American Home Shield 2006 Annual Report Download - page 29

monthly to quarterly service frequency. With the improved efficacy of liquid termite treatments, the Company began providing
consumers with the choice of receiving termite services through baiting systems or liquid treatments. As previously disclosed, with
this enhanced termite offering, the Company anticipated and did experience a shift in the mix of its termite customer base from bait
to liquid. While the estimated lifetime values of these two types of offerings are comparable, the earnings cycles are different with
liquid customers having less first year revenues and profits but more profitability in subsequent years. By offering consumers a
choice in treatments, Terminix was able to increase the average price realized for each of the two treatment alternatives, thus
helping to offset the adverse, short-term revenue and profit impacts of the mix shift. The mix of new termite sales ("termite
completions"), which represent about a quarter of Terminix's total revenue, moved from approximately 80 percent bait and 20
percent liquid at the end of 2003 to approximately 45 percent bait and 55 percent liquid at the end of 2004. As a result, overall
termite completion revenue increased only modestly in 2004, even though the Company achieved solid double-digit unit growth in
sales and improved price realization for each treatment alternative viewed discreetly.
Termite renewal revenues experienced strong growth, supported by improved pricing. Pest control revenue increased modestly as
high single-digit growth in customer counts, attributable in part to a 100 basis point improvement in retention, was partially offset
by the unfavorable impact to revenues from the increased number of customers receiving quarterly service visits versus monthly
service visits. The Company believes this shift has had a positive impact on improving customer satisfaction and has already caused
and should continue to lead to improved labor efficiencies.
Operating income grew modestly as the projected termite mix shift did have a negative effect on first year gross profit. Operating
income was also adversely impacted by higher insurance, fuel, and bad debt costs, as well as the costs associated with a procedural
change in the branches to ensure that termite renewal reinspections occur before the actual renewal payments are due. In 2004, the
Company recorded a final adjustment to reflect positive trending in damage claim costs associated with the Sears termite customer
base acquired several years ago. This resulted in an $8 million reduction in expense in 2004, compared with a $13 million reduction
in 2003. In the fourth quarter of 2003, Terminix corrected its method of recognizing renewal revenue from certain customers who
have prepaid. A cumulative adjustment was recorded reducing fourth quarter 2003 revenue by $9 million and operating income by
$7 million.
Capital employed in the Terminix segment increased six percent, primarily reflecting acquisitions.
American Home Shield Segment
The American Home Shield segment reported an eight percent increase in revenue to $487 million from $450 million in 2003, and
operating income growth of 24 percent to $72 million compared to $58 million in 2003.
Renewal sales, which are American Home Shield's largest source of revenue, experienced solid growth, reflecting management's
specific programs to improve satisfaction and retention. Real estate sales, which are the second-largest channel, had slight growth
with volume negatively impacted by strong declines in home listings in high warranty usage states like California and Texas. And
consumer sales, which are the smallest but fastest-growing channel, experienced very strong double-digit growth, reflecting an
increased level of direct-mail solicitations. American Home Shield's total new contract sales in the fourth quarter increased three
percent, a rate less than the full year growth rate of six percent due in part to the relative timing of direct mail solicitations.
Operating income increased, reflecting the effects of revenue growth and continued very strong controls over claim costs. Partially
offsetting these factors were continuing investments to increase market penetration and customer retention. In 2005, American
Home Shield is planning to continue its efforts to expand sales in less established real estate markets by expanding its sales force,
improving training, and reducing the span of control of sales force supervisors. These efforts are intended to drive a replication of
the results of high performing account executives. Management is also focusing on continuing to improve customer satisfaction and
retention through enhanced customer communications.
In the third quarter of 2004, American Home Shield recorded a cumulative, non-cash negative adjustment to revenue and operating
income of approximately $5.5 million related to the conversion from a historically manual deferred revenue calculation to an
automated computation. In the fourth quarter of 2003, American Home Shield recorded a cumulative adjustment of a comparable
amount related to a correction in its method of recognizing revenue from customers who have prepaid.
Capital employed increased 25 percent reflecting a higher level of cash and marketable securities due to the growth in the business
and improved market performance. The calculation of capital employed for the American Home Shield segment includes
approximately $258 million and $221 million of cash, short-term and long-term securities at December 31, 2004 and 2003,
respectively. The interest and realized gains/losses on these investments are reported as non-operating income/expense.
Other Operations Segment
The Other Operations segment reported an eight percent increase in revenue to $164 million in 2004 compared with $152 million in
2003. On a combined basis, the ServiceMaster Clean and Merry Maids franchise operations reported revenue growth of 10 percent
and a solid increase in operating income. ServiceMaster Clean continued to experience strong growth in disaster restoration
services. At Merry Maids, a better economy and improved sales processes have driven steady increases in internal revenue growth
in both the branch and franchise operations. The segment's operating loss increased over the prior year, primarily reflecting a higher
level of variable incentive compensation expense at the headquarters level, partially offset by increased profits in the franchise
operations.
Total initial and recurring franchise fees represented 3.3 percent and 3.2 percent of consolidated revenue in 2004 and 2003,
respectively and direct franchise operating expenses were 2.1 percent and 2.0 percent of consolidated operating expenses in 2004
and 2003, respectively. Total franchise fee