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 March 31, 2007
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
incorporation or organization)
  (I.R.S. Employer
Identification No.)
5995 OPUS PARKWAY
MINNETONKA, MINNESOTA 55343
(Address of principal executive offices and zip code)
Registrant’s telephone number, including area code (952) 912-5500
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 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
April 30, 2007 was 21,520,121 shares
 
 

 


 

G&K Services, Inc.
Form 10-Q
Table of Contents
             
        PAGE
           
  Financial Statements        
 
           
 
  Consolidated Condensed Balance Sheets as of March 31, 2007 and July 1, 2006     3  
 
           
 
  Consolidated Condensed Statements of Operations for the three and nine months ended March 31, 2007 and April 1, 2006     4  
 
           
 
  Consolidated Condensed Statements of Cash Flows for the nine months ended March 31, 2007 and April 1, 2006     5  
 
           
 
  Notes to Consolidated Condensed Financial Statements     6  
 
           
  Management’s Discussion and Analysis of Financial Condition and Results of Operations     13  
 
           
  Quantitative and Qualitative Disclosure About Market Risk     22  
 
           
  Controls and Procedures     22  
 
           
           
  Risk Factors     23  
  Unregistered Sales of Equity Securities and Use of Proceeds     23  
  Exhibits     24  
        25  
 302 Certification of Chief Executive Officer
 302 Certification of Chief Financial Officer
 906 Certification of Chief Executive Officer
 906 Certification of Chief Financial Officer

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PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED CONDENSED BALANCE SHEETS
G&K Services, Inc. and Subsidiaries
                 
           
    March 31,     July 1,  
    2007     2006  
(In thousands)   (Unaudited)          
 
ASSETS
               
Current Assets
               
Cash and cash equivalents
  $ 16,758     $ 19,690  
Accounts receivable, less allowance for doubtful accounts of $3,304 and $3,011
    102,168       94,964  
Inventories
    141,404       141,031  
Prepaid expenses
    17,377       15,552  
 
Total current assets
    277,707       271,237  
 
 
               
Property, Plant and Equipment, net
    253,457       249,001  
Goodwill, net
    376,994       349,469  
Other Assets
    80,949       81,385  
 
 
  $ 989,107     $ 951,092  
 
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current Liabilities
               
Accounts payable
  $ 23,617     $ 27,404  
Accrued expenses
    76,791       72,999  
Deferred income taxes
    10,370       10,419  
Current maturities of long-term debt
    62,669       18,199  
 
Total current liabilities
    173,447       129,021  
 
 
               
Long-Term Debt, net of Current Maturities
    159,269       195,355  
Deferred Income Taxes
    32,260       34,343  
Other Noncurrent Liabilities
    48,002       44,985  
Stockholders’ Equity
    576,129       547,388  
 
 
  $ 989,107     $ 951,092  
 
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  
    March 31,     April 1,     March 31,     April 1,  
(In thousands, except per share data)   2007     2006     2007     2006  
 
Revenues
                               
Rental operations
  $ 211,842     $ 201,562     $ 628,273     $ 594,985  
Direct sales
    23,400       24,579       60,861       58,452  
 
Total revenues
    235,242       226,141       689,134       653,437  
 
Operating Expenses
                               
Cost of rental operations
    136,951       131,387       403,436       383,565  
Cost of direct sales
    16,923       17,659       44,579       42,015  
Selling and administrative
    50,110       49,619       150,031       141,219  
Depreciation and amortization
    11,326       10,883       33,776       32,126  
 
Total operating expenses
    215,310       209,548       631,822       598,925  
 
Income from Operations
    19,932       16,593       57,312       54,512  
Interest expense
    3,647       3,395       10,526       9,712  
 
Income before Income Taxes
    16,285       13,198       46,786       44,800  
Provision for income taxes
    4,136       2,840       15,801       13,837  
 
Net Income
  $ 12,149     $ 10,358     $ 30,985     $ 30,963  
 
Basic weighted average number of shares outstanding
    21,304       21,132       21,227       21,069  
Basic Earnings per Common Share
  $ 0.57     $ 0.49     $ 1.46     $ 1.47  
 
Diluted weighted average number of shares outstanding
    21,445       21,311       21,394       21,228  
Diluted Earnings per Common Share
  $ 0.57     $ 0.49     $ 1.45     $ 1.46  
 
 
Dividends per share
  $ 0.0400     $ 0.0175     $ 0.1200     $ 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  
    March 31,     April 1,  
(In thousands)   2007     2006  
 
Operating Activities:
               
Net income
  $ 30,985     $ 30,963  
Adjustments to reconcile net income to net cash provided by operating activities —
               
Depreciation and amortization
    33,776       32,126  
Stock-based compensation
    3,597       3,060  
Deferred income taxes
    (257 )     354  
Changes in current operating items, exclusive of acquisitions
    (18,772 )     (17,320 )
Other assets and liabilities
    1,862       829  
 
Net cash provided by operating activities
    51,191       50,012  
 
Investing Activities:
               
Property, plant and equipment additions, net
    (23,214 )     (26,414 )
Acquisitions of business assets, net
    (47,543 )     (11,300 )
Purchase of investments, net
    (2,043 )     (1,720 )
 
Net cash used for investing activities
    (72,800 )     (39,434 )
 
Financing Activities:
               
Repayments of long-term debt
    (7,579 )     (7,661 )
Proceeds from short-term borrowings, net
    26,446       2,050  
Cash dividends paid
    (2,575 )     (1,112 )
Sale of common stock
    3,004       2,395  
 
Net cash provided by (used for) financing activities
    19,296       (4,328 )
 
(Decrease)/Increase in Cash and Cash Equivalents
    (2,313 )     6,250  
Effect of Exchange Rates on Cash
    (619 )     365  
 
               
Cash and Cash Equivalents:
               
Beginning of period
    19,690       15,345  
 
End of period
  $ 16,758     $ 21,960  
 
 
               
Supplemental Cash Flow Information:
               
Non-Cash Transactions —
               
Debt issued to seller in connection with business acquisitions
  $     $ (1,419 )
 
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 March 31, 2007 and April 1, 2006
(Unaudited)
The consolidated condensed financial statements included herein, except for the July 1, 2006 balance sheet which was derived from the audited consolidated financial statements for the fiscal year ended July 1, 2006, 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 March 31, 2007, and the results of its operations for the three and nine months ended and its cash flows for the nine months ended March 31, 2007 and April 1, 2006. 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 March 31, 2007 and April 1, 2006 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 1, 2006.
     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 North American industries including automotive, warehousing, distribution, transportation, energy, manufacturing, food processing, pharmaceutical, semi-conductor, retail, restaurants and hospitality, and many others providing them with rented uniforms and facility services products such as floor mats, dust mops, wiping towels, restroom supplies and selected linen items. The Company also manufactures certain uniform garments that it uses to support its garment rental and direct purchase 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 damaged 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 limit exposure to changes in interest rates and energy prices. Interest rate swap contracts are used to balance the 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 sheet and the related gains or losses on these contracts are deferred in stockholders’ equity (as a component of other comprehensive income). 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. In addition, the Company purchases futures contracts to effectively hedge a portion of it’s anticipated commodity 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 deferred in stockholders’ equity (as a component of other comprehensive income) or in the statements of operations depending on the effectiveness of the cash flow hedge. Upon settlement of each contract, the actual gain or loss is reflected in cost of rental operations.
The Company may also enter into foreign currency exchange contracts to hedge firm commitments with its foreign subsidiary. These agreements are recorded at current market values and the gains and losses are included in earnings.
     Per Share Data
Basic earnings per common share was 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 non-vested restricted stock, using the treasury stock method.
                                 
    Three Months Ended     Nine Months Ended  
    March 31,     April 1,     March 31,     April 1,  
    2007     2006     2007     2006  
     
 
                               
Weighted average number of common shares outstanding used in computation of basic earnings per share
    21,304       21,132       21,227       21,069  
 
                               
Weighted average effect of non-vested restricted stock grants and assumed exercise of options
    141       179       167       159  
 
                               
     
Shares used in computation of diluted earnings per share
    21,445       21,311       21,394       21,228  
     
Potential common shares related to the Company’s outstanding stock options and restricted stock grants of 755,000 and 492,000 for the three months ended March 31, 2007 and April 1, 2006, and 594,000 and 487,000 for the nine months ended March 31, 2007 and April 1, 2006, 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.
     Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

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     Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (SFAS) No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans”, an amendment of SFAS No. 87, 88, 106 and 132R which will be effective for the Company’s fiscal year ending June 30, 2007. The standard requires the Company to:
    Recognize in its statement of financial position the over-funded or under-funded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation.
 
    Recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise during the period but pursuant to SFAS 87 and 106 are not recognized as components of net periodic benefit cost.
 
    Recognize as an adjustment to the opening balance of retained earnings, net of tax, any transition asset or transition obligation remaining from the initial application of SFAS 87 or 106.
 
    Measure defined benefit plan assets and defined benefit plan obligations as of the date of the employer’s statement of financial position.
 
    Disclose additional information in the notes to financial statements about certain effects on net periodic benefit cost in the upcoming fiscal year that arise from delayed recognition of the actuarial gains and losses and the prior service costs and credits.
On July 13, 2006, the Financial Accounting Standards Board issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement SFAS109,” which fundamentally changes the way that an entity will be required to treat their uncertain tax positions for financial accounting purposes. FIN 48 prescribes rules regarding how an entity should recognize, measure and disclose in its financial statements the tax positions that an entity has taken or will take in its tax return that are reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. Differences between tax positions taken in a tax return and amounts recognized in the financial statements will generally result in an increase in a liability for income taxes payable, or a reduction in a deferred tax asset or an increase in a deferred tax liability.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurement” (SFAS 157). SFAS 157 provides a definition of fair value, provides guidance for measuring fair value in U.S. GAAP and expands disclosures about fair value measurement. SFAS 157 will be effective at the beginning of fiscal 2009.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS 159 will be effective at the beginning of fiscal 2009. The Company is currently evaluating the impact of these standards on its consolidated financial statements.
2.   Comprehensive Income
For the three and nine month periods ended March 31, 2007 and April 1, 2006, the components of comprehensive income were as follows:
                                 
    Three Months Ended     Nine Months Ended  
    March 31,     April 1,     March 31,     April 1,  
    2007     2006     2007     2006  
     
Net income
  $ 12,149     $ 10,358     $ 30,985     $ 30,963  
Other comprehensive income:
                               
Foreign currency translation adjustments, net of tax
    1,479       (405 )     (5,287 )     6,331  
Net unrealized holding gain (loss) on derivative financial instruments, net of tax
    513       457       (984 )     975  
     
Comprehensive income
  $ 14,141     $ 10,410     $ 24,714     $ 38,269  
     

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3.   Goodwill and Intangible Assets
Goodwill and other intangible assets include the following:
                         
    United States     Canada     Total  
     
Balance as of July 1, 2006
  $ 286,170     $ 63,299     $ 349,469  
Acquisitions/purchase accounting adjustments
    29,812       (340 )     29,472  
Currency exchange and other
          (1,947 )     (1,947 )
     
Balance as of March 31, 2007
  $ 315,982     $ 61,012     $ 376,994  
     
The net increase in goodwill includes an increase of approximately $23,812 related to the acquisition of two entities in the third quarter of fiscal 2007, and an increase of $6,000 for additional consideration related to a prior acquisition executed in fiscal 2005. These increases were offset by a decrease of $1,947 from change in foreign currency exchange rates and $340 related to purchase price adjustments.
As part of the prior acquisition executed in fiscal 2005, the sellers were entitled to additional consideration after year two if certain financial and other conditions were met. These conditions were met resulting in an additional $6,000 earned by the former owners, which was paid in January 2007. No future earn-out related to this acquisition will be due as the term of the arrangement has now expired.
Information regarding the Company’s other intangible assets, which are included in other assets on the consolidated condensed balance sheet, are as follows:
                 
    March 31, 2007   July 1, 2006
Other Intangible Assets:
               
Customer Contracts
  $ 110,421     $ 106,408  
Accumulated Amortization
    (65,203 )     (58,158 )
             
Net
  $ 45,218     $ 48,250  
             
 
Non-Competition Agreements
  $ 11,041     $ 10,908  
Accumulated Amortization
    (9,152 )     (8,446 )
             
Net
  $ 1,889     $ 2,462  
             
The customer contracts include the combined value of the written service agreements and the related customer relationship. It has been determined that there are not any customer relationships with a significant separate value.
Amortization expense was $8,051 and $8,056 for the nine months ended March 31, 2007 and April 1, 2006, respectively. Estimated amortization expense for each of the next five fiscal years based on the intangible assets as of March 31, 2007 is as follows:
         
 
2007 remaining
  $ 2,729  
2008
    10,512  
2009
    6,791  
2010
    6,620  
2011
    5,944  
2012
    5,177  
 

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4.   Long-Term Debt
The Company maintains a revolving credit facility of $325,000 which expires on August 31, 2010. As of March 31, 2007, borrowings outstanding under the revolving credit facility were $62,200. 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 March 31, 2007, letters of credit outstanding against the revolver were $21,251. 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 March 31, 2007 bear interest at a rate of 6.17%. The Company also pays a fee on the unused daily balance of the revolving credit facility based on a leverage ratio calculated on a quarterly basis.
The Company issued $50,000 of 8.4% unsecured fixed rate private placement notes with certain institutional investors. The 10-year notes have a seven-year average life with a final maturity on July 20, 2010. Each year until maturity, the Company is required to repay $7,143 of the principal amount at par. As of March 31, 2007, the outstanding balance was $28,571.
The Company maintains a revolving loan agreement up to $60,000 expiring on October 23, 2007. The Company is required to pay interest on outstanding loan balances at a rate per annum of one month LIBOR plus a margin or, if the lender is funding the loan through the issuance of commercial paper to third parties, at a rate per annum equal to a margin plus the average annual interest rate for such commercial paper. In connection with the loan agreement, the Company granted a first priority security interest in certain U.S. based receivables. The amount of funds available under the loan agreement will be based on the amount of eligible receivables less various reserve requirements. At March 31, 2007, there was $55,000 outstanding under the agreement at a current interest rate of 5.33%. The Company expects to renew or refinance this credit facility before it expires.
The Company has $75,000 of unsecured variable rate private placement notes. The notes do not require principal payments until maturity on June 30, 2015. The interest rate is reset and interest payments are paid on a quarterly basis. As of March 31, 2007, the outstanding balance of the notes was $75,000 at a current rate of 5.95%.
5.   Share-Based Compensation
The Company maintains Stock Option and Compensation Plans in order to grant certain stock awards, including stock options and restricted shares of stock to key employees and external directors of the Company. Stock options granted to employees generally vest annually in equal amounts over three years and stock options granted on an annual basis to external directors, vest over one year. The stock options have an exercise price equal to the market price of the Company’s common stock on the date of grant. Restricted stock granted to employees generally vest annually in equal amounts over five years. Generally, the Company recognizes compensation expense for share-based compensation on a straight-line basis over the vesting period. Total compensation expense related to share-based awards was $1,527 and $942 for the three months ended March 31, 2007 and April 1, 2006, and $3,597 and $3,060 for the nine months ended March 31, 2007, and April 1, 2006, respectively. The number of options that have been exercised and restricted stock that vested since July 1, 2006, was 134,225 shares.

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6.   Employee Benefit Plans
The components of net periodic pension cost are as follows for the three months ended March 31, 2007 and April 1, 2006:
                                 
                    Supplemental Executive  
    Pension Plan     Retirement Plan  
    Three Months Ended     Three Months Ended  
    March 31,     April 1,     March 31,     April 1,  
    2007     2006     2007     2006  
     
Service cost
  $     $ 1,190     $     $ 234  
Interest cost
    774       809       173       188  
Expected return on assets
    (703 )     (617 )            
Prior service cost
          13             11  
Loss
          341             76  
     
Net periodic pension cost
  $ 71     $ 1,736     $ 173     $ 509  
     
The components of net periodic pension cost are as follows for the nine months ended March 31, 2007 and April 1, 2006:
                                 
                    Supplemental Executive  
    Pension Plan     Retirement Plan  
    Nine Months Ended     Nine Months Ended  
    March 31,     April 1,     March 31,     April 1,  
    2007     2006     2007     2006  
     
Service cost
  $ 1,432     $ 3,571     $ 317     $ 702  
Interest cost
    2,322       2,427       518       565  
Expected return on assets
    (2,110 )     (1,850 )            
Prior service cost
    8       39       8       32  
Loss
          1,021             228  
     
Net periodic pension cost
  $ 1,652     $ 5,208     $ 843     $ 1,527  
     
Effective January 1, 2007, the Company froze its pension and Supplemental Executive Retirement Plan (SERP). As a result, future growth in benefits will no longer occur after December 31, 2006, and the net periodic pension cost will be significantly reduced.
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 single customer’s transactions accounted for more than 1.5% of the Company’s revenues.

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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. The Company evaluates performance based on income from operations. Financial information by geographic location for the three and nine month periods ended March 31, 2007 and April 1, 2006 is as follows:
                         
    United              
For the Three Months Ended   States     Canada     Total  
 
Third Quarter Fiscal Year 2007:
                       
Revenues
  $ 195,797     $ 39,445     $ 235,242  
Income from operations
    13,817       6,115       19,932  
Capital expenditures
    4,471       388       4,859  
Depreciation and amortization expense
    9,781       1,545       11,326  
Third Quarter Fiscal Year 2006:
                       
Revenues
  $ 186,965     $ 39,176     $ 226,141  
Income from operations
    10,254       6,339       16,593  
Capital expenditures
    9,144       788       9,932  
Depreciation and amortization expense
    9,389       1,494       10,883  
 
                         
    United              
For the Nine Months Ended   States     Canada     Total  
 
Fiscal Year 2007:
                       
Revenues
  $ 570,154     $ 118,980     $ 689,134  
Income from operations
    38,282       19,030       57,312  
Capital expenditures
    21,671       1,543       23,214  
Depreciation and amortization expense
    28,999       4,777       33,776  
Fiscal Year 2006:
                       
Revenues
  $ 541,459     $ 111,978     $ 653,437  
Income from operations
    35,419       19,093       54,512  
Capital expenditures
    24,320       2,094       26,414  
Depreciation and amortization expense
    27,653       4,473       32,126  
 
8.   Inventory
The components of inventory as of March 31, 2007 and July 1, 2006 are as follows:
                 
    March 31,     July 1,  
    2007     2006  
     
Raw Materials
  $ 5,363     $ 5,742  
Work in Process
    4,494       4,587  
Finished Goods
    54,650       52,457  
     
New Goods
  $ 64,507     $ 62,786  
     
Merchandise In Service
  $ 76,897     $ 78,245  
     
Total Inventories
  $ 141,404     $ 141,031  
     

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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 currently 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. The North American rental market is approximately $6.5-$7.0 billion, while the portion of the direct sale market targeted by us is approximately $4.5-$5.0 billion in size.
Our industry continues to consolidate from many family owned and small local providers to several large providers. We are participating in this industry consolidation. Our rental acquisition strategy is focused on acquisitions in the rental and direct purchase businesses that expand our geographic presence and/or expand our local market share in order to further leverage our existing plants.
In the third quarter of fiscal year 2007, our revenue was $235.2 million, a 4% increase from the $226.1 million reported during the third quarter of fiscal 2006. Continued momentum in rental organic growth throughout 2006 and into 2007 drove the increase compared to the prior year.
Earnings per diluted share was $0.57 for the quarter compared to $0.49 during the prior-year quarter. These results reflect increased revenue in the third quarter of fiscal year 2007, which resulted from new account growth and the implementation of better pricing control in the third quarter of fiscal year 2007. These results were partially offset by increased merchandise expense which was driven by accelerated account growth and increased selling expense which helped drive new accounts.
We made two acquisitions during the third quarter of fiscal 2007. In January, 2007, we acquired the outstanding stock and certain real estate from Grand Rapids Coats and Apron Service, Inc, a uniform rental and facility services company serving Western Michigan. Also, in February, 2007, we acquired the outstanding stock and certain real estate assets from Alltex Uniform Rental Services, Inc., a leading uniform and facility services company serving the New England states. These two acquisitions enhance our geographic coverage in North America and further strengthens our ability to meet the needs of large national account customers. These two acquisitions add approximately $20.0 million in annual revenue.
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 $38.5 million. The total purchase price exceeded the estimated fair value of assets acquired and liabilities assumed by $23.8 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 United States 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 uncertainties, the most important and pervasive accounting policies used and 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 damaged 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 methodologies, and in making our estimates over the past three fiscal years, 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 (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” 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 unit 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 2006 and there have been no events or circumstances through the first nine months of fiscal 2007 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 write-downs of any long-lived assets or definite-lived intangible assets in fiscal 2006 or through the first nine months of fiscal 2007.

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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 actuarial analyses provided by third parties. Changes in the cost of medical care, our ability to settle claims and the present value 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. Our past examinations by governmental revenue authorities leads management to believe that our past provisions for exposures related to income tax planning are 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 obligations based upon current facts, circumstances and tax law.

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Results of Operations
The percentage relationships to revenues of certain income and expense items for the three and nine month periods ended March 31, 2007 and April 1, 2006, 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
    March 31,   April 1,   March 31,   April 1,   FY 2007   FY 2007
    2007   2006   2007   2006   vs. FY 2006   vs. FY 2006
Revenues:
                                               
Rental
    90.1 %     89.1 %     91.2 %     91.1 %     5.1 %     5.6 %
Direct
    9.9       10.9       8.8       8.9       (4.8 )     4.1  
                     
Total revenues
    100.0       100.0       100.0       100.0       4.0       5.5  
 
                                               
Expenses:
                                               
Cost of rental sales
    64.6       65.2       64.2       64.5       4.2       5.2  
Cost of direct sales
    72.3       71.8       73.2       71.9       (4.2 )     6.1  
                     
Total cost of sales
    65.4       65.9       65.0       65.1       3.2       5.3  
 
                                               
Selling and administrative
    21.3       22.0       21.8       21.7       1.0       6.2  
Depreciation and amortization
    4.8       4.8       4.9       4.9       4.1       5.1  
                     
Income from operations
    8.5       7.3       8.3       8.3       20.1       5.1  
 
                                               
Interest expense
    1.6       1.5       1.5       1.4       7.4       8.4  
                     
Income before income taxes
    6.9       5.8       6.8       6.9       23.4       4.4  
Provision for income taxes
    1.7       1.2       2.3       2.2       45.6       14.2  
                     
 
Net income
    5.2 %     4.6 %     4.5 %     4.7 %     17.3 %     0.1 %
                     
Three months ended March 31, 2007 compared to three months ended April 1, 2006
Revenues. Total revenues in the third quarter of fiscal 2007 increased 4.0% to $235.2 million from $226.1 million in the third quarter of fiscal 2006. Rental revenue increased $10.3 million in the third quarter, or 5.1%. The organic industrial rental growth rate was approximately 4.0%, an improvement from approximately 3.5% in the same period of fiscal 2006. Organic industrial rental revenue has improved primarily due to increase in new account sales, improved customer retention and improved pricing controls.
Direct sale revenue decreased 4.8% to $23.4 million in the third quarter of fiscal 2007 compared to $24.6 million in the same period of fiscal 2006. The organic direct sale growth rate during the current period was a negative 5.0%. The prior-year period included the installation of a large new uniform program with a major customer of our Lion Uniform Group.
Organic growth rates are calculated using industrial rental and direct sale revenue, respectively, adjusted to remove the impact of foreign currency exchange rate changes and revenue from newly acquired business compared to prior-period results. 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.

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Cost of Rental and Direct Sale. Cost of rental operations increased 4.2% to $137.0 million in the third quarter of fiscal 2007 from $131.4 million in the same period of fiscal 2006. Gross margin from rental sales increased to 35.4% in the third quarter of fiscal 2007 from 34.8% in the same period of fiscal 2006. Higher rental gross margins during the quarter resulted from leveraging our revenue growth and slightly lower energy costs. These productivity improvements were offset by increased merchandise cost associated with continued new account growth.
Cost of direct sales decreased 4.2% to $16.9 million in the third quarter of fiscal 2007 from $17.7 million in the same period of fiscal 2006. Gross margins from direct sales decreased to 27.7% in the third quarter of fiscal 2007 from 28.2% in the third quarter of fiscal 2006. The decrease in direct sales margins is primarily the result of increased compensation costs and a lower sales volume.
Selling and Administrative. Selling and administrative expenses increased 1.0% to $50.1 million in the third quarter of fiscal 2007 from $49.6 million in the same period of fiscal 2006. As a percentage of total revenues, selling and administrative expenses decreased to 21.3% in the third quarter of fiscal 2007 from 22.0% in the third quarter of fiscal 2006. The prior-year third quarter included $2.1 million of legal expense and negative 0.9% of consolidated revenue for settling two specific legal matters. Selling expenses as a percent of consolidated revenue were higher in the third quarter of fiscal year 2007 than in the same period of the prior fiscal year as a result of our expansion in our sales force in fiscal year 2007. This increase is partially offset by lower administrative expenses due to office productivity savings as a result of our handheld initiative, leverage due to improved revenue growth and lower retirement plan expenses.
Depreciation and Amortization. Depreciation and amortization expense increased 4.1% to $11.3 million in the third quarter of fiscal 2007 from $10.9 million in the same period of fiscal 2006. As a percentage of total revenues, depreciation and amortization expense remained at 4.8% in the third quarter of both fiscal 2007 and fiscal 2006. Net capital expenditures, excluding acquisition of businesses, were $4.9 million in the third quarter of fiscal 2007 compared to $9.9 million in the prior year’s quarter.
Interest Expense. Interest expense was $3.6 million in the third quarter of fiscal 2007, up from $3.4 million in the same period of fiscal 2006. Interest expense increased due to higher interest rates in fiscal 2007 than in fiscal 2006, offset by lower average debt levels.
Provision for Income Taxes. Our effective tax rate increased to 25.4% in the third quarter of fiscal 2007 from 21.5% in the same period of fiscal 2006. This increase is primarily due to higher pretax income that is taxed at our statutory rate. The effective tax rate for both periods is lower than our statutory rate primarily due to the expiration of certain statutes and the favorable resolution of other tax matters which resulted in the reversal of tax reserves that were no longer required, as well as adjustments resulting from the final calculation and filing of the Company’s fiscal 2005 and 2006 tax returns.
Nine months ended March 31, 2007 compared to Nine months ended April 1, 2006
Revenues. Total revenues for the first nine months of fiscal 2007 increased 5.5% to $689.1 million from $653.4 million for the same period of fiscal 2006. Rental revenue increased $33.3 million in the first nine months, or 5.6%. The organic industrial rental growth rate was approximately 4.5% in 2007 versus 3.5% in 2006. Organic industrial rental revenue has improved primarily due to an improvement in customer retention, increase in new account sales and to a lesser extent improved pricing controls.
Direct sale revenue increased 4.1% to $60.9 million in the first nine months of fiscal 2007 compared to $58.5 million in the same period of fiscal 2006. The organic direct sale growth rate during the current period was approximately 3.0%. Organic direct sale revenue growth is due to a number of new direct sale customers sold during the past year, offset by the installation of a new uniform program with a major customer in our Lion Uniform Group in fiscal year 2006 that didn’t reoccur in fiscal year 2007.
Cost of Rental and Direct Sale. Cost of rental operations increased 5.2% to $403.4 million in the first nine months of fiscal 2007 from $383.6 million in the same period of fiscal 2006. Gross margins from rental sales increased to 35.8% in the first nine months of fiscal 2007 from 35.5% in the same period of fiscal 2006. The slight increase in gross margins was driven by lower production and delivery costs in the first quarter of fiscal year 2007 which were partially offset by increased merchandise amortization costs as well as higher worker compensation and healthcare costs throughout the first nine months of fiscal 2007. Increased merchandise amortization costs are associated with greater levels of in-service inventory resulting from the increased levels of new account sales over the past year.

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Cost of direct sales increased 6.1% to $44.6 million in the first nine months of fiscal 2007 from $42.0 million in the same period of fiscal 2006. Gross margin from direct sales decreased to 26.8% in the first nine months of fiscal 2007 from 28.1% in the same period of fiscal 2006. The decrease in direct sales margins is the result of a combination of increased compensation costs as well as increased customer fulfillment and shipping costs at our Lion Uniform Group. These costs increased due to the expiration of a certain cost sharing arrangement at the end of fiscal year 2006.
Selling and Administrative. Selling and administrative expenses increased 6.2% to $150.0 million in the first nine months of fiscal 2007 from $141.2 million in the same period of fiscal 2006. As a percentage of total revenues, selling and administrative expenses increased slightly to 21.8% in the first nine months of fiscal 2007 from 21.7% in the same period of fiscal 2006. The primary drivers of the increased selling and administrative expenses are the expansion of our sales force and the continued rollout of our information technology initiatives. These increases were partially offset by lower administrative expenses due to office productivity savings driven by the Company’s handheld initiative, leverage due to improved revenue growth and lower retirement plan expenses. In addition, fiscal 2006 included $2.1 million (0.3% of consolidated revenue) of legal expenses for settling two specific legal matters.
Depreciation and Amortization. Depreciation and amortization expense increased 5.1% to $33.8 million in the first nine months of fiscal 2007 from $32.1 million in the same period of fiscal 2006. As a percentage of total revenues, depreciation and amortization expense remained at 4.9% in the first nine months of both fiscal 2007 and fiscal 2006. Net capital expenditures, excluding acquisition of businesses, were $23.2 million in the first nine months of fiscal 2007 compared to $26.4 million in the same period of fiscal 2006.
Interest Expense. Interest expense was $10.5 million in the first nine months of fiscal 2007, up from $9.7 million in the same period of fiscal 2006. The increase was due to higher interest rates in fiscal year 2007 compared to fiscal year 2006, offset by lower average debt levels.
Provision for Income Taxes. Our effective tax rate increased to 33.8% in the first nine months of fiscal 2007 from 30.9% in the same period of fiscal 2006. This increase is primarily due to higher pretax income that is taxed at our statutory rate and larger reversals in the prior year of tax reserves that were no longer required due to the expiration of certain statutes.
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.
Working capital at March 31, 2007 was $104.3 million, down 26.7% from $142.2 million at July 1, 2006. The decrease in working capital is largely due to the maturity of the $53.0 million outstanding under our revolving loan agreement in October 2007.
Operating Activities. Net cash provided by operating activities was $51.2 million in the first nine months of fiscal 2007 and $50.0 million in the same period of fiscal 2006. The increase in cash generated from operating activities is largely due to a decrease in the expenditures for inventory, which was partially offset by lower accounts payable balances.
Investing Activities. Net cash used in investing activities was $72.8 million in the first nine months of fiscal 2007 and $39.4 million in the same period of fiscal 2006. In fiscal 2007, cash was primarily used for the acquisition of business assets and property, plant and equipment. In fiscal 2006, cash was largely used for property, plant and equipment additions and for acquisition of business assets.
Financing Activities. Cash provided by financing activities was $19.3 million in the first nine months of fiscal 2007 and cash used for financing activities was $4.3 million in the same period of fiscal 2006. Cash provided by financing activities in fiscal 2007 was from debt proceeds used primarily for the acquisition of business assets. Cash used in financing activities in fiscal 2006 was used primarily to repay borrowings from our debt instruments. The Company paid dividends of $2.6 million and $1.1 million during the nine months ended March 31, 2007 and April 1, 2006, respectively.

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We maintain a revolving credit facility of $325.0 million which expires on August 31, 2010. As of March 31, 2007, borrowings outstanding under the revolving credit facility were $62.2 million. The unused portion of the revolver may be used for general corporate purposes, acquisitions, working capital needs and to provide up to $50.0 million in letters of credit. As of March 31, 2007, letters of credit outstanding against the revolver were $21.3 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 March 31, 2007 bear interest at a rate of 6.17%. We also pay a fee on the unused daily balance of the revolving credit facility based on a leverage ratio calculated on a quarterly basis.
We have $50.0 million, 8.4% unsecured fixed rate private placement notes with certain institutional investors. The 10-year notes have a seven-year average life with a final maturity on July 20, 2010. Each year until maturity, we are required to repay $7.1 million of the principal amount at par. As of March 31, 2007, the outstanding balance was $28.6 million.
We maintain a revolving loan agreement up to $60.0 million expiring on October 23, 2007. We are required to pay interest on outstanding loan balances at a rate per annum of one month LIBOR plus a margin or, if the lender is funding the loan through the issuance of commercial paper to third parties, at a rate per annum equal to a margin plus the average annual interest rate for such commercial paper. In connection with the loan agreement, we granted a first priority security interest in certain of our U.S. based receivables. The amount of funds available under the loan agreement will be based on the amount of eligible receivables less various reserve requirements. At March 31, 2007, there was $55.0 million outstanding under the agreement at a current rate of 5.33%. We expect to renew or refinance this credit facility before its expiration on October 23, 2007.
We have $75.0 million of unsecured variable rate private placement notes. The notes do not require principal payments until maturity on June 30, 2015. The interest rate is reset and interest payments are paid on a quarterly basis. As of March 31, 2007, the outstanding balance of the notes was $75.0 million at a current rate of 5.95%.
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.
At March 31, 2007, we had available cash on hand of $16.8 million and approximately $240.0 million of available capacity under our revolving credit facility. We anticipate that we will generate sufficient cash flows from operations to satisfy our cash commitments and capital requirements for fiscal 2007 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 2007 will be approximately $30 million.
The amount of cash flow generated from operations could be affected by a number of risks and uncertainties. In fiscal 2007, 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.
Off Balance Sheet Arrangements
At March 31, 2007, we had stand-by letters of credit totaling $21.3 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.
Pension Obligations
We account for our defined benefit pension plan using SFAS 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 $0.1 million in the third quarter of fiscal 2007 and $1.7 million in the same period of fiscal 2006. At July 1, 2006, the fair value of our pension plan assets totaled $32.8 million.

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Effective January 1, 2007 we have frozen our defined benefit pension plan and related supplemental executive retirement plan. We incurred $0.2 million in costs associated with this action in fiscal year 2006. All benefits earned by defined benefit plan participants through the end of calendar year 2006 will be available upon retirement under plan provisions. Future growth in benefits will no longer occur beyond December 31, 2006.
The calculation of pension expense and the corresponding liability requires the use of a number of critical 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 1, 2006, we estimated that the pension plan assets will generate a long-term rate of return of 8.0%. This rate was developed by evaluating input from our outside actuary as well as long-term inflation assumptions. The expected long-term rate of return on plan assets at July 1, 2006 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 2007 pension expense by approximately $0.2 million. Pension liability and future pension expense increase as the discount rate is reduced. We discounted future pension obligations using a rate of 6.45% at July 1, 2006. Our outside actuary determines the discount rate by creating a yield curve based on high quality bonds. Decreasing the discount rate by 0.5% (from 6.45% to 5.95%) would increase our accumulated benefit obligation at July 1, 2006 by approximately $4.6 million and increase the estimated fiscal 2007 pension expense by approximately $0.3 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, we believe that our results of operations are not dependent on moderate changes in the inflation rate. Historically, we have been able to manage the impacts 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 4.5% 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 which were settled in the last fiscal year, and are presently being administered. None of these legal actions are expected to have a material adverse effect on our results of operations or financial position.
Share-Based Compensation
We maintain Stock Option and Compensation Plans to grant certain stock awards, including stock options and restricted shares of stock to key employees and external directors of the Company. Stock options granted to employees generally vest annually in equal amounts over three years and stock options granted on an annual basis to external directors, vest over one year. The stock options have an exercise price equal to the market price of our common stock on the date of grant. Restricted stock granted to employees prior to January 1, 2002, vest annually in equal amounts over seven years and grants after January 1, 2002, vest annually in equal amounts over five years. Generally we recognize compensation expense for share-based compensation on a straight-line basis over the pertinent vesting period. Total compensation expense related to share-based awards was $1.5 million for the three months ended March 31, 2007 and $0.9 million in the same period of fiscal 2006, and $3.6 million for the nine months ended March 31, 2007 and $3.1 million in the same period of fiscal 2006. The number of options that have been exercised and restricted stock that vested since July 1, 2006, was 134,225 shares.

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Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (SFAS) No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans”, an amendment of FASB statements No. 87, 88, 106 and 132R which will be effective for our fiscal year ending June 30, 2007. The standard requires us to:
    Recognize in our statement of financial position the over-funded or under-funded status of a defined benefit postretirement plan measured as the difference between the fair value of plan assets and the benefit obligation.
    Recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs and credits that arise during the period but pursuant to FAS 87 and 106 are not recognized as components of net periodic benefit cost.
 
    Recognize as an adjustment to the opening balance of retained earnings, net of tax, any transition asset or transition obligation remaining from the initial application of FAS 87 or 106.
 
    Measure defined benefit plan assets and defined benefit plan obligations as of the date of our statement of financial position.
 
    Disclose additional information in our notes to financial statements about certain effects on net periodic benefit cost in the upcoming fiscal year that arise from delayed recognition of the actuarial gains and losses and the prior service costs and credits.
On July 13, 2006, the Financial Accounting Standards Board issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement 109,” which fundamentally changes the way that we will be required to treat our uncertain tax positions for financial accounting purposes and will be effective for our fiscal year starting July 1, 2007. FIN 48 prescribes rules regarding how we should recognize, measure and disclose in our financial statements the tax positions that we have taken or will take on our tax return that are reflected in measuring current or deferred income tax assets and liabilities for interim or annual periods. Differences between tax positions taken in a tax return and amounts recognized in the financial statements will generally result in an increase in a liability for income taxes payable, or a reduction in a deferred tax asset or an increase in a deferred tax liability.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurement” (SFAS 157). SFAS 157 provides a definition of fair value, provides guidance for measuring fair value in U.S. GAAP and expands disclosures about fair value measurement. SFAS 157 will be effective at the beginning of fiscal 2009.
In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (SFAS 159). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS 159 will be effective at the beginning of fiscal 2009.
We are currently evaluating the impact of these standards on our consolidated financial statements.
Cautionary Statements Regarding Forward-Looking Statements
The Private Securities Litigation Reform Act of 1995 provides a safe harbor from civil litigation for forward-looking statements. Forward-looking statements may be identified by words such as “estimates,” “anticipates,” “projects,” “plans,” “expects,” “intends,” “believes,” “seeks,” “could,” “should,” “may” and “will” or the negative versions thereof and similar expressions and by the context in which they are used. Such statements are based upon our current expectations and speak only as of the date made. These statements are subject to various risks, uncertainties and other factors that could cause actual results to differ from those set forth in or implied by this quarterly report on Form 10-Q. Factors that might cause such a difference include, but are not limited to, the possibility of greater than anticipated operating costs, including energy costs, lower sales volumes, the performance and costs of integration of acquisitions or assumption of unknown liabilities in connection with acquisitions, fluctuations in costs of materials and labor, costs and possible effects of union organizing activities, loss of key management, uncertainties regarding any existing or newly-discovered expenses and liabilities related to environmental compliance and remediation, failure to achieve and maintain effective internal controls for financial reporting required by the Sarbanes-Oxley Act of 2002, the initiation or outcome of litigation, higher assumed sourcing or distribution costs of products, the disruption of operations from catastrophic events, changes in federal and state tax laws and the reactions of competitors in terms of price and service. We undertake no obligation to update any forward-looking statements to reflect events or circumstances arising after the date on which they are made except as required by law. Additional information concerning potential factors that could effect future financial results are included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 1, 2006.

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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 2007 by approximately $0.3 million. This estimated exposure considers the mitigating effects of interest rate swap agreements outstanding at March 31, 2007 on the change in the cost of variable rate debt. The current fair market value of all outstanding contracts at March 31, 2007 is $0.8 million.
Energy Cost Risk
We use derivative financial instruments to manage the risk that changes in energy costs will have on the future financial results of the Company. We purchase futures contracts to effectively hedge a portion of anticipated energy purchases. The futures contracts are reflected at fair value in the consolidated balance sheet and the related gains or losses on these contracts are deferred in stockholders’ equity (as a component of other comprehensive income) for contracts that cash flow hedge accounting is achieved 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 cost of rental operations. The current fair market value of all outstanding contracts at March 31, 2007 is a positive $0.3 million.
Foreign Currency Exchange Risk
We have material foreign subsidiaries located in Canada. The assets and liabilities of these subsidiaries 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
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) or Rule 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this Form 10-Q. Based on their evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures are effective.
There have been no changes in our internal controls over financial reporting that occurred 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 1A. RISK FACTORS
In addition to the other information set forth in this Quarterly Report on Form 10-Q, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended July 1, 2006, which could materially affect our business, financial condition or future results. There have been no material changes to the risk factors set forth in our Annual Report on Form 10-K for the year ended July 1, 2006. The risks described in our Annual Report on Form 10-K are not the only risks we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
The following table includes information about our share repurchases for the quarter ended March 31, 2007.
                                 
                            Maximum Number (or
                    Total Number of   Approximate Dollar
                    Shares (or Units)   Value) of Shares
                    Purchased as Part   (or Units) that May
    Total Number of           of Publicly   Yet be Purchased
    Shares (or Units)   Average Price Paid   Announced Plans or   Under the Plans or
Period   Purchased   per Share (or Unit)   Programs   Programs
Month #1
(Fiscal month ending
February 3, 2007)
    327     $ 0.00              
Month #2
(Fiscal month ending
March 3, 2007)
    747     $ 0.00              
Month #3
(Fiscal month ending
March 31, 2007)
        $ 0.00              
All repurchased shares were initially issued under the Employee Plans as restricted stock grants subject to forfeiture upon termination of employment. All repurchases were made upon forfeiture of shares to pay for taxes by the recipient of such restricted stock grants. Pursuant to the Restricted Stock Agreements governing such grants, the repurchase price for all shares granted prior to August 31, 2004 was $0.50 per share and for shares granted after August 31, 2004 the repurchase price was $0.00 per share. The repurchase price represents the per share amount paid by the restricted stock grant recipient on the date of grant.

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ITEM 6. EXHIBITS
     a. Exhibits
10.1 Executive Employment Agreement with David F. Fisher, dated March 13, 2007 (incorporated herein by reference to Registrant’s Form 8-K filed March 19, 2007).
10.2 Executive Employment Agreement with Douglas A. Milroy, dated March 13, 2007 (incorporated herein by reference to Registrant’s Form 8-K filed March 19, 2007).
10.3 Executive Employment Agreement with David M. Miller, dated March 13, 2007 (incorporated herein by reference to Registrant’s Form 8-K filed March 19, 2007).
10.4 Executive Employment Agreement with Robert G. Wood, dated March 13, 2007 (incorporated herein by reference to Registrant’s Form 8-K filed March 19, 2007).
31.1 Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a) 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-14(a)/15d-14(a) 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 duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  G&K SERVICES, INC.
(Registrant)
 
 
Date: May 4, 2007  By:   /s/ Jeffrey L. Wright    
    Jeffrey L. Wright   
    Senior Vice President
and Chief Financial Officer
(Principal Financial Officer) 
 
         
     
  By:   /s/ Thomas J. Dietz    
    Thomas J. Dietz   
    Vice President and Controller
(Principal Accounting Officer) 
 
 

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