreements are recorded at current market values and the gains and losses are included in earnings. Gains and losses on such transactions were not significant in the third quarter of fiscal 2006 or 2005.
 
    Per Share Data
 
    Basic earnings per common share were computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per common share was computed similarly to the computation of basic earnings per share, except that the denominator is increased for the assumed exercise of dilutive options and other dilutive securities, including nonvested restricted stock, using the treasury stock method.
                                 
    Three Months Ended     Nine Months Ended  
    April 1,     April 2,     April 1,     April 2,  
    2006     2005     2006     2005  
     
Weighted average number of common shares outstanding used in computation of basic earnings per share
    21,132       20,994       21,069       20,910  
 
                               
Weighted average effect of nonvested restricted stock grants and assumed exercise of options
    179       328       159       452  
 
                               
     
Shares used in computation of diluted earnings per share
    21,311       21,322       21,228       21,362  
     
    Potential common shares related to the Company’s outstanding stock options and restricted stock grants of 492,000 and 84,000 for the three month periods, and 487,000 and 210,000 for the nine month periods ended April 1, 2006 and April 2, 2005, respectively, were excluded from the computation of diluted earnings per share. Inclusion of these shares would have been anti-dilutive as the exercise price of these shares exceeded market value.

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    Reclassifications
 
    Certain prior period amounts have been reclassified to conform with current year presentation. These reclassifications did not impact current or historical net income or stockholders’ equity.
 
2.   Comprehensive Income
 
    For the three and nine month periods ended April 1, 2006 and April 2, 2005, the components of comprehensive income were as follows:
                                 
    Three Months Ended     Nine Months Ended  
    April 1,     April 2,     April 1,     April 2,  
    2006     2005     2006     2005  
     
Net income
  $ 10,358     $ 9,950     $ 30,963     $ 28,745  
Other comprehensive income
                               
Foreign currency translation adjustments, net of tax
    (405 )     (1,205 )     6,331       9,233  
Net unrealized holding gain on derivative financial instruments, net of tax
    457       575       975       804  
     
Comprehensive income
  $ 10,410     $ 9,320     $ 38,269     $ 38,782  
     
3.   Goodwill and Intangible Assets
 
    The changes in the carrying amount of goodwill for the nine months ended April 1, 2006, by operating segment, are as follows:
                         
    United States     Canada     Total  
     
Balance as of July 2, 2005
  $ 286,313     $ 52,388     $ 338,701  
Goodwill acquired during the period, net of purchase price adjustments
    (229 )     3,388       3,159  
Other, primarily foreign currency translation
          2,782       2,782  
     
Balance as of April 1, 2006
  $ 286,084     $ 58,558     $ 344,642  
     

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    Information regarding the Company’s other intangible assets, which are included in other assets on the consolidated condensed balance sheet, are as follows:
                         
    As of April 1, 2006
    Carrying     Accumulated        
    Amount     Amortization     Net  
     
Customer contracts
    $105,683       $55,344       $50,339  
Non-competition agreements
    10,879       8,142       2,737  
     
Total
    $116,562       $63,486       $53,076  
     
                         
    As of July 2, 2005  
    Carrying     Accumulated        
    Amount     Amortization     Net  
     
Customer contracts
    $102,021       $47,821       $54,200  
Non-competition agreements
    10,829       7,239       3,590  
     
Total
    $112,850       $55,060       $57,790  
     
    The customer contracts include the combined value of the written service agreements and the related customer relationship. It has been determined that there is no significant separate value in any customer relationships.
 
    Amortization expense was $8,056 and $6,803 for the nine months ended April 1, 2006 and April 2, 2005, respectively. Estimated amortization expense for each of the five succeeding fiscal years based on the intangible assets as of April 1, 2006 is as follows:
         
 
2006 remaining
  $ 2,770  
2007
    10,610  
2008
    10,048  
2009
    6,329  
2010
    6,152  
2011
    5,482  
 
4.   Long-Term Debt
 
    On August 31, 2005, the Company amended and restated its revolving credit facility. The amended and restated revolving credit facility of $325,000 expires on August 31, 2010. As of April 1, 2006, borrowings outstanding under the revolving credit facility were $58,300. The unused portion of the revolver may be used for general corporate purposes, acquisitions, working capital needs and to provide up to $50,000 in letters of credit. As of April 1, 2006, letters of credit outstanding against the revolver were $33,140.
 
    Borrowings under the revolving credit facility bear interest at 0.55% to 1.50% over the London Interbank Offered Rate (“LIBOR”), or the Canadian prime rate for Canadian borrowings, based on a leverage ratio calculated on a quarterly basis. Advances outstanding as of April 1, 2006 bear interest at LIBOR plus 0.875%. The Company also pays a fee on the unused daily balance of the revolver based on a leverage ratio calculated each quarter.

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5.   Stock-Based Compensation
 
    The Company maintains Stock Option and Compensation Plans (the “Employee Plans”) to grant certain stock awards, including stock options at fair market value and restricted shares, to key employees of the Company. Exercise periods for stock options are limited to a maximum of 10 years and a minimum of one year. A maximum of 3,000,000 stock awards can be granted under the Employee Plans and 1,039,194 awards were available for grant as of April 1, 2006.
 
    The Company also maintains the 1996 Director Stock Option Plan (the “Directors’ Plan”). The Directors’ Plan provides for automatic grant of 3,000 nonqualified stock options (initial grants) to nonemployee directors of the Company as of the later of August 1996 or the date such individuals became directors of the Company and 1,500 nonqualified stock options on each subsequent annual shareholder meeting date and 500 stock grants on the first business day of each calendar year that each nonemployee director is serving. The Company has reserved 100,000 shares of Class A common stock for issuance under the Directors’ Plan. These options expire within 10 years of grant and are exercisable one year from the date of grant, except for the initial grants, of which, one-third of the total options are exercisable each year beginning with the first anniversary of the date of grant. The option price will be the average market price of the Class A common stock during the 10 business days preceding the date of grant.
 
    The Company has adopted the provisions of the Statement of Financial Accounting Standards No. 123 (revised 2004) “Share-Based Payment” (“SFAS 123(r)”) in the first quarter of fiscal 2006 under the modified retrospective transition method. SFAS 123(r) eliminates accounting for share-based compensation transactions using the intrinsic value method prescribed in APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and requires instead that the fair value of all share-based transactions, including grants of employee stock options, be recognized in the income statement. Under the modified retrospective transition method, all prior period financial statements were restated to recognize compensation cost in the amounts previously reported in the Notes to Consolidated Financial Statements.
 
    As a result of adopting SFAS 123(r) on July 3, 2005, income before income taxes and net income have been restated by $765 and $476 for the three month period, and $2,214 and $1,378 for the nine month period ended April 2, 2005, respectively. Basic and diluted earnings per share have been restated by $0.03 and $0.02 per share for the three month period, and $0.07 and $0.07 per share for the nine month period ended April 2, 2005, respectively. The beginning balances of deferred taxes, paid in capital and retained earnings have been restated by $6,013, $18,496 and $12,483, respectively, to recognize compensation cost for fiscal years 1996 through 2005 in the amounts previously reported in the Notes to Consolidated Financial Statements under provisions of SFAS No.123, “Accounting for Stock-Based Compensation.”

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    The following schedule summarizes activity in the plans for the three and nine month periods ended April 1, 2006:
                                 
    Stock Options  
                            Weighted  
    Employee     Directors’             Average  
    Plans     Plan     Grant Price     Exercise Price  
Three months:
                               
Outstanding at December 31, 2005
    1,358,744       60,500     $ 25.00 – 53.34     $ 35.81  
Granted
    2,350       1,500       38.09 – 38.34       38.25  
Exercised
    (32,349 )           27.95 – 36.41       31.55  
Canceled
    (5,662 )           27.95 – 46.00       39.33  
 
 
Outstanding at April 1, 2006
    1,323,083       62,000     $ 25.00 – 53.34     $ 35.87  
 
 
                               
 
Nine months:
                               
Outstanding at July 2, 2005
    1,161,547       55,000     $ 25.00 – 53.34     $ 34.21  
Granted
    260,015       15,000       38.09 – 42.97       42.08  
Exercised
    (66,026 )     (8,000 )     25.00 – 41.56       31.38  
Canceled
    (32,453 )           27.95 – 46.00       38.28  
 
 
Outstanding at April 1, 2006
    1,323,083       62,000     $ 25.00 – 53.34     $ 35.87  
 
 
Exercisable at April 1, 2006
    849,555       43,000     $ 25.00 – 53.34     $ 34.12  
 
    The following schedule summarizes the information related to stock options outstanding at April 1, 2006:
                                         
    Options Outstanding     Options Exercisable  
            Average                      
            Remaining     Weighted             Weighted  
   Range of   Number     Option Life     Average     Number     Average  
   Exercise Price   Outstanding     (Years)     Exercise Price     Exercisable     Exercise Price  
 
$16.50 – 25.00
    42,300       4.2     $ 25.00       42,300     $ 25.00  
25.01 – 37.00
    860,794       7.0       32.57       647,682       31.76  
37.01 – 53.34
    481,989       5.9       42.71       202,573       43.58  
 
 
    1,385,083       6.5     $ 35.87       892,555     $ 34.12  
 
    The weighted average fair value of options granted was $11.47 and $12.76 for the three month periods, and $10.90 and $10.96 for the nine month periods ended April 1, 2006 and April 2, 2005, respectively. The weighted average exercise price was $31.55 and $30.26 for the three month periods, and $31.38 and $29.37 for the nine month periods ended April 1, 2006 and April 2, 2005, respectively.
 
    The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used: risk-free interest rates of 4.40% and 3.88% for the three month periods, and 3.91% and 3.37% for the nine month periods ended April 1, 2006 and April 2, 2005, respectively; expected annual dividends of $0.07 per share; expected lives of 4 years and 5 years for the three and nine months ended April 1, 2006 and April 2, 2005, respectively; and expected volatility of 24.52% and 25.85% for the three month periods, and 24.46% and 26.41% for the nine month periods ended April 1, 2006 and April 2, 2005, respectively.

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    Compensation cost for stock options is recognized on a straight-line basis over the requisite service period of the award (or to an employee’s eligible retirement date, if earlier). Total compensation expense related to stock options was $600 and $765 for the three month periods, and $2,205 and $2,214 for the nine month periods ended April 1, 2006 and April 2, 2005, respectively.
 
    Under the Employee Plans, the Company grants restricted stock to key employees for nominal consideration. The restrictions lapse over periods up to seven years. The Company granted 450 shares of restricted stock in the three month period ended April 1, 2006 and 80,185 and 12,250 shares of restricted stock in the nine month periods ended April 1, 2006 and April 2, 2005, respectively. The weighted average grant date fair value per share of restricted stock granted during the three month period ended April 1, 2006 was $39.09, and for the nine month periods ended April 1, 2006 and April 2, 2005 was $42.57 and $36.41, respectively. Compensation expense is recognized as the restrictions are removed from the stock for the difference between the par value and fair market value as of the grant date. Total compensation expense related to restricted stock was $342 and $154 for the three month periods, and $855 and $677 for the nine month periods ended April 1, 2006 and April 2, 2005, respectively.
 
6.   Employee Benefit Plans
 
    The components of net periodic pension cost are as follows for the three months ended April 1, 2006 and April 2, 2005:
                                 
                    Supplemental Executive  
    Pension Plan     Retirement Plan  
    Three Months Ended     Three Months Ended  
    April 1,     April 2,     April 1,     April 2,  
    2006     2005     2006     2005  
     
Service cost
  $ 1,190     $ 948     $ 234     $ 198  
Interest cost
    809       681       188       171  
Expected return on assets
    (617 )     (545 )            
Prior service cost
    13       14       11       11  
Loss
    341       129       76       47  
     
Net periodic pension cost
  $ 1,736     $ 1,227     $ 509     $ 427  
     
    The components of net periodic pension cost are as follows for the nine months ended April 1, 2006 and April 2, 2005:
                                 
                    Supplemental Executive  
    Pension Plan     Retirement Plan  
    Nine Months Ended     Nine Months Ended  
    April 1,     April 2,     April 1,     April 2,  
    2006     2005     2006     2005  
     
Service cost
  $ 3,571     $ 2,843     $ 702     $ 588  
Interest cost
    2,427       2,042       565       509  
Expected return on assets
    (1,850 )     (1,634 )            
Prior service cost
    39       42       32       32  
Loss
    1,021       387       228       151  
     
Net periodic pension cost
  $ 5,208     $ 3,680     $ 1,527     $ 1,280  
     

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7.   Segment Information
 
    The Company has two operating segments, United States and Canada, which have been identified as components of the Company that are reviewed by the Company’s Chief Executive Officer to determine resource allocation and evaluate performance. Each operating segment derives revenues from the branded identity apparel and facility services industry, which includes garment rental and non-apparel items such as floor mats, dust mops, wiping towels, selected linen items and several restroom products. No one customer’s transactions account for 1.0% or more of the Company’s revenues.
 
    The accounting policies of the segments are the same as those described in the summary of significant accounting policies (see Note 1). Corporate expenses are allocated to the segments based on segment revenue. Income from operations for the three and nine months ended April 1, 2006, for United States operating segment, includes a provision of $2,050 related to the pending resolution of two specific legal matters. The Company evaluates performance based on income from operations. Financial information by geographic location for the three and nine month periods ended April 1, 2006 and April 2, 2005 is as follows:
                         
    United              
For the Three Months Ended   States     Canada     Total  
 
Third Quarter Fiscal Year 2006:
                       
Revenues
  $ 186,965     $ 39,176     $ 226,141  
Income from operations
    10,254       6,339       16,593  
Property, plant and equipment additions, net
    9,144       788       9,932  
Depreciation and amortization expense
    9,389       1,494       10,883  
Third Quarter Fiscal Year 2005:
                       
Revenues
  $ 170,069     $ 33,741     $ 203,810  
Income from operations
    12,510       6,460       18,970  
Property, plant and equipment additions, net
    4,884       1,215       6,099  
Depreciation and amortization expense
    8,976       1,431       10,407  
 
                         
    United              
For the Nine Months Ended   States     Canada     Total  
 
Fiscal Year 2006:
                       
Revenues
  $ 541,459     $ 111,978     $ 653,437  
Income from operations
    35,419       19,093       54,512  
Property, plant and equipment additions, net
    24,320       2,094       26,414  
Depreciation and amortization expense
    27,653       4,473       32,126  
Fiscal Year 2005:
                       
Revenues
  $ 489,113     $ 92,264     $ 581,377  
Income from operations
    36,263       17,900       54,163  
Property, plant and equipment additions, net
    7,119       3,075       10,194  
Depreciation and amortization expense
    26,683       4,043       30,726  
 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Unaudited)
Overview
G&K Services, Inc., founded in 1902 and headquartered in Minnetonka, Minnesota, is a market leader in providing branded identity apparel and facility services programs that enhance image and safety in the workplace. We serve a wide variety of North American industrial, service and high-technology companies providing them with rented uniforms and facility services products such as floor mats, dust mops, wiping towels, restroom supplies and selected linen items. We also sell uniforms and other apparel items to customers in our direct sale programs. Industry-wide North American rental market revenues are approximately $6.5-$7.0 billion annually, while the portion of the industry-wide revenues targeted by us is approximately $4.5-$5.0 billion in size.
In the third quarter of fiscal year 2006 our rental business increased to $201.6 million, up 7.2 percent over the prior-year quarter. Direct sale revenue increased to $24.6 million, up 56.1 percent over the prior-year quarter, driven almost entirely by organic growth. The growth of direct sale revenue for the quarter was driven primarily by revenue from Lion Uniform Group. Earnings per diluted share totaled $0.49 for the quarter, up 4.3 percent from $0.47 during the prior-year quarter. The increase in earnings were due to higher sales and a lower effective tax rate, partially offset by the impact of higher costs, continued investment in strategic initiatives, costs associated with the accelerated new account growth, reserves established for the pending resolution of two specific legal matters and increased employee benefit costs which includes healthcare and worker’s compensation costs.
Our industry is consolidating from many family owned and small local providers to several large providers. We are participating in this industry consolidation. Our goal is to build a national footprint and, we accordingly, place strategic value on acquisitions which expand our geographic presence.
We made two small acquisitions during the first nine months of fiscal 2006. In October, 2005, we acquired certain assets from an organization in Ontario, Canada, a uniform and textile service company serving customers in Sarnia, Ontario, Detroit, Michigan and St. Louis, Missouri. This purchase expands and enhances our uniform and textile rental business in North America. Also in October, 2005, we acquired certain customer contracts from an organization, serving customers in the southeast United States. This purchase enhances our geographic coverage in North America.
The pro forma effect of these acquisitions, had they been acquired at the beginning of each fiscal year, were not material, either individually or in aggregate. The total purchase price consideration, including related acquisition costs of the transaction was $11.3 million. The total purchase price exceeded the estimated fair values of assets acquired and liabilities assumed by $3.2 million.
Critical Accounting Policies
The discussion of the financial condition and results of operations are based upon the consolidated condensed financial statements, which have been prepared in conformity with U.S. generally accepted accounting principles. As such, management is required to make certain estimates, judgments and assumptions that are believed to be reasonable based on the information available. These estimates and assumptions affect the reported amount of assets and liabilities, revenues and expenses, and disclosure of contingent assets and liabilities at the date of the financial statements. Actual results may differ from these estimates under different assumptions or conditions.
Critical accounting policies are defined as those that are reflective of significant judgments and estimates, the most important and pervasive accounting policies used and the areas most sensitive to material changes from external factors. See Note 1 to the consolidated condensed financial statements for additional discussion of the application of these and other accounting policies.

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Revenue Recognition and Allowance for Doubtful Accounts
Our rental operations business is largely based on written service agreements whereby we agree to collect, launder and deliver uniforms and other related products. The service agreements provide for weekly billing upon completion of the laundering process and delivery to the customer. Accordingly, we recognize revenue from rental operations in the period in which the services are provided. Revenue from rental operations also includes billings to customers for lost or abused merchandise. Direct sale revenue is recognized in the period in which the product is shipped. Estimates are used in determining the collectibility of billed accounts receivable. Management analyzes specific accounts receivable and historical bad debt experience, customer credit worthiness, current economic trends and the age of outstanding balances when evaluating the adequacy of the allowance for doubtful accounts. Significant management judgments and estimates are used in connection with establishing the allowance in any accounting period. While we have been consistent in applying our judgments and in making our estimates over relevant periods, material differences may result in the amount and timing of bad debt expense recognition for any given period if management makes different judgments or utilizes different estimates.
Inventories
Our inventories consist of new goods and rental merchandise in service. Estimates are used in determining the likelihood that new goods on hand can be sold to customers or used in rental operations. Historical inventory usage and current revenue trends are considered in estimating both obsolete and excess inventories. New goods are stated at lower of cost or market, net of any reserve for obsolete or excess inventory. Merchandise placed in service to support rental operations is amortized into cost of rental operations over the estimated useful lives of the underlying inventory items, primarily on a straight-line basis, which results in a matching of the cost of the merchandise with the weekly rental revenue generated by the merchandise. Estimated lives of rental merchandise in service range from nine months to three years. In establishing estimated lives for merchandise in service, management considers historical experience and the intended use of the merchandise. Material differences may result in the amount and timing of operating profit for any period if management makes different judgments or utilizes different estimates.
Goodwill, Intangibles and Other Long-Lived Assets
As required under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”), goodwill is separately disclosed from other intangible assets on the balance sheet and no longer amortized. SFAS 142 also requires that companies test goodwill for impairment on an annual basis and when events occur or circumstances change that would more likely than not reduce the fair value of the reporting unit to which goodwill is assigned below its carrying amount. Our evaluation follows the two step impairment test prescribed by SFAS 142. First we assess whether the fair value of the reporting units exceeds the carrying amount of the unit including goodwill. Our evaluation considers changes in the operating environment, competitive position, market trends, operating performance, quoted market prices for our equity securities and fair value models and research prepared by independent analysts. If the carrying amount of a reporting unit exceeded its fair value, we would perform a second test to measure the amount of impairment loss, if any. Management completes its annual impairment tests in the fourth quarter of each fiscal year. There have been no impairments of goodwill or definite-lived intangible assets in fiscal 2005 and we believe there have been no events or circumstances through the first nine months of fiscal 2006 that would indicate that there may have been any impairment of goodwill or definite-lived assets. Future events could cause management to conclude that impairment indicators exist and that goodwill and other intangibles associated with acquired businesses are impaired. Any resulting impairment loss could have a material impact on our financial condition and results of operations.
Property, plant and equipment and definite-lived intangible assets are depreciated or amortized over their useful lives. Useful lives are based on management estimates of the period that the assets will add value. Long-lived assets and definite-lived intangible assets are evaluated for impairment whenever events and circumstances indicate an asset may be impaired. There have been no material write-downs of long-lived assets or definite-lived intangible assets in fiscal 2005 or through the first nine months of fiscal 2006.

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Insurance
We self-insure for certain obligations related to health, workers’ compensation and auto and general liability programs. We purchase stop-loss insurance policies to protect us from catastrophic losses. Estimates are used in determining the potential liability associated with reported claims and for losses that have occurred, but have not been reported. Management estimates consider historical claims experience, escalating medical cost trends, expected timing of claim payments and an actuarial analysis provided by a third party. Changes in the cost of medical care, our ability to settle claims and the estimates and judgments used by management could have a material impact on the amount and timing of expense for any period.
Income Taxes
In the normal course of business, we are subject to audits from federal, state, Canadian provincial and other tax authorities regarding various tax liabilities. These audits may alter the timing or amount of taxable income or deductions, or the allocation of income among tax jurisdictions. The amount ultimately paid upon resolution of issues raised may differ from the amount accrued. We believe that taxes accrued on our consolidated balance sheets fairly represent the amount of future tax liability due.
We utilize income tax planning to reduce our overall cost of income taxes. Upon audit, it is possible that certain strategies might be disallowed resulting in an increased liability for income taxes. We believe that the provision for liabilities resulting from the implementation of income tax planning is appropriate. To date, we have not experienced an examination by governmental revenue authorities that would lead management to believe that our past provisions for exposures related to income tax planning are not appropriate.
Deferred income taxes are determined in accordance with SFAS No. 109, “Accounting for Income Taxes.” Deferred tax assets and liabilities are recorded for temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, using statutory rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the results of operations in the period that includes the enactment date. We record valuation allowances to reduce deferred tax assets when it is more likely than not that some portion of the asset may not be realized. We evaluate our deferred tax assets and liabilities on a periodic basis. We believe that we have adequately provided for our future tax consequences based upon current facts and circumstances.
Results of Operations
The percentage relationships to net sales of certain income and expense items for the three and nine month periods ended April 1, 2006 and April 2, 2005, and the percentage changes in these income and expense items between periods are presented in the following table:
                                                 
    Three Months     Nine Months     Percentage  
    Ended     Ended     Change  
                                    Three Months     Nine Months  
    April 1,     April 2,     April 1,     April 2,     FY 2006     FY 2006  
    2006     2005     2006     2005     vs. FY 2005     vs. FY 2005  
Revenues:
                                               
Rental
    89.1 %     92.3 %     91.1 %     94.2 %     7.2 %     8.7 %
Direct
    10.9       7.7       8.9       5.8       56.1       72.4  
                     
Total revenues
    100.0       100.0       100.0       100.0       11.0       12.4  
 
                                               
Expenses:
                                               
Cost of rental sales
    65.2       63.4       64.5       63.3       10.3       10.7  
Cost of direct sales
    71.8       76.3       71.9       74.7       47.0       65.8  
                     
Total cost of sales
    65.9       64.3       65.1       64.0       13.6       14.4  
 
                                               
Selling and administrative
    22.0       21.3       21.7       21.4       14.6       13.4  
Depreciation and amortization
    4.8       5.1       4.9       5.3       4.6       4.6  
                     
Income from operations
    7.3       9.3       8.3       9.3       (12.5 )     0.6  
 
                                               
Interest expense
    1.5       1.4       1.4       1.4       17.4       20.2  
                     
Income before income taxes
    5.8       7.9       6.9       7.9       (17.9 )     (2.8 )
Provision for income taxes
    1.2       3.0       2.2       3.0       (53.7 )     (20.2 )
                     
 
                                               
Net income
    4.6 %     4.9 %     4.7 %     4.9 %     4.1 %     7.7 %
                     

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Three months ended April 1, 2006 compared to three months ended April 2, 2005
Revenues. Total revenues in the third quarter of fiscal 2006 increased 11.0% to $226.1 million from $203.8 million in the third quarter of fiscal 2005. Rental revenue increased $13.5 million in the third quarter, or 7.2%. The organic industrial rental growth rate was approximately 3.5%, an improvement from 1.5% in the same period of fiscal 2005. Organic industrial rental revenue has improved due to growth initiatives and in particular, accelerated new account growth. These improvements were slightly offset by lost revenues related to hurricanes.
Direct sale revenue increased 56.1% to $24.6 million in the third quarter of fiscal 2006 compared to $15.7 million in the same period of fiscal 2005. The organic direct sale growth rate during the same period was approximately 54.0%. The increase in organic direct sale revenue was due primarily to the installation of a new uniform program with a major customer in our Lion Uniform Group, along with increased revenue from a number of other customers.
Organic growth rates are calculated using industrial rental and direct sale revenue, respectively, adjusted for foreign currency exchange rate differences and revenue from newly acquired business compared to prior-period results with comparable adjustments. We believe that the organic growth rates better reflect the growth of our existing industrial rental and direct sale business and are therefore useful in analyzing our financial condition and results of operations.
Cost of Rental and Direct Sale. Cost of rental operations increased 10.3% to $131.4 million in the third quarter of fiscal 2006 from $119.1 million in the same period of fiscal 2005. Gross margin from rental sales decreased to 34.8% in the third quarter of fiscal 2006 from 36.6% in the same period of fiscal 2005. Rental gross margins declined due to higher energy costs and costs associated with new customer growth. These costs were partially offset by operational initiatives focused on lower merchandise and production costs as well as the impact of higher pricing.
Cost of direct sales increased 47.0% to $17.7 million in the third quarter of fiscal 2006 from $12.0 million in the same period of fiscal 2005. Gross margin from direct sales increased to 28.2% in the third quarter of fiscal 2006 from 23.7% in the third quarter of fiscal 2005. The increase in gross margin was primarily due to improved efficiencies from higher volume.
Selling and Administrative. Selling and administrative expenses increased to $49.6 million in the third quarter of fiscal 2006 from $43.3 million in the same period of fiscal 2005. As a percentage of total revenues, selling and administrative expenses increased to 22.0% in the third quarter of fiscal 2006 from 21.3% in the third quarter of fiscal 2005. Total selling and administrative expenses increased due to the establishment of $2.1 million of reserves for two specific legal matters, the continued investment in growth oriented initiatives, information technology and productivity improvements and sales expenses associated with new account growth.
Depreciation and Amortization. Depreciation and amortization expense increased 4.6% to $10.9 million in the third quarter of fiscal 2006 from $10.4 million in the same period of fiscal 2005. As a percentage of total revenues, depreciation and amortization expense decreased to 4.8% in the third quarter of fiscal 2006 from 5.1% in the third quarter of fiscal 2005. Capital expenditures, excluding acquisition of businesses, were $9.9 million in the third quarter of fiscal 2006 compared to $6.1 million in the prior year’s quarter with similar adjustments.
Interest Expense. Interest expense was $3.4 million in the third quarter of fiscal 2006, up from $2.9 million in the same period of fiscal 2005. The increase was due to increased debt levels in conjunction with the acquisition of business assets in the previous twelve months and an increase in interest rates.
Provision for Income Taxes. Our effective tax rate decreased to 21.5% in the third quarter of fiscal 2006 from 38.1% in the same period of fiscal 2005 due to a reduction in taxes previously provided for as a result of the expiration of certain tax statutes and adjustments resulting from the final calculation and filing of the Company’s fiscal 2005 tax returns.

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Nine months ended April 1, 2006 compared to nine months ended April 2, 2005
Revenues. Total revenues for the first nine months of fiscal 2006 increased 12.4% to $653.4 million from $581.4 million for the same period of fiscal 2005. Rental revenue increased $47.5 million in the first nine months, or 8.7%. The organic industrial rental growth rate was approximately 3.5%. Organic industrial rental revenue has improved due to growth initiatives and in particular, accelerated new account growth and improved customer retention. These improvements were slightly offset by lost revenues associated with hurricanes.
Direct sale revenue increased 72.4% to $58.5 million in the first nine months of fiscal 2006 compared to $33.9 million in the same period of fiscal 2005. The organic direct sale growth rate was approximately 29.5%. The increase in organic direct sale revenue is largely due to garment sales through our rental operations including our annual outerwear promotion and growth in our Lion Uniform Group which was due primarily to the installation of a new uniform program with a major customer.
Cost of Rental and Direct Sale. Cost of rental operations increased 10.7% to $383.6 million in the first nine months of fiscal 2006 from $346.6 million in the same period of fiscal 2005. Gross margin from rental sales decreased to 35.5% in the first nine months of fiscal 2006 from 36.7% in the same period of fiscal 2005. Higher energy costs, costs associated with new customer growth, the impact of hurricanes on the operations and costs related to acquisitions, primarily in Canada were partially offset by numerous operational initiatives as well as the impact of higher pricing.
Cost of direct sales increased 65.8% to $42.0 million in the first nine months of fiscal 2006 from $25.3 million in the same period of fiscal 2005. Gross margin from direct sales increased to 28.1% in the first nine months of fiscal 2006 from 25.3% in the same period of fiscal 2005. The increase in margins was primarily due to improved cost leverage resulting from greater sales volume.
Selling and Administrative. Selling and administrative expenses increased 13.4% to $141.2 million in the first nine months of fiscal 2006 from $124.6 million in the same period of fiscal 2005. As a percentage of total revenues, selling and administrative expenses increased to 21.7% in the first nine months of fiscal 2006 from 21.4% in the same period of fiscal 2005. The increase as a percent of revenue was due to the establishment of a reserve of $2.1 million for two specific legal matters, continued investment in growth initiatives and increased staffing to support long-term growth and strategic initiatives. These costs were partially offset as a percent of revenue by additional leverage provided by incremental revenue growth.
Depreciation and Amortization. Depreciation and amortization expense increased 4.6% to $32.1 million in the first nine months of fiscal 2006 from $30.7 million in the same period of fiscal 2005. As a percentage of total revenues, depreciation and amortization expense decreased to 4.9% in the first nine months of fiscal 2006 from 5.3% in the same period of fiscal 2005. Capital expenditures, excluding acquisition of businesses, were $26.4 million in the first nine months of fiscal 2006 compared to $10.2 million in the same period of fiscal 2005. The increase in capital expenditures was driven primarily by the addition of a new facility and improvements to existing facilities. These additions were partially offset by disposals of fixed assets.
Income from Operations. Hurricanes in the first nine months of fiscal 2006 had a negative impact on net operating margins of approximately 0.3%.
Interest Expense. Interest expense was $9.7 million in the first nine months of fiscal 2006, up from $8.1 million in the same period of fiscal 2005. The increase was due to increased debt levels in conjunction with the acquisition of business assets in the previous twelve months and an increase in interest rates.

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Provision for Income Taxes. Our effective tax rate decreased to 30.9% in the first nine months of fiscal 2006 from 37.6% in the same period of fiscal 2005 due to a reduction in taxes previously provided for as a result of the expiration of certain tax statutes and adjustments resulting from a favorable mix of income earned in various taxing jurisdictions and the final calculation and filing of the Company’s fiscal 2005 tax returns.
Liquidity, Capital Resources and Financial Condition
Our primary sources of cash are net cash flows from operations and borrowings under our debt arrangements. Primary uses of cash are interest payments on indebtedness, capital expenditures, acquisitions and general corporate purposes.
Operating Activities. Net cash provided by operating activities was $50.0 million in the first nine months of fiscal 2006 and $44.4 million in the same period of fiscal 2005. This increase is due primarily to cash provided from net income and changes in operating items.
Working capital at April 1, 2006 was $142.4 million, up 37.2% from $103.8 million at July 2, 2005. The increase in working capital is largely due to the increases in our accounts receivable and inventory in connection with the overall growth of the Company.
Investing Activities. Net cash used in investing activities was $39.4 million in the first nine months of fiscal 2006 and $85.1 million in the same period of fiscal 2005. In fiscal 2006, cash was primarily used for acquisition of property plant and equipment additions and business assets. In fiscal 2005, cash was largely used for acquisition of business assets and property plant and equipment additions, partially offset by proceeds from the sale of selected plant assets. Proceeds on these sales totaled $5.6 million.
Financing Activities. Cash used for financing activities was $4.3 million in the first nine months of fiscal 2006 and cash provided by financing activities was $23.1 million in the same period of fiscal 2005. Cash used in fiscal 2006 was for repayments of long-term debt. Cash provided in fiscal 2005 was primarily related to the short-term borrowings in connection with the acquisition of business assets. The Company paid dividends of $1.1 million during the first nine months of fiscal 2006.
As of April 1, 2006, borrowings outstanding under the revolving credit facility were $58.3 million. The unused portion of the revolver may be used for general corporate purposes, acquisitions, working capital needs and to provide up to $50 million in letters of credit. As of April 1, 2006, letters of credit outstanding against the revolver were $33.1 million.
Borrowings under the revolving credit facility bear interest at 0.55% to 1.50% over the London Interbank Offered Rate (“LIBOR”), or the Canadian prime rate for Canadian borrowings, based on a leverage ratio calculated on a quarterly basis. Advances outstanding as of April 1, 2006 bear interest at LIBOR plus 0.875%. We also pay a fee on the unused daily balance of the revolver based on a leverage ratio calculated each quarter.
Cash Obligations. Under various agreements, we are obligated to make future cash payments in fixed amounts. These include payments under the variable rate term loan and revolving credit facility, the fixed rate term loan, capital lease obligations and rent payments required under non-cancelable operating leases with initial or remaining terms in excess of one year.

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The following table summarizes our fixed cash obligations as of April 1, 2006 for the fiscal years ending June (in thousands):
                                                         
                                            2011 and        
    2006                                     There-        
    Remaining     2007     2008     2009     2010     after     Total  
Variable rate revolving credit facility
  $     $     $     $     $ 58,300     $     $ 58,300  
Variable rate senior notes
                                  75,000       75,000  
Variable rate senior loan
                50,000                         50,000  
Fixed rate notes
          7,143       7,143       7,143       7,143       7,142       35,714  
Other debt arrangements, including capital leases
    38       10,777       120       42                   10,977  
Operating leases
    4,546       16,387       13,404       9,070       6,541       6,014       55,962  
 
Total contractual cash obligations
  $ 4,584     $ 34,307     $ 70,667     $ 16,255     $ 71,984     $ 88,156     $ 285,953  
 
Also, at April 1, 2006, we had stand-by letters of credit totaling $33.1 million issued and outstanding, primarily in connection with our property and casualty insurance programs and to provide security in connection with a promissory note. No amounts have been drawn upon these letters of credit.
At April 1, 2006, we had available cash on hand of $22.0 million and approximately $234 million of available capacity under our revolving credit facility when considering current outstanding borrowings and letters of credit. We anticipate that we will generate sufficient cash flows from operations to satisfy our cash commitments and capital requirements for fiscal 2006 and to reduce the amounts outstanding under the revolving credit facility; however, we may utilize borrowings under the revolving credit facility to supplement our cash requirements from time to time. We estimate that capital expenditures in fiscal 2006 will be approximately $30 million to $35 million.
The amount of cash flow generated from operations is subject to a number of risks and uncertainties. In fiscal 2006, we may actively seek and consider acquisitions of business assets; the consummation of any acquisition could affect our liquidity profile and level of outstanding debt. We believe that our earnings and cash flow from operations, existing credit facilities and our ability to obtain additional debt or equity capital, if necessary, will be adequate to finance acquisition opportunities.
Pension Obligations
We account for our defined benefit pension plan using Statement of Financial Accounting Standards No. 87 “Employer’s Accounting for Pensions” (“SFAS 87”). Under SFAS 87, pension expense is recognized on an accrual basis over employees’ approximate service periods. Pension expense calculated under SFAS 87 is generally independent of funding decisions or requirements. We recognized expense for our defined benefit pension plan of $1.7 million in the third quarter of fiscal 2006 and $1.2 million in the same period of fiscal 2005. At July 2, 2005, the fair value of our pension plan assets totaled $29.1 million.
The calculation of pension expense and the corresponding liability requires the use of a number of assumptions, including the expected long-term rate of return on plan assets and the assumed discount rate. Changes in these assumptions can result in different expense and liability amounts, and future actual experience can differ from these assumptions. Pension expense increases as the expected rate of return on pension plan assets decreases. At July 2, 2005, we estimated that the pension plan assets will generate a long-term rate of return of 8.0%. This rate was

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developed by evaluating input from our actuary as well as long-term inflation assumptions. The expected long-term rate of return on plan assets at July 2, 2005 is based on an allocation of U.S. equities and U.S. fixed income securities. Decreasing the expected long-term rate of return by 0.5% (from 8.0% to 7.5%) would increase our estimated fiscal 2006 pension expense by approximately $0.1 million. Pension liability and future pension expense increase as the discount rate is reduced. We discounted future pension obligations using a rate of 5.50% at July 2, 2005. The discount rate is determined based on the current rates earned on high quality long-term bonds. Decreasing the discount rate by 0.5% (from 5.50% to 5.00%) would have increased our accumulated benefit obligation at July 2, 2005 by approximately $4.1 million and increased the estimated fiscal 2006 pension expense by approximately $1.1 million.
Future changes in plan asset returns, assumed discount rates and various other factors related to the participants in our pension plan will impact our future pension expense and liabilities. We cannot predict with certainty what these factors will be in the future.
Impact of Inflation
In general, management believes that our results of operations are not dependent on moderate changes in the inflation rate. Historically, we have been able to manage the impact of more significant changes in inflation rates through our customer relationships, customer agreements that generally provide for price increases consistent with the rate of inflation or 5.0%, whichever is greater, and continued focus on improvements of operational productivity.
Significant increases in energy costs, specifically natural gas and gasoline, can materially affect our results of operations and financial condition. Currently, energy costs represent approximately 5% of our total revenue.
Litigation
We are involved in a variety of legal actions relating to personal injury, employment, environmental and other legal matters that arise in the normal course of business. These legal actions include lawsuits that challenge the practice of charging for certain environmental services on invoices and certain contract disputes. During the three months ended April 1, 2006, the Company recorded a provision of $2.1 million related to the pending resolution of two specific legal matters. None of these legal actions are expected to have a material adverse effect on our results of operations or financial position.
Stock-Based Compensation
We have adopted the provisions of the Statement of Financial Accounting Standards No. 123 (revised 2004) “Share-Based Payment” (“SFAS 123(r)”) in the first quarter of fiscal 2006 under the modified retrospective transition method. SFAS 123(r) eliminates accounting for share-based compensation transactions using the intrinsic value method prescribed in APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and requires instead that the fair value of all share-based transactions, including grants of employee stock options, be recognized in the income statement. Under the modified retrospective transition method, all prior period financial statements were restated to recognize compensation cost in the amounts previously reported in the Notes to Consolidated Financial Statements.
As a result of our adopting SFAS 123(r) on July 3, 2005, income before income taxes and net income have been restated by $0.8 million and $0.5 million for the three month period, and $2.2 million and $1.4 million for the nine month period ended April 2, 2005, respectively. Basic and diluted earnings per share have been restated by $0.03 and $0.02 per share for the three month period, and $0.07 and $0.07 per share for the nine month period ended April 1, 2006, respectively. The beginning balances of deferred taxes, paid in capital and retained earnings have been restated by $6.0 million, $18.5 million and $12.5 million, respectively, to recognize compensation cost for fiscal years 1996 through 2005 in the amounts previously reported in the Notes to Consolidated Financial Statements under provisions of SFAS No.123, “Accounting for Stock-Based Compensation.”
We estimate the fair value of each option grant on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used: risk-free interest rates of 4.40% and 3.88% for the three month periods, and 3.91% and 3.37% for the nine month periods ended April 1, 2006 and April 2, 2005,

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respectively; expected annual dividends of $0.07 per share; expected lives of 4 years and 5 years for the three and nine months ended April 2, 2006 and April 2, 2005, respectively; and expected volatility of 24.52% and 25.85% for the three month periods, and 24.46% and 26.41% for the nine month periods ended April 1, 2006 and April 2, 2005, respectively.
We recognize compensation cost for stock options on a straight-line basis over the requisite service period of the award (or to an employee’s eligible retirement date, if earlier). Total compensation expense related to stock options was $0.6 million and $0.8 million for the three month periods, and $2.2 million and $2.2 million for the nine month periods ended April 1, 2006 and April 2, 2005, respectively.
Under the Employee Plans, we grant restricted stock to key employees for nominal consideration. The restrictions lapse over periods up to seven years. We granted 450 shares of restricted stock in the three month period ended April 1, 2006 and 80,185 and 12,250 shares of restricted stock in the nine month periods ended April 1, 2006 and April 2, 2005, respectively. The weighted average grant date fair value per share of restricted stock granted during the three month period ended April 1, 2006 was $39.09, and for the nine month periods ended April 1, 2006 and April 2, 2005 was $42.57 and $36.41, respectively. We recognize compensation expense as the restrictions are removed from the stock for the difference between the par value and fair market value as of the grant date. Total compensation expense related to restricted stock was $0.3 million and $0.2 million for the three month periods, and $0.9 million and $0.7 million for the nine month periods ended April 1, 2006 and April 2, 2005, respectively.
Cautionary Statements Regarding Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 (the “Act”) provides companies with a “safe harbor” when making forward-looking statements as a way of encouraging them to furnish their shareholders with information regarding expected trends in their operating results, anticipated business developments and other prospective information. Statements made in this report concerning our intentions, expectations or predictions about future results or events are “forward-looking statements” within the meaning of the Act. These statements reflect our current expectations or beliefs, and are subject to risks and uncertainties that could cause actual results or events to vary from stated expectations, which could be material and adverse. Given that circumstances may change, and new risks to the business may emerge from time to time, having the potential to negatively impact our business in ways we could not anticipate at the time of making a forward-looking statement, you are cautioned not to place undue reliance on these statements, and we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Some of the factors that could cause actual results or events to vary from stated expectations include, but are not limited to, the following: unforeseen operating risks; the effects of overall economic conditions and employment levels; fluctuations in costs of insurance and energy; acquisition integration costs; the performance of acquired businesses; preservation of positive labor relationships; competition, including pricing, within the branded identity apparel and facility services industry; unplanned litigation or regulatory proceedings; and the availability of capital to finance planned growth. Additional information concerning potential factors that could effect future financial results is included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 2, 2005.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Interest Rate Risk
We are subject to market risk exposure related to changes in interest rates. We use financial instruments, including fixed and variable rate debt, as well as interest rate swaps to manage interest rate risk. Interest rate swap agreements are entered into for periods consistent with related underlying exposures and do not constitute positions independent of those exposures. Assuming the current level of borrowings, a one percentage point increase in interest rates under these borrowings would have increased our interest expense for the third quarter of fiscal 2006 by approximately $0.3 million. This estimated exposure considers the mitigating effects of interest rate swap agreements outstanding at April 1, 2006 on the change in the cost of variable rate debt.
Energy Cost Risk
We use derivative financial instruments to manage the risk that changes in gasoline cost will affect the future financial results of the Company. We purchase gasoline futures contracts to effectively hedge a portion of anticipated actual gasoline purchases. The gasoline futures contracts are reflected at fair value in the consolidated condensed balance sheet and the related gains or losses on these contracts are deferred in stockholders’ equity (as a component of other comprehensive income) or in the statements of operations depending on the effectiveness of the hedge. Upon settlement of each contract, the actual gain or loss is reflected in gasoline expense. The current fair market value of all outstanding contracts at April 1, 2006 is a negative $0.1 million.
Foreign Currency Exchange Risk
We have a significant foreign subsidiary located in Canada. The assets and liabilities of this subsidiary are denominated in the Canadian dollar and as such are translated into U.S. dollars at the exchange rate in effect at the balance sheet date. Results of operations are translated using the average exchange rates throughout the period. The effect of exchange rate fluctuations on translation of assets and liabilities are recorded as a component of stockholders’ equity. Gains and losses from foreign currency transactions are included in results of operations.
ITEM 4. CONTROLS AND PROCEDURES
Based on our management’s evaluation (with the participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.
There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect theses controls subsequent to the date of the evaluation referenced above. There was no change in our internal control over financial reporting during the period covered by this Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II
OTHER INFORMATION
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
    At the beginning of the third quarter, the Company had two classes of voting securities outstanding: Class A Common Stock, $0.50 par value per share, and Class B Common Stock, $0.50 par value per share. Each share of Class A Common Stock is entitled to one vote, and each share of Class B Common Stock was entitled to 10 votes, in each case, on matters submitted to a vote of the Company’s shareholders. Class A Common Stock may be acquired by holders of Class B Common Stock upon conversion of their shares of Class B Common Stock, at any time, on the basis of one share of Class A Common Stock for each share of Class B Common Stock converted. On February 3, 2006 and March 23, 2006 the Company issued 1,208,256 and 67,573 shares of Class A Common Stock, respectively, to three of its shareholders upon the conversion by such shareholders of a like number of shares of Class B Common Stock. The Company received no proceeds from such issuance. The Company relied on available exemptions from registration to complete this transaction.
ITEM 6. EXHIBITS
a. Exhibits
31.1 Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-15(e)/15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-15(e)/15d-15(e) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  G&K SERVICES, INC.
(Registrant)
 
 
Date: May 5, 2006       By:     /s/ Jeffrey L. Wright    
    Jeffrey L. Wright   
    Senior Vice President
and Chief Financial Officer
(Principal Financial Officer) 
 
 
     
       By:     /s/ Michael F. Woodard    
    Michael F. Woodard   
    Vice President and Controller
(Principal Accounting Officer) 
 
 

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