10-Q 1 ee_2qf.txt SECOND QUARTER FY 2001 10-Q ============================================================================= UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Thirteen Weeks Ended March 2, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File No. 1-12188 SODEXHO MARRIOTT SERVICES, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 52-0936594 --------------------------------- --------------------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 9801 Washingtonian Boulevard, Gaithersburg, Maryland 20878 ---------------------------------------------------- -------------- (Address of principal executive offices) (Zip Code) (301) 987-4500 --------------------------------------------------- (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 [ ] Shares outstanding Class at April 10, 2001 ------------------- ------------------ Common Stock $1.00 par value per share 63,610,236 ============================================================================= SODEXHO MARRIOTT SERVICES, INC. FORM 10-Q INDEX

OVERVIEW Sodexho Marriott Services, Inc. (the "Company") is the leading provider in North America of outsourced food and facilities management services to businesses, health care facilities, colleges and universities, and primary and secondary schools. Food services include food and beverage procurement, preparation and menu planning, as well as the operation and maintenance of food service and catering facilities, generally on a client's premises. Facilities management services include plant maintenance, energy management, grounds keeping, housekeeping and custodial services. FORWARD-LOOKING STATEMENTS This report by the Company contains forward-looking statements within the meaning of the federal securities laws. These statements are based on the Company's current expectations and relate to anticipated future events that are not historical facts, such as the Company's business strategies and their intended results. The forward-looking statements included in this report are subject to numerous risks and uncertainties that could cause the Company's future activities and results of operations to differ materially from those expressed or implied in the forward-looking statements. These risks and uncertainties, which are further discussed in Management's Discussion and Analysis of Results of Operations and Financial Condition and other parts of this report, include: (i) the ability of the Company to adapt to various changes, including changes in its structure, senior management and in its relationship with its largest shareholder--Sodexho Alliance, S.A., (ii) the potential adverse impact of the Company's substantial indebtedness, including restrictions and remedies available within the related debt covenants, (iii) the ability of the Company to attract, hire, train and retain competent management personnel, (iv) competition in the food services and facilities management industries, (v) the effects of general economic conditions, including the record low level of unemployment, (vi) the ability of the Company to retain clients and obtain new clients on satisfactory terms, and other factors described from time to time in the Company's filings with the Securities and Exchange Commission including those set forth in Exhibit 99 filed herein. As a result of these risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements included in this report or that may be made elsewhere from time to time by, or on behalf of, the Company. The Company assumes no obligation to update any forward-looking statements. -1- PART I FINANCIAL INFORMATION (UNAUDITED) ITEM 1. FINANCIAL STATEMENTS Sodexho Marriott Services, Inc. Condensed Consolidated Statements of Income ($ in millions, except per share amounts) (Unaudited)

See notes to the condensed consolidated financial statements. -2- Sodexho Marriott Services, Inc. Condensed Consolidated Balance Sheets ($ in millions) (Unaudited)

See notes to the condensed consolidated financial statements. -3- Sodexho Marriott Services, Inc. Condensed Consolidated Statements of Cash Flows ($ in millions) (Unaudited)

See notes to the condensed consolidated financial statements. -4- Sodexho Marriott Services, Inc. Condensed Consolidated Statement of Stockholders' Deficit (amounts in millions) (Unaudited)

See notes to the condensed consolidated financial statements. -5- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation The accompanying Condensed Consolidated Financial Statements of the Company are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial statements. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and notes thereto included in the Company's Annual Report on Form 10-K for the period ended September 1, 2000. In the opinion of management, the accompanying Condensed Consolidated Financial Statements reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position of the Company as of March 2, 2001 and September 1, 2000, and the results of operations for the 13 and 26 weeks ended March 2, 2001 and March 3, 2000. Interim results are not necessarily indicative of fiscal year performance. All material intercompany transactions and balances between Sodexho Marriott Services, Inc., and its consolidated subsidiaries have been eliminated. Certain amounts previously presented have been reclassified to conform to the current presentation. Revenue Recognition and Accounts and Notes Receivable Revenues are recognized at the time services are rendered or products are delivered. Revenues include reimbursements for food and payroll costs incurred on behalf of customers under contracts in which the Company manages food service programs for a fee. Losses, if any, are provided for at the time management determines the cost will ultimately exceed contract revenue for the duration of the contract. The allowance for doubtful accounts was $23 million at March 2, 2001, unchanged from September 1, 2000. Concentration of credit risk within accounts receivable is limited because a large number of customers make up the Company's customer base, thus spreading risk associated with trade credit. In addition, the Company closely monitors its accounts receivable. The Company generally does not require collateral and maintains reserves for potential uncollectible amounts, which, in the aggregate, have not exceeded management's expectations. Earnings Per Share Basic earnings per share is computed by dividing net income by the weighted-average number of outstanding common shares. Diluted earnings per share is computed by dividing net income, adjusted for interest expense related to convertible securities (after-tax), by the diluted weighted-average number of outstanding common shares, including the effect of the Company's employee incentive plans (including deferred and restricted stock) and the convertible subordinated debt securities. Segment Reporting Information from operating segments is derived from methods used by the Company's management to allocate resources and measure performance. For fiscal year reporting, the Company disclosed profit/loss, revenues and assets for each segment identified, including reconciliations of these items to consolidated totals. For interim reporting periods, the Company disclosed profit/loss and revenues for each segment (see Note 5). -6- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements, Continued (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED Adoption of Statement of Financial Accounting Standards No. 133 ("SFAS No. 133") On September 2, 2000, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended. In accordance with the provisions in SFAS No. 133, the Company has designated all of its interest-rate agreements as cash flow hedges. The Company has determined that these agreements are highly effective in offsetting the variable interest cash flows of the Company's debt portfolio. The agreements were recorded on the balance sheet at fair value in other long-term assets with the offsetting entry to accumulated other comprehensive income, a component of stockholders' deficit, net of tax. The transition adjustment from the adoption of SFAS No. 133, resulted in a cumulative-effect adjustment to accumulated other comprehensive income of $15 million, net of taxes totaling $7 million. The Company does not anticipate any reclassifications to earnings from accumulated other comprehensive income over the next 12 months, with adjustments during the year related mostly to changes in the fair value of the related agreements. There were no net gains or losses recognized on derivatives that had previously been deferred, or as adjustments to the carrying amount of the hedged items. Currently, the Company does not have any other financial contracts, which contain embedded derivatives or fair value hedge relationships, which would fall within the scope of SFAS No. 133. Cash Flow Hedges The Company's derivative and hedging strategy is aimed at managing interest-rate risk and prohibits the use of derivative instruments for trading purposes. Currently, the Company uses interest-rate agreements (the "agreements") to carry out its interest-rate risk management strategy. These agreements generally involve the exchange of fixed and variable rate interest payments between two parties, based on a common notional principal amount and maturity date. The notional amount and interest payments in these agreements match the cash flows of assets and/or liabilities. The notional balances of these agreements represent a balance used to calculate the exchange of cash flows and are not assets or liabilities of the Company. Accordingly, any market risk or opportunity associated with these agreements is offset by the opposite market impact on the related debt. The Company's credit risk related to interest-rate agreements is considered low because they are entered into with only strong creditworthy counterparties and are generally settled on a net basis. The difference paid or received on interest-rate agreements is recognized as an adjustment to interest expense. See Note 2 for the notional amounts, related rates, maturities, and fair values of these agreements. All derivatives are recognized on the balance sheet at their fair value. Reflective of the Company's current derivative and hedging strategy, derivative contracts entered into are designated as a cash flow hedges; a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability. Accordingly, changes in the fair value of these highly effective agreements are recorded in other accumulated comprehensive income, until earnings are affected by the variability of their cash flows (e.g., when periodic settlements on a variable-rate asset or liability are recorded in earnings). Accumulated Other Comprehensive (Loss) Income Comprehensive income for the Company includes activity in foreign exchange translation adjustments and cash flow hedges under the adoption of SFAS No. 133. Items identified as comprehensive income are reported, under separate captions, in the Condensed Consolidated Balance Sheets and the Condensed Consolidated Statement of Stockholders' Deficit. Results for the Canada division are translated to U.S. dollars using the average exchange rates during the period. Assets and liabilities are translated using the exchange rate in effect at the applicable balance sheet date, and the resulting translation adjustments are reflected in stockholders' deficit as accumulated other comprehensive income. -7- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements, Continued (Unaudited) (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED Accumulated Other Comprehensive (Loss) Income, Continued Total accumulated other comprehensive loss included $10 million of gross unrealized losses on the fair value of derivatives, net of taxes totaling $4 million, partially offset by $2 million of gross foreign exchange translation gains, net of taxes totaling $1 million, at March 2, 2001. Total accumulated other comprehensive income included gross foreign exchange translation gains totaling $3 million, net of taxes totaling $1 million, at September 1, 2000. During the first half fiscal year 2001, total comprehensive income was comprised of $53 million in net income, $15 million for the gross cumulative effect of change in accounting method, net of taxes totaling $7 million, a $25 million decrease in fair value of derivatives, net of taxes totaling $11 million, and $1 million of foreign exchange translation losses, net of taxes. (2) DEBT

Senior Secured Credit Facility - the senior secured credit facility consists of $235 million of revolving credit and an additional $500 million, six-year term loan facility. Interest is based on a bank prime rate, an amount over the Federal funds rate, or an amount over the London interbank offered rate for Eurodollar deposits ("LIBOR"), payable in arrears quarterly. At March 2, 2001, the Company is paying a rate of 6.68% on the term loan facility, adjusted for fee amortization and hedging costs. The senior secured credit facility is secured predominately by inventory, accounts receivable and the stock of certain subsidiaries of the Company. Up to $100 million of the $235 million revolving credit may be used to collateralize letters of credit, which totaled $21 million at March 2, 2001, and September 1, 2000. At March 2, 2001, $214 million of this facility was not used and was available to the Company, the same as at September 1, 2000. -8- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements, Continued (Unaudited) (2) DEBT, CONTINUED Senior Guaranteed Credit Facility - the senior guaranteed credit facility consists of a $620 million seven-year term loan. Interest is based on a bank prime rate, an amount over the Federal funds rate, or an amount over LIBOR, payable in arrears quarterly. At March 2, 2001, the Company is paying a rate of 6.87% on this facility, adjusted for fee amortization and hedging costs. This facility is guaranteed by Sodexho Alliance, S.A. ("Sodexho") for which the Company pays Sodexho an annual fee of 0.5% of the outstanding balance of the Senior Guaranteed Credit Facility, or $3 million pretax. The Company's debt agreements require the maintenance of certain financial ratios and stockholders' equity balances, and also include, among other things, limitations on additional indebtedness, certain acquisitions, dividend payments, pledging of assets, and other restrictions on operations related to cash flows. The Company met the financial covenants of the debt agreements as of March 2, 2001 and for the 26 weeks then ended. Cash Flow Hedges In accordance with the provisions in SFAS No. 133, the Company has designated all of its interest-rate agreements as cash flow hedges. The Company entered into these agreements to convert its floating-rate debt to fixed rates. At March 2, 2001, the majority of the Company's debt was payable at variable rates of interest. In May 1998, the Company entered into several interest-rate agreements totaling $900 million in notional principal balances to hedge a portion of its variable rate debt. These agreements guarantee a fixed rate of interest over the life of the agreements. The Company is paying a fixed rate ranging between 5.70% and 5.90%, plus a residual margin that is not hedged relating to the underlying variable-rate debt. The aggregate fair value of the interest-rate agreements at March 2, 2001 was an unrealized pretax loss of $9 million, compared with an unrealized pretax gain of $15 million at the end of fiscal year 2000 (see Note 1). At March 2, 2001 and for the 26-week period ended, the Company did not have any ineffective or deferred gain/loss adjustments related to its cash flow hedges. The weighted-average rate for the total debt portfolio, including the effect of the interest-rate agreements, was 6.87% at March 2, 2001. These agreements expire between May 2001 and February 2005. At March 2, 2001, the Company did not have any accrued interest receivable or payable to its counterparties and did not have any unamortized fees or premiums. All of the Company's interest-rate agreements are for purposes other than trading. In January and February 2001, the Company entered into several forward agreements totaling $300 million in notional principal balance for the replacement of certain swap agreements that mature between May and August 2001. These forward agreements mature in May and August 2001, and had a negative fair value of approximately $1 million (pretax) at March 2, 2001. Details of these interest-rate agreements as of March 2, 2001 are as follows: ($ in millions)

-9- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements, Continued (Unaudited) (3) STOCKHOLDERS' DEFICIT Stockholders' Deficit The Company is authorized to issue three hundred million shares of the Company's common stock, with a par value of $1 per share. At March 2, 2001, the Company had 63,536,538 shares outstanding. One million shares of preferred stock, without par value, are authorized, with none issued. Earnings Per Share The following table details earnings and number of shares used in the basic and diluted earnings per share calculations.

-10- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements, Continued (Unaudited) (4) EMPLOYEE BENEFIT AND INCENTIVE PLANS Benefit Plans Employees meeting certain eligibility requirements can participate in the Company's savings and deferred compensation plans. The Company currently contributes generally 50% of the participants' contributions to these plans, limited to 6% of compensation, with certain exceptions. For the 13-week and 26-week periods ended March 2, 2001, expenses that related to these plans totaled approximately $4 million and $8 million, respectively, compared to $3 million and $7 million for the same periods last year. Incentive Plans The Company has two stock-based incentive plans-- the Sodexho Marriott Services, Inc. 1993 and 1998 Comprehensive Stock Incentive Plans (the "1993 Plan" or the "1998 Plan"). The purpose of these plans is to promote and enhance the long-term growth of the Company by aligning the interests of the employees with the interests of the Company's shareholders. The 1993 Plan administers converted stock options prior to the merger in March 1998, with no new awards made under this plan. The 1998 Plan governs the issuance and administration of conversion awards and is also available for the issuance of new awards. These stock plans are administered by the Compensation Policy Committee as authorized by the Board of Directors. As part of the amendment of these plans, the Board of Directors has approved up to 10 million shares of common stock to be available under the 1998 Plan for converted options as well as new awards. In addition, on January 10, 2001, the shareholders approved the Board of Directors' recommendation to increase the number of shares approved under the 1998 Plan from 10 million to 11.5 million. This increase ensures the Company's ability to continue to promote and enhance the long-term growth of the Company through rewarding and recognizing outstanding employee performance. Employee stock options may be granted to officers and key employees at exercise prices not less than the market price of the Company's stock on the date of grant. Most options under the stock option plans become vested in installments of one-fourth at the end of each of the first four years following the date of grant. In December 2000, the Company issued approximately 1 million stock option awards (within the Company's 1998 Plan and vesting terms detailed above) and also issued approximately 360,000 employee restricted stock units. Generally, the restricted stock units become issued shares (unrestricted) annually, on a pro rata basis, over a four-year period. The Company believes these restricted stock units will serve as an additional means to retain, reward and recognize outstanding employees. A summary of the Company's stock option activity during the 26 weeks ended March 2, 2001, is presented below:

-11- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements, Continued (Unaudited) (5) BUSINESS SEGMENTS The Company is the leading provider in North America of outsourced food and facilities management services to businesses, health care facilities, colleges and universities, primary and secondary schools and other clients. The Company has six business segments within these markets: Corporate Services, Health Care, Education, Schools, Canada, and Laundries/Other. Sales and operating profit by business segment:

-12- Sodexho Marriott Services, Inc. Notes To The Condensed Consolidated Financial Statements, Continued (Unaudited) (6) COMMITMENTS AND CONTINGENCIES On January 24, 2001, Sodexho Alliance, S.A. submitted a proposal to the Board of Directors of the Company to acquire all of the common stock of the Company it does not already own for $27 per share in cash. On January 25, 2001, Barry Feldman v. William Shaw et. al. was filed in the Court of Chancery, New Castle County, Delaware. A total of nine cases have now been filed, on a similar basis, in which plaintiffs have sued the 8 individual members of the Board of Directors of the Company, Sodexho Alliance, S.A., and the Company, alleging that shareholders of the Company, as a class, have been harmed by the defendants' claimed breaches of fiduciary duties related to the Sodexho Alliance, S.A. proposal. These nine lawsuits are likely to be consolidated. The Company intends to defend the lawsuits vigorously, and believes the lawsuits to be without merit. The nature of the Company's business causes it to be involved in routine legal proceedings from time to time. Management of the Company believes that there are no pending or threatened legal proceedings that upon resolution would have a material adverse impact to the Company. (7) OTHER MATTERS On January 29, 2001, the Company announced that its Board of Directors had appointed a special committee to evaluate the proposal by Sodexho Alliance, S.A. ("Sodexho") to acquire all of the outstanding common shares of the Company that are not already held by Sodexho, for $27 per share in cash. Also, Sodexho and the Company have agreed that the royalty agreement, set to change on March 27, 2001, will continue under its present terms and conditions (0.05% of annual gross revenues) until August 31, 2001. Sodexho and the Company will negotiate the royalty fee to commence September 1, 2001, based on the fair market value of the Company's use of the Sodexho name, consistent with the terms of the existing royalty agreement. It is not yet known if, or to what extent, the royalty fee might change; however, an increase in the royalty fee could have a material adverse effect on the Company's results of operations. -13- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS THE SECOND QUARTER FISCAL YEAR 2001 COMPARED WITH THE SECOND QUARTER FISCAL YEAR 2000 The Company had net income for the second quarter of fiscal year 2001 (13 weeks ended March 2, 2001) of $17 million, or $0.27 per diluted common share, compared with $14 million, or $0.23 per diluted common share for the second quarter of fiscal year 2000 (13 weeks ended March 3, 2000). Diluted average shares totaled 64.5 million for the current quarter compared with 63.3 million for the prior year's quarter. Total sales for the second quarter of fiscal year 2001 were $1.24 billion, an increase of $58 million, or 5% over the $1.18 billion in total sales for the second quarter of fiscal year 2000. The divisions had solid growth performance in the current quarter versus last year's quarter, with all divisions having growth of 5% or more, excluding the Corporate Services division. This growth was the result of solid increases in sales at existing accounts and good retention. The Corporate Services division had sales growth of 1% in the current quarter versus the prior year's quarter, due to lower account retention in the prior year, and slower new sales in the later half of fiscal year 2000 and carrying over into fiscal year 2001. This division's overall sales growth will continue to be challenged by the very competitive nature of this segment. Operating profit for the current quarter totaled $80 million, an increase of $2 million, or 4% compared with operating profit of $78 million for the second quarter of last year. Strong increases in the Education, Health Care and Canada divisions, the result of growth in sales at existing accounts, was partially offset by under-performance in the Corporate Services, Schools and Laundries/Other divisions. Corporate Services had several under-performing accounts and increases in bad debt expense. Schools also had a bad debt charge at one large account and the unfavorable impact of a softer new sales season in fiscal year 2000. The Laundries/Other division was impacted by the under-performance of one larger facility and start up related costs for a new facility in Chicago. Partially offsetting the operating profit growth for the second quarter of fiscal year 2001 was a $2 million increase in corporate expenses (excluding amortization of intangible assets) when compared to the last year's second quarter. Most of this increase was the result of positions unfilled in last year's second quarter which were filled in the latter half of fiscal year 2000 and into the first half of fiscal year 2001, predominately in the Human Resources and Information Technology areas. Interest expense decreased $2 million or 8%, impacted by reduced levels of debt and improved working capital results that helped keep down the use of the Company's short-term credit facility (see "Liquidity and Capital Resources" below). The effective tax rate for the current quarter was 40.3%, down from 44.0% in last year's second quarter, mostly due to the reduced impact of nondeductible expenses and a lower effective state tax rate. -14- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, CONTINUED RESULTS OF OPERATIONS, CONTINUED THE FIRST HALF FISCAL YEAR 2001 COMPARED WITH THE FIRST HALF FISCAL YEAR 2000 The Company had net income for the first half of fiscal year 2001 (26 weeks ended March 2, 2001) of $53 million, or $0.83 per diluted common share, compared with $42 million, or $0.67 per diluted common share for the first half of fiscal year 2000 (26 weeks ended March 3, 2000). Diluted average shares totaled 64.1 million for the first half of fiscal year 2001 compared with 63.5 million for the prior year's period. Total sales for the first half of fiscal year 2001 were $2.60 billion, an increase of $129 million, or 5% over the $2.47 billion in total sales for the first half of fiscal year 2000. All the divisions had solid growth performance of 6% or more, excluding the Corporate Services division, due to solid increases in sales at existing accounts and good retention. The Corporate Services division had sales growth of 2% in the first half of fiscal 2001 versus the prior year's first half, due to lower account retention in the prior year, and slower new sales in the later half of fiscal year 2000 and carrying over into fiscal year 2001. This division's overall sales growth will continue to be challenged by the very competitive nature of this segment, with modest sales growth anticipated for the remainder of fiscal year 2001. Operating profit for the first half of fiscal year 2001 totaled $198 million, an increase of $17 million, or 10% compared with operating profit of $181 million for the first half of last year. Strong increases in the Education, Health Care, Schools and Canada divisions, the result of growth in sales at existing accounts, was partially offset by under-performance in the Corporate Services and Laundries/Other divisions. Corporate Services had unfavorable trends in several under-performing accounts and increases in bad debt expense. The Laundries/Other division was impacted by under-performance of one larger facility and start up related costs for a new facility in Chicago. Last fiscal year, the Company experienced inefficiencies in several first year accounts in the Education division, negatively impacting operating profits for this division in fiscal year 2000. Beginning in fiscal year 2001, the Company implemented several initiatives to reduce start-up costs associated with opening new business in this division as well as changes in the under-performing accounts to improve their operating results. The results in this division for the first half of fiscal year 2001 have been strong; but, as fiscal year 2001 progresses, the Education division is expected to compare less favorably to the stronger operating profit results in the latter part of fiscal year 2000. In the Corporate Services division, the challenges with retention in this highly competitive segment and the slower new sales in the first half of fiscal year 2001 are anticipated to continue to place pressure on this division's operating profit. However, continued focus on labor costs, procurement initiatives, and the improvement of several under-performing accounts are anticipated to maintain or slightly improve the growth in operating profits for Corporate Services in the second half of fiscal year 2001. In the Health Care division, continued stable labor costs and improvements from procurement initiatives were partially offset by some under-performance in a few larger client accounts. The Health Care segment continues to be a challenging and consolidating market segment as a result of pressure to assist new and existing clients in meeting their demanding and changing fiscal requirements. The Health Care division continues to focus on opportunities to improve its under-performing accounts, as well as offering additional services, which bring value to clients and improve the operating results of this segment. Overall, management believes that this segment will continue to improve its operating results compared with the prior year in the second half of fiscal year 2001. -15- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, CONTINUED RESULTS OF OPERATIONS, CONTINUED THE FIRST HALF FISCAL YEAR 2001 COMPARED WITH THE FIRST HALF FISCAL YEAR 2000, CONTINUED Partially offsetting the operating profit growth for the first half of fiscal year 2001 was a $5 million (12%) increase in corporate expenses (excluding the amortization of intangible assets) versus last year's period. Most of this increase was the result of positions unfilled in last year's first half which were filled in the latter half of fiscal year 2000 and into the first half of fiscal year 2001, predominately in the Human Resources and Information Technology areas. Interest expense decreased $4 million or 9%, impacted by reduced levels of debt and improved working capital results that helped keep down the use of the Company's short-term credit facility (see "Liquidity and Capital Resources" below). The effective tax rate for the first half of fiscal year 2001 was 42.5%, down from 44.0% in last year's first half, mostly due to the reduced impact of nondeductible expenses and a lower effective state tax rate. LIQUIDITY AND CAPITAL RESOURCES The Company funds its capital needs from a combination of existing cash balances and cash from operations. The Company's large debt portfolio is a result of the Company's spin-off and merger in March 1998. Net cash flows from operations for the first half of fiscal year 2001 totaled $87 million, an improvement of $5 million when compared with the first half of fiscal year 2000. This favorable result was mostly attributed to the increase in net income when comparing the first half of fiscal year 2001 with the prior year's period. The Company continues to focus on increasing collection efforts in its accounts receivable portfolio and refining its vendor payment cycles. The Company achieved its $40 million cumulative synergy target for fiscal year 2000. In addition, the Company achieved its overall objective established at the time of the March 1998 merger of $60 million in cumulative synergies through the second quarter of fiscal year 2001. The Company's Board of Directors did not declare a dividend during the first half of fiscal year 2001. The Company may pay dividends in the future, subject to the restrictive covenants contained in the Company's credit facility agreements and other relevant considerations. The payment and amount of cash dividends on the Company's common stock will be subject to the sole discretion of the Company's Board, which will review the Company's dividend policy at such times as may be deemed appropriate. The Board will closely monitor the results of the Company's operations, capital requirements, and other considerations to determine the extent to which a dividend may be declared in future periods. In addition, the Company has undertaken an information systems strategy study to evaluate the current state of its information systems, and consider information technology options. Among the options under consideration is the adoption of certain elements of the technology platform adopted by Sodexho Alliance. At a recent Board of Directors meeting, the Board approved an initial phase of the Company's information technology strategy, which has now moved from a strategic study to a phased-in implementation process. This phase includes the approval of a new accounting system in the Company's Financial Services Center located in Buffalo, New York, with an estimated cost of approximately $30 million over the next 24 months. Of this $30 million, approximately $26 million would be capitalized and the remaining balance would be recognized within the Company's operating expenses. The total operating expenses to be incurred in fiscal year 2001 are not expected to be material. Approximately $8 million of capital expenditures are anticipated to be disbursed within the current fiscal year. Management anticipates that additional details regarding the system, vendor selection and implementation strategy will be available later in the fiscal year. Updates regarding additional steps of the Company's overall information systems strategy will be made available as those stages are approved. -16- MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION, CONTINUED LIQUIDITY AND CAPITAL RESOURCES, CONTINUED Most recently, the Company began a study of a solution set for its payroll, benefits and human resources information systems, as the Company migrates from the current Marriott International payroll-related systems. Though the current agreement requires the Company to migrate off the Marriott International payroll infrastructure no later than fiscal year 2002, Marriott International and the Company are finalizing terms to extend this agreement beyond fiscal year 2002. This extension is anticipated to be finalized later in fiscal year 2001. This extension will provide the Company additional time to select the best payroll and benefit alternatives to meet the Company's and its client's needs. NEW ACCOUNTING STANDARDS On September 2, 2000, the Company adopted Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," as amended ("SFAS No. 133"). In accordance with the provisions in SFAS No. 133, the Company has designated all of its interest-rate agreements as cash flow hedges. The Company has determined that these agreements are highly effective in offsetting the variable interest cash flows of the Company's debt portfolio. The agreements have been recorded on the balance sheet at fair value in other long-term assets with the offsetting entry to accumulated other comprehensive income, a component of stockholders' deficit, net of tax. The transition adjustment resulting from the adoption of SFAS No. 133 at September 2, 2000, resulted in a cumulative-effect adjustment to accumulated other comprehensive income of $15 million, net of taxes totaling $7 million (see Note 1). At March 2, 2001, all agreements were considered highly effective. The Company does not anticipate any reclassifications to earnings from accumulated other comprehensive income in fiscal year 2001, with adjustments during the year related mostly to changes in the fair value of the related agreements. There were no net gains or losses recognized on derivatives that had previously been deferred, or as adjustments to the carrying amount of the hedged items. Currently, the Company does not have any other financial contracts, which contain embedded derivatives or fair value hedge relationships, which would fall within the scope of SFAS No. 133. OTHER MATTERS On January 29, 2001, the Company announced that its Board of Directors had appointed a special committee to evaluate the proposal by Sodexho Alliance, S.A. ("Sodexho") to acquire all of the outstanding common shares of the Company that are not already held by Sodexho, for $27 per share in cash (see Note 7). Also, Sodexho and the Company have agreed that the royalty agreement, set to change on March 27, 2001, will continue under its present terms and conditions (0.05% of annual gross revenues) until August 31, 2001. Sodexho and the Company will negotiate the royalty fee to commence September 1, 2001, based on the fair market value of the Company's use of the Sodexho name, consistent with the terms of the existing royalty agreement. It is not yet known if, or to what extent, the royalty fee might change; however, an increase in the royalty fee could have a material adverse effect on the Company's results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's earnings are not materially affected by changes in interest rates, due to the relatively low balances of borrowings at floating interest rates as well as notes receivable which earn a variable rate of interest. However, changes in interest rates also impact the fair value of the Company's debt, totaling $940 million at March 2, 2001. If interest rates increased by 100 basis points, the fair value of the Company's debt would have decreased by approximately $15 million, while a 100 basis point decrease in rates would have increased the fair value of the Company's debt by approximately $15 million, based on balances at March 2, 2001. -17- PART II OTHER INFORMATION AND SIGNATURES ITEM 1. LEGAL PROCEEDINGS -------------------------- On January 24, 2001, Sodexho Alliance, S.A. submitted a proposal to the Board of Directors of the Company to acquire all of the common stock of the Company it does not already own for $27 per share in cash. On January 25, 2001, Barry Feldman v. William Shaw et. al. was filed in the Court of Chancery, New Castle County, Delaware. A total of nine cases have now been filed, on a similar basis, in which plaintiffs have sued the 8 individual members of the Board of Directors of the Company, Sodexho Alliance, S.A., and the Company, alleging that shareholders of the Company, as a class, have been harmed by the defendants' claimed breaches of fiduciary duties related to the Sodexho Alliance, S.A. proposal. These nine lawsuits are likely to be consolidated. The Company intends to defend the lawsuits vigorously, and believes the lawsuits to be without merit. ITEM 2. CHANGES IN SECURITIES ------------------------------ None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES ---------------------------------------- None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ------------------------------------------------------------ The Annual Meeting of the shareholders of the Company was held on January 10, 2001, in Gaithersburg, Maryland. Chairman of the Board William J. Shaw presided and 56,364,619 of the 63,258,994 common shares outstanding as of the record date of November 15, 2000, were represented at the meeting in person or by proxy. 1- Elections of Directors Nominees for membership on the Board of Directors of the Corporation, listed below, were elected by the shareholders. The following schedule lists the number of shares cast for each nominee: Total Total Votes Votes For Withheld ----------------- ---------------- Daniel J. Altobello 56,213,671 150,948 Pierre Bellon 56,216,904 147,715 Bernard Carton 56,215,673 148,946 Edouard de Royere 55,797,939 566,680 Michel Landel 56,213,965 150,654 John W. Marriott III 56,178,685 185,934 Mary S. Metz 56,195,230 169,389 William J. Shaw 56,188,494 176,125 -18- ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - CONTINUED ------------------------------------------------------------------------ 2- Ratification of the appointment of PricewaterhouseCoopers, LLP as independent auditors of the Company for fiscal year 2001: By a vote of 56,250,086 For, to 85,537 Against, with 28,996 Abstaining, the Company's shareholders approved the appointment of PricewaterhouseCoopers, LLP as independent auditors of the Company for fiscal year 2001. 3- Approval for the amendment of the 1998 Comprehensive Stock Incentive Plan to increase the number of shares available under the Plan from 10 million to 11.5 million shares: By a vote of 55,753,209 For, to 553,092 Against, with 58,318 Abstaining, the Company's shareholders approved the amendment of the 1998 Comprehensive Stock Incentive Plan to increase the number of shares available under the Plan from 10 million to 11.5 million shares. ITEM 5. OTHER INFORMATION -------------------------- None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K ----------------------------------------- (a) Exhibits Exhibit No. Descriptions ------- ------------ 99 Forward-Looking Statements (b) Reports on Form 8-K January 29, 2001 Appointment of Special Committee by the Company's Board of Directors in response to Sodexho Alliance's proposal to acquire all the remaining shares of the Company's Common Stock not already held by Sodexho Alliance. February 27, 2001 Announcement by the Special Committee of its financial and legal advisors regarding the proposal from Sodexho Alliance to acquire all the remaining shares of the Company's Common Stock not already held by Sodexho Alliance. March 15, 2001 Announcement of the award of a multi-year service agreement between the Company and the U.S. Marine Corps. -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. SODEXHO MARRIOTT SERVICES, INC. April 12, 2001 /s/ JOHN M. BUSH ------------------------------- John M. Bush Senior Vice President and Chief Financial Officer /s/ CHARLES B. RUSSELL ------------------------------ Charles B. Russell Vice President, Corporate Controller and Chief Accounting Officer -20-

SODEXHO MARRIOTT SERVICES INC 10-Q