As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 3/16/07  Mac-Gray Corp                     10-K       12/31/06    5:2.5M                                   Merrill Corp-MD/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Annual Report                                       HTML   1.49M 
 2: EX-23.1     Consent of Experts or Counsel                       HTML      6K 
 3: EX-31.1     Certification -- Sarbanes-Oxley Act - Sect. 302     HTML     14K 
 4: EX-31.2     Certification -- Sarbanes-Oxley Act - Sect. 302     HTML     13K 
 5: EX-32.1     Certification -- Sarbanes-Oxley Act - Sect. 906     HTML     11K 

PART I

Forward-Looking Statements

Some of the statements made in this report under the captions “Risk Factors,” “Business,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report or in documents incorporated herein by reference are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases you can identify these statements by forward-looking words such as “anticipate,” “assume,” “believe,” “estimate,” “expect,” “intend,” and other similar expressions. Investors should not rely on forward-looking statements since they involve known and unknown risks, uncertainties and other factors, which are, in some cases, beyond the Company’s control and which could materially affect actual results, performance or achievements. Factors that could cause actual results, performance or achievements to differ materially from those expressed or implied by these forward-looking statements include, without limitation, the factors described under Item 1A, “Risk Factors.” Investors should carefully review all of the factors described therein, which may not be an exhaustive list of the factors that could cause these differences.

Item 1.   Business

Overview

Since its founding in 1927, Mac-Gray Corporation has grown to become the second largest laundry facilities management business in the United States. Through our portfolio of card- and coin-operated laundry equipment located in laundry facilities across the country, we provide laundry convenience to residents of multi-unit housing; such as apartment buildings, condominiums, colleges and university residence halls, and hotels and motels. Based on our ongoing survey of colleges and universities, we believe we are the largest provider of such services to the college and university market in the United States. Unless the context requires otherwise, all references in this report to “we,” “our,” “Mac-Gray,” the “Company,” or “us” means Mac-Gray Corporation and its subsidiaries and predecessors. Mac-Gray Corporation was incorporated in Delaware in 1997.

We derive our revenue principally as a laundry facilities management contractor for the multi-unit housing industry. In 2006, 82% of our consolidated revenue was derived from laundry facilities management. We manage laundry rooms under long-term leases with property owners, colleges and universities and governmental agencies. We refer to these leases as “laundry leases” or “management contracts” and this business as “laundry facilities management.” As of December 31, 2006, our laundry facilities management business had revenue-generating laundry equipment operating in 43 states and the District of Columbia.

Intirion, which operates our MicroFridge® business, derives revenue through the sale and rental of a family of patented combination refrigerator/freezer/microwave ovens, or “Units,” and other household appliances to colleges and universities, military bases, the hotel and motel market, and assisted living facilities. Intirion also derives revenue through the sales of commercial laundry equipment to the United States military and is also a national distributor of Whirlpool’s Maytag, Amana®, and Magic Chef® brands of appliances using the brand name “Maytag Direct®.”

Our laundry equipment sales unit sells and services commercial laundry equipment manufactured by Whirlpool Corporation, Dexter Laundry Company, and American Dryer Corporation. This business unit sells commercial laundry equipment to retail laundromats, restaurants, hotels, health clubs and similar institutional users that operate their own on-premise laundry facilities. We refer to this business as our “equipment sales business.”

Our reprographics business unit (“Copico”) derives its revenue principally through managing college and municipal libraries’ vended reprographic equipment, with operations concentrated in the northeast

1

---

United States. In the fourth quarter of 2006, the Company incurred an impairment charge for the write-off of a significant portion of the assets associated with the operations of this business unit.

Segment Information

The following is a discussion of each of our reportable business segments: (i) Facilities Management and (ii) Product Sales. Financial information with regard to each business segment is reported under Note 16 to the Company’s consolidated financial statements included in this report.

Facilities Management Segment

Mac-Gray’s Facilities Management segment includes both our laundry facilities management business and reprographics facilities management business. For the years ended December 31, 2005 and 2006, our facilities management segment accounted for approximately 82% and 83% of our total revenue, respectively, and 82% of our gross margin for each year.

Laundry Facilities Management Business

Through our Facilities Management segment, we act as a laundry facilities management contractor with property owners or managers. The property owner or manager is usually responsible for maintaining, cleaning, and securing of the premises and payment of utilities. Mac-Gray leases space within a property, in some instances improves the leased space with flooring, ceilings and other improvements (“betterments”), and then installs and services the laundry equipment and collects the payments. Under our long-term leases, we typically receive the exclusive right to service laundry rooms within a multi-unit housing property in exchange for a negotiated percentage of the total revenue collected. This percentage is referred to herein as “facilities management rent.”  During the past five years, we have retained approximately 97% of our equipment base per year. For the years ended December 31, 2005 and 2006, we have been able to add 5% and 4%, respectively, to our equipment base through internally generated growth. Mac-Gray believes that its ability to retain its existing equipment base, while growing that base through internally generated growth in equipment installations, is indicative of its service of, and attention to, property owners and managers. The Company has also been able to provide its customers with proprietary technologies, and continues to invest in research and development of such technologies. We generally have the ability to set and adjust the vend pricing for our equipment based upon local market conditions.

Mac-Gray has centralized its administrative and marketing operations at its corporate headquarters in Waltham, Massachusetts. Mac-Gray also operates sales and/or service centers in Connecticut, Florida (four locations), Georgia, Illinois, Maine, Maryland, Massachusetts (two locations), New York (two locations), North Carolina, Tennessee, New Jersey, Arizona (two locations), Colorado, Louisiana, New Mexico, Oregon, Texas (three locations), Utah, and Washington.

Mac-Gray also generates revenue by leasing equipment to commercial laundry customers who choose neither to purchase equipment nor to become a laundry facilities management customer, but instead wish to maintain their own laundry rooms. This leasing business generated revenue of $3.6 million and $4.0 million for the years ended December 31, 2005 and 2006, respectively, and is included in the laundry facilities management business unit.

Mac-Gray’s laundry facilities management business has certain intrinsic characteristics in both its industry and its customer base, including the following:

Revenue.   Mac-Gray operates as a laundry facilities management contractor under long-term leases and other arrangements with property owners or managers. Mac-Gray’s efforts are designed to maintain these customer relationships over the long-term. Our typical lease has an original average term of approximately seven years, with an option to renew if mutually agreed upon by us and the owner or

2

---

manager. In each of the past five years, we have retained approximately 97% of our equipment base per year.

Customers.   As of February 1, 2007, Mac-Gray provided laundry equipment and related services to approximately 58,000 laundry rooms located in 43 states in the northeast, south, midwest, and northwest United States, as well as the District of Columbia. As of February 1, 2007, no customer contract accounted for more than 1% of Mac-Gray’s laundry facilities management revenue. Mac-Gray serves customers in multi-unit housing facilities, including apartment buildings, college and university residence halls, condominiums and public-housing complexes.

Seasonality.   The Company experiences moderate seasonality as a result of its operations in the college and university market. Revenues derived from the college and university market represented approximately 16% of the laundry facilities management revenue for 2006. Academic facilities management revenues are derived substantially during the school year in the first, second and fourth calendar quarters. Conversely, the Company increases its operating and capital expenditures during a significant portion of the third calendar quarter, when it has its greatest product installation activities, which is when most colleges and universities are not in session. Product sales, principally of MicroFridge® products, to this market are typically higher during the third calendar quarter as compared to the rest of the calendar year, somewhat offsetting the seasonality effect of the laundry facilities management business unit.

Competition.   The laundry facilities management industry is highly competitive, capital intensive and requires the delivery of reliable and prompt services to customers. Mac-Gray believes that customers consider different factors in selecting a laundry facilities management contractor, such as customer service, reputation, facilities management rent rates, including incentives, advance rents, and range of products and services. Mac-Gray believes that different types of customers assign varied weight to each of these factors and that no one factor alone determines a customer’s selection of a laundry facilities management contractor. Within any given geographic area, Mac-Gray may compete with local independent operators, regional and multi-regional operators, and one national operator. The industry is highly fragmented; consequently, Mac-Gray has grown by acquisitions, as well as through new equipment placement. As of February 1, 2007, Mac-Gray believes that it is the second largest laundry facilities management contractor in the United States.

3

Impact of Occupancy Rates.   The Company’s laundry facilities management revenue is affected by changes in the multi-unit housing occupancy rates. Occupancy rates in the multi-unit housing industry are affected by several factors. These factors include local economic conditions, local unemployment levels and mortgage interest rates as they relate to first-time homebuyers, and the supply of apartments in specific markets, particularly the conversion of apartments to condominiums. The Company is somewhat protected from revenue decreases caused by declining occupancy rates due to the variation of markets served, the various types of multi-unit housing facilities therein, and the high percentage of revenue derived from colleges and universities. The Company monitors independent market research data regarding trends in occupancy rates in all of its significant markets, to better understand laundry facilities revenue trends and variations.

Suppliers.   The Company currently purchases substantially all of the equipment that it uses in its laundry facilities management business from Whirlpool. In addition, the Company derives a portion of its revenue, as well as certain competitive advantages, from its position as a distributor of Whirlpool commercial laundry products. The Company has maintained a relationship with Whirlpool and its predecessor corporation, Maytag, since 1927. Either party upon written notice may terminate the purchase and distribution agreements between the Company and Whirlpool. A termination of, or substantial revision of the terms of, the contractual arrangements or business relationships with Whirlpool could have a material adverse effect on the Company’s business, results of operations, financial condition and prospects.

Reprographics Facilities Management Business

Our reprographics facilities management business unit, operating as Copico, is a provider of card- and coin-operated reprographics equipment and services to the academic and public library markets in the Northeast, and to a lesser extent in the Mid-Atlantic and the Midwest. Copico provides and services copiers and laser printers for the libraries of colleges, universities, graduate schools and public libraries. Copico represented less than 1% of the Company’s consolidated revenue in 2006.

Copico’s revenue and corresponding operating income have been declining since 1999 when college libraries, followed by public libraries, began to make reference material electronically available to patrons. Electronic availability, widespread conversion to laser printers (free of charge in many school libraries) and other technical advancements have led to reduced use of vended copy machines resulting in reduced revenue at several accounts. As a result, in 2006 the Company recorded a pre-tax impairment charge of $2.5 million to write down the value of the reprographics business unit to its net realizable value.

Product Sales Segment

Mac-Gray’s Product Sales segment includes both MicroFridge® and Laundry Equipment Sales. For the years ended December 31, 2005 and 2006, our product sales segment accounted for approximately 18% and 17% of our total revenue, respectively, and 18% of our gross margin for each year.

MicroFridge® Sales Business

Revenue.   Our MicroFridge® business unit consists of supplying combination refrigerator/ freezer/microwave ovens (Units) under the brand name MicroFridge® to multi-unit housing facilities such as military bases, hotels, motels, colleges and universities and assisted living facilities. The MicroFridge® business unit revenue includes sales of Units under the brand name MicroFridge® to a customer base which includes hospitality and assisted living facilities, military housing, and colleges and universities. The MicroFridge® business unit is a national distributor of Whirlpool’s Maytag, Amana® and Magic Chef® brands of kitchen appliances using “Maytag Direct.”®, our brand name. For the years ended December 31,

4

---

2005 and 2006, our MicroFridge® business unit accounted for approximately 12% and 11% of our total revenue, respectively.

Products.   The MicroFridge® product line with Safe Plug™ is a family of patented combination refrigerator/freezer/microwave ovens. The Units’ patented circuitry has proven to be an important feature for those customers who have concerns about electrical capacity and seek a safer alternative to hot plates and other cooking or heating appliances. MicroFridge® sales efforts have been focused on such “home-away-from-home” markets as military bases, hotels, motels, colleges and universities and assisted living facilities.

Mac-Gray believes that the MicroFridge® Units product line enhances the Company’s ability to provide multiple amenities to both its current customer base as well as future customers seeking one source to fill multiple needs.

Customers.   The MicroFridge® business unit revenue is derived from both the sale and rental of MicroFridge® Units and related products. In 2006, the largest market was the hospitality lodging industry and assisted living market throughout the United States, to which we sell both directly and through an independent dealer network. The second largest market was government living, consisting principally of military bases. In this market, the MicroFridge® Unit product line is available through government contracts with various governmental agencies. MicroFridge® Units have been installed at a number of United States government facilities throughout the world. MicroFridge® Units are also sold and leased to the academic living market. The academic living market is composed of more than 1,800 colleges and universities across the United States that have on-campus residence halls.

Competition.   In addition to large direct sellers, the MicroFridge® business unit also competes with the major retail stores and local and regional distributors who sell various brand-name compact refrigerators as well as microwave ovens in the markets served by MicroFridge®. Although we jointly hold a patent on combination units utilizing internal circuitry, there has been continuing competition from “similar look” products utilizing an external circuitry control mechanism. There also exists local and regional competition in the MicroFridge® rental business. Management believes that its expertise gained from being the first entrant in the market enables it to compete effectively against new entrants in the combination appliance business. MicroFridge®’s principal competitors include Absocold, Avanti, General Electric, Sanyo Fisher Sales, Sears, Tatung, Home Depot, Lowe’s, Wal-Mart, and several companies focused on the college rental marketplace.

Suppliers.   The MicroFridge® business unit maintains original equipment manufacturer, or “OEM,” arrangements with two primary manufacturers: Sanyo E&E Corporation, and Nisshin Industry Co. Ltd. The principal patent underlying the MicroFridge® product is held jointly by Sanyo and us. The patented circuitry of the MicroFridge® Units is marketed under the trade name Safe Plug™. In 1997 Sanyo signed a non-competition agreement with us whereby Sanyo is precluded from entering the MicroFridge® market, provided that certain minimum annual quantities of products are purchased from Sanyo. These quantity requirements were met in 2006. The OEM agreement with Nisshin Industry Co. Ltd. is renewable year to year unless terminated with proper notice.

Laundry Equipment Sales and Services Business

Through its equipment sales and services business, Mac-Gray is a significant distributor for several commercial laundry equipment manufacturers, primarily Whirlpool. Mac-Gray does not manufacture any of the commercial laundry equipment that it sells. As an equipment distributor, Mac-Gray sells commercial laundry equipment to public retail laundromats, as well as to the multi-unit housing industry. In addition, Mac-Gray sells commercial laundry equipment directly to institutional purchasers, including hospitals, restaurants, and hotels, for use in their own on-premise laundry facilities. Mac-Gray is certified by the

5

---

manufacturers to service the commercial laundry equipment that it sells. All installation and repair services are provided on an occurrence basis, not on a contractual basis. Related revenue is recognized at the time the installation service, or other service, is provided to the customer. For the years ended December 31, 2005 and 2006, our laundry equipment sales business unit accounted for approximately 6% of our total revenue each year.

Employee Base

As of February 1, 2007, the Company employed 737 full-time employees. No employee is covered by a collective bargaining agreement and the Company believes that its relationship with its employees is good.

Operating Characteristics

The Company maintains a corporate staff as well as centralized finance, human resources, legal services, information technology and marketing departments. Regionally, the Company maintains service centers and warehouses staffed by service technicians, collectors, customer service representatives and inventory handlers. These facilities service the Facilities Management segment as well as laundry equipment sales.

The Facilities Management segment’s sales and marketing efforts are conducted primarily by employees of the Company. Outside service providers are used periodically for various matters, including advertising, research, and equipment installation. The Product Sales segment uses an internal sales force and independent distributors in parts of the United States where business opportunities do not warrant a direct sales force.

Backlog

Due to the nature of the Company’s laundry facilities management business, backlogs do not exist. There is no significant backlog of orders in the Company’s two sales businesses.

Contact Information

The Company files its annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K with the Securities and Exchange Commission, or “SEC.” Company reports filed with the SEC are available at the SEC’s website at www.sec.gov and the Company’s website at www.macgray.com. The information contained on our website is not included as a part of, or incorporated by reference into, this annual report on Form 10-K.

The Company’s corporate offices are located at 404 Wyman Street, Suite 400, Waltham, Massachusetts, 02451-1212. The Company’s telephone number is (781) 487 7600, its fax number is (781) 487 7606, and its email address for investor relations is ir@macgray.com.

Item 1A.   Risk Factors

This annual report on Form 10-K contains statements, which are not historical facts and are considered forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements contain projections of the Company’s future results of operations or financial position or state other forward-looking information. In some cases you can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will” and “would” or similar words. You should not rely on forward-looking statements, because they involve known and unknown risks, uncertainties and other factors, some of which are beyond the Company’s control. These risks, uncertainties and other factors may cause the Company’s actual results, performance or achievements to differ materially from the anticipated future results,

6

---

performance or achievements expressed or implied by the forward-looking statements. Some of the factors that might cause these differences are as follows:

If we are unable to establish new laundry leases, renew our existing laundry leases or retain relationships with our customers who are not subject to leases, our business, results of operations, cash flows and financial condition could be adversely affected.

Our laundry facilities management business unit, which provided 82% of our total revenue for the year ended December 31, 2006, is highly dependent upon the renewal of leases with property owners or property management companies. Leases that we have entered into or renewed since 2001 provide for an average initial term of seven years. Approximately 10% to 15% of our leases are up for renewal each year. We have traditionally relied upon exclusive, long-term leases with our customers, as well as frequent customer interaction and an emphasis on customer service, to assure continuity of financial and operating results. We cannot guarantee that in the future we will be able to establish long-term leases with new customers or renew existing long term leases as they expire on favorable terms, or at all.

Failure by us to continue to establish long-term leases with new customers, or to successfully renew existing long-term leases as they expire, could have a material adverse effect on our business, results of operations, cash flows and financial condition. Further, approximately 10% of our customers are not subject to leases, are subject to short term leases of less than one year remaining, or have the right to terminate their lease with us at their option. Failure to retain these customers could have a material adverse effect on our business, results of operations, cash flows and financial condition.

We face strong competition in the outsourced laundry facilities management industry.

The outsourced laundry facilities management industry is highly competitive, and we compete for long-term leases, both locally and nationally, with property owners and other operators in the industry. We compete based on customer service, reputation, facilities management rent rates, incentive payments and a range of products and services. Smaller local and regional operators typically have long standing relationships with property owners and managers in their specific geographic market. As such, we may have difficulty penetrating such markets, as property owners and managers may be resistant to terminating such long-standing relationships. We also compete with property owners, as there is no guarantee that property owners will continue to outsource their laundry facilities management to operators. Nationally, there is one competitor in the industry, Coinmach Corporation, with a larger installed equipment base than us. Competition in the industry may make it more difficult and more expensive to consummate acquisitions in the future and to maintain and expand our installed equipment base. In addition, some of our competitors may have less indebtedness than we do, and therefore, more of their cash is potentially available for business purposes other than debt service. We cannot assure you that our results of operations, cash flows or financial condition will not be materially and adversely affected by competition, or that we will be able to maintain our profitability if the competitive environment changes.

Our cash flows may not be sufficient to finance the significant capital expenditures required to replace equipment and implement new technology or make incentive payments to property managers.

We must continue to make capital expenditures in order to maintain and replace our installed equipment base and implement new technology in our equipment. We must also make incentive payments to some property managers in order to secure new customer leases and renew existing customer leases. While we anticipate that existing capital resources, as well as cash from operations, will be adequate to finance anticipated capital expenditures and incentive payments for at least the next year, we cannot assure you that our resources or cash flows will be sufficient. To the extent that available resources are insufficient to fund our capital needs, we may need to raise additional funds through public or private financings or curtail certain expenditures. These financings may not be available on favorable terms, or at all, and, in the

7

---

case of equity financings, could result in dilution to stockholders. If we cannot maintain or replace our equipment as we require or implement our new technologies, our results of operations, cash flows and financial condition could be materially and adversely affected.

If we are unable to continue our relationships with Whirlpool and other equipment suppliers, our revenues could be reduced, and our ability to meet customer requirements could be materially and adversely affected.

We purchase substantially all of the equipment that we use in our laundry facilities management business unit from Whirlpool. In addition, we derive a significant amount of our product sales revenue from our position as a distributor of Whirlpool commercial laundry products. We cannot assure you that Whirlpool will continue its relationship with us. If Whirlpool terminates its relationship with us, our results of operations, cash flows and financial condition could be materially and adversely affected, and further, we may be unable to replace our relationship with Whirlpool with a comparable company on favorable terms, or at all. Whirlpool has become our largest supplier of laundry equipment following its acquisition of Maytag Corporation in March 2006. There have been no significant changes in our relationship as a result of the acquisition.

In addition, we currently obtain the products used by our MicroFridge business from two suppliers. If either of these suppliers terminates or demands a substantial revision of the contracts or business relationships currently in place, we may be unable to find a replacement in a timely manner, on favorable terms, or at all, which could adversely affect our results of operations and our ability to meet customer demands.

The MicroFridge business has a non-competition agreement with Sanyo whereby Sanyo is precluded from entering the MicroFridge market provided that certain minimum annual quantities of products are purchased from Sanyo. If we are unable to meet the minimum requirements stipulated in the agreement, Sanyo may enter the MicroFridge market and, as a result, our market share may decrease. In addition, as our agreement with Sanyo has a one year term and is renegotiated annually, there is a possibility that Sanyo may choose not to renew the agreement.

A decrease in multi-unit housing sector occupancy rates in the markets in which we conduct business could adversely affect our facilities management revenue.

Our facilities management revenue from our operation of card- and coin-operated laundry equipment, particularly in the multi-unit housing sector, depends partially upon the level of tenant occupancy. The number of apartments occupied in an apartment building with a vended laundry facility directly affects our revenue. Extended periods of reduced occupancy in our clients’ buildings can adversely affect our operations. The level of occupancy can be adversely affected by many market and general economic conditions, all of which are beyond our control, including:

·       local economic recessions and increases in the unemployment rate;

·       oversupply of apartments; and

·       conversion of apartment units to condominiums.

If we are unable to access capital on acceptable financial terms, our ability to consummate acquisitions will be limited.

The success of our long-term growth strategy is partially dependent upon our ability to identify, finance and consummate acquisitions on acceptable financial terms. Access to capital is subject to the following risks:

·       use of common stock as acquisition consideration may result in dilution to stockholders;

8

---

·       if our common stock does not maintain a sufficient valuation or if potential acquisition candidates are unwilling to accept shares of our common stock, then we would be required to increase our use of cash resources or other consideration to consummate acquisitions;

·       if we are unable to generate sufficient cash for acquisitions from existing operations, we will not be able to consummate acquisitions unless we are able to obtain additional capital through external financings, which we may not be able to consummate on commercially reasonable terms, or at all;

·       funding future acquisitions through debt financing would result in additional leverage; and

·       the agreements governing our indebtedness include significant limitations on our ability to borrow money for acquisitions and other purposes and, as a result, we may not be able to take advantage of acquisition opportunities.

We may have difficulties integrating future acquisitions into our business.

We have in the past, and intend to in the future, engage in acquisitions to continue the expansion of our laundry facilities management business unit. The failure to successfully complete the integration of any acquisition would adversely affect our business and results of operations.

Any future acquisitions could involve numerous risks, including:

·       potential disruption of our ongoing business and distraction of management;

·       difficulty integrating the operations of the acquired businesses;

·       unanticipated expenses related to equipment, maintenance and technology integration;

·       exposure to unknown liabilities, including litigation against the companies that we may acquire;

·       additional costs due to entering new geographic locations and duplication of key talent;

·       potential loss of key employees or customers of the acquired businesses;

·       the inability to achieve anticipated synergies or increase the revenue and profit of the acquired business; and

·       the expenditure of a disproportionate amount of money and time integrating acquired businesses, particularly operations located in new geographic regions and operations involving new lines of business.

We may not be successful in addressing these risks or any other problems encountered in connection with any acquisitions.

Our internal controls over financial reporting may not be adequate and our independent auditors may not be able to certify as to their adequacy, which could have a significant and adverse effect on our business and reputation.

Section 404 of the Sarbanes-Oxley Act of 2002 requires a reporting company such as ours to, among other things, annually review and disclose its internal controls over financial reporting, and evaluate and disclose changes in its internal controls over financial reporting quarterly. Although we were successful in 2006, if we are not able to achieve and maintain adequate compliance or our independent auditors are not able to certify as to the effectiveness of our internal control over financial reporting, we may be subject to sanctions or investigation by regulatory authorities, such as the SEC. As a result, there could be an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements. In addition, we may be required to incur costs in improving our internal control system and the hiring of additional personnel. Any such action could adversely affect our results.

9

---

 

Our MicroFridge® products may be susceptible to product liability claims for which our current levels of insurance coverage may not be adequate.

Through our MicroFridge® business, we market and distribute combination refrigerator/freezer/ microwave oven units under the brand name MicroFridge®. The sale and distribution of MicroFridge® units, as well as other products, entails a risk of product liability claims. Although MicroFridge® units are manufactured by third parties under contract with us, we may still be subject to risks of product liability claims related to MicroFridge® units. Potential product liability claims may exceed the amount of our product liability insurance coverage or may be excluded from that coverage. We cannot assure you that we will be able to renew our existing product liability insurance at a cost and level of coverage comparable to that currently in place, if at all. In the event that our MicroFridge® business is held liable for a claim for which it is not indemnified or for damages exceeding the limits of our product liability insurance coverage, the claim could have a material adverse effect on our business, results of operations and financial condition.

Inability to protect our trademarks and other proprietary rights could adversely impact our competitive position.

We rely on patents, copyrights, trademarks, trade secrets, confidentiality provisions and employee and third party non-disclosure and non-solicitation agreements to establish and protect our intellectual property and proprietary rights. We cannot be certain that steps we have taken to protect our intellectual property and proprietary rights will be adequate or that third parties will not infringe or misappropriate any of our intellectual property or proprietary rights. While we have periodically made filings with the U.S. Patent and Trademark Office, we have traditionally relied upon the protections afforded by contract rights and common law ownership rights, and we cannot assure you that these contract rights and common law ownership rights will adequately protect our intellectual property and proprietary rights. Any infringement or misappropriation of our intellectual property and proprietary rights could damage their value and could have a material adverse effect on our business, results of operations and financial condition. We may have to engage in litigation to protect our rights to our intellectual property and proprietary rights, which could result in significant litigation expenses and require a significant amount of management’s time.

We own or license several registered and unregistered trademarks, including Mac-Gray, Web, MicroFridge, Intelligent Laundry Solutions, LaundryView, LaundryLinx, PrecisionWash, TechLinx, VentSnake, IntelliVault, and SnackMate that we use in the marketing and sale of our products. However, the degree of protection that these trademarks afford us is unknown and these trademarks may expire or be terminated. In the event that someone infringes on or misappropriates our trademarks, the brand images and reputations, which we have developed, could be damaged and could have a material adverse effect on our business, results of operations and financial condition.

We are dependent on key personnel, and the loss of any of our key personnel could have a material adverse effect on our business, results of operations and financial condition.

Our continued success will depend largely on the efforts and abilities of our executive officers, management teams and certain other key employees. The loss of any of these officers or other key employees could result in inefficiencies in our operations, lost business opportunities or the loss of one or more customers. See “Management.”

We have significant intangible assets and goodwill, the value of which might not be realized in the event of an impairment in, or a sale or liquidation of our businesses.

At December 31, 2006, approximately $164.0 million, or 48.4%, of our total assets were intangible assets, consisting primarily of contract rights and goodwill. In the event of a sale or liquidation, there can be no assurance that the value of our intangible assets would be realized.

10

---

We face risks associated with environmental regulation.

Our business and operations are subject to federal, state and local environmental laws and regulations, including those governing the discharge of pollutants, the handling, generation, storage and disposal of hazardous materials, substances and wastes and the cleanup of contaminated sites. In connection with current or historical operations by us or at our sites, we could incur substantial costs, including clean up costs, fines and civil or criminal sanctions, and third party claims for property damage or personal injury, as a result of violations of, or liabilities under, environmental laws and regulations. While we are not aware of any existing or potential environmental claims against us that are likely to have a material adverse effect on our business or financial condition, we cannot guarantee you that we will not in the future incur liability or other costs under environmental laws and regulations that could have a material adverse effect on our business or financial condition.

We are controlled by a concentrated group of stockholders, whose interests could be in conflict with yours.

As of December 31, 2006, our directors, executive officers, and certain of our stockholders related to such persons and their affiliates beneficially owned in the aggregate approximately 35.3% of the outstanding shares of our common stock. See Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters” below. This percentage ownership does not include options to purchase 485,000 shares of our common stock held by some of these persons, which are exercisable at, or 60 days subsequent to, December 31, 2006. If all of these options had been exercised as of December 31, 2006, then these stockholders and their affiliates would have beneficially owned 40.0% of the outstanding shares of our common stock. Additionally, we have entered into a stockholders’ agreement, dated June 26, 1997, with some of these stockholders that gives them rights of first offer to purchase shares of our common stock offered for sale by another stockholder party thereto. See Item 13, “Certain Relationships and Related Transactions and Director Independence” below. As a result of this concentration in ownership, these stockholders, acting together, have the ability to significantly influence the outcome of the election of directors and all other matters requiring approval by a majority of stockholders. Circumstances may arise in which the interests of this group of stockholders could be in conflict with interests of other stockholders.

Provisions in our charter and bylaws, Delaware law, and the stockholder rights agreement could have the effect of discouraging takeovers.

Specific provisions of our charter and bylaws, as described below; sections of the corporate law of Delaware; the stockholder rights agreement, and powers of our Board of Directors may discourage takeover attempts not first approved by the Board of Directors, including takeovers which some stockholders may deem to be in their best interests. These provisions and powers of the Board of Directors could delay or prevent the removal of incumbent directors or the assumption of control by stockholders, even if the particular removal or assumption of control would be beneficial to stockholders. These provisions and powers of the Board of Directors could also discourage or make more difficult a merger, tender offer or proxy contest, even if these events would be beneficial, in the short term, to the interests of stockholders. The anti-takeover provisions and powers of the Board of Directors include, among other things:

·       the ability of our Board of Directors to issue shares of preferred stock and to establish the voting rights, preferences and other terms of such preferred stock;

·       a classified Board of Directors serving staggered three-year terms;

·       the elimination of stockholder voting by written consent;

·       the absence of cumulative voting for directors;

11

---

·       the removal of directors only for cause;

·       the vesting of exclusive authority in our Board of Directors to determine the size of the Board of Directors and, subject to the rights of holders of any series of preferred stock, if issued, to fill vacancies thereon;

·       the vesting of exclusive authority in our Board of Directors, except as otherwise required by law, to call special meetings of stockholders;

·       advance notice requirements for stockholder proposals and nominations for election to the Board of Directors;

·       ownership restrictions, under the corporate law of Delaware, with limited exceptions, upon acquirers including their affiliates and associates of 15% or more of its common stock; and

·       our entry into a shareholder rights agreement providing for the issuance of rights that will cause substantial dilution to a person or group of persons that acquires 15% or more of the common shares unless the rights are redeemed.

Item 1B.   Unresolved SEC Staff Comments

None.

12

Item 2.                        Properties

Mac-Gray rents approximately 32,000 square feet in Waltham, Massachusetts that it uses as its corporate headquarters and which houses the Company’s administrative and central services. Mac-Gray owns a sales and service facility in Tampa, Florida consisting of approximately 12,000 square feet. At December 31, 2006, Mac-Gray leased the following regional facilities, which are largely operated as sales and service facilities, although limited administrative functions are also performed at many of them:

 

All properties are primarily utilized for the laundry facilities management business except for the Walpole, Massachusetts facility, which is utilized by both the Product Sales segment and Copico. The Product Sales segment also leases space at public warehouses, where rent is based on handling and the number of Units stored.

Mac-Gray believes that its properties are generally well maintained and in good condition. Mac-Gray believes that its properties are adequate for present needs and that suitable additional or replacement space will be available as required.

13

---

Item 3.                        Legal Proceedings

From time to time Mac-Gray is a party to litigation arising in the ordinary course of business. There can be no assurance that Mac-Gray’s insurance coverage will be adequate to cover any liabilities resulting from such litigation. In the opinion of management, any liability that Mac-Gray might incur upon the resolution of currently pending litigation will not, individually or in the aggregate, have a material adverse effect on our business, financial condition, results of operations or cash flows.

Our business and operations are subject to federal, state and local environmental laws and regulations, including those governing the discharge of pollutants, the handling, generation, disposal and storage of hazardous materials and wastes, and the cleanup of contaminated sites. In connection with current or historical operations by us or at our sites, we could incur substantial costs, including clean-up costs, fines and civil or criminal sanctions, and third-party claims for property damage or personal injury, as a result of violations of, or liabilities under, environmental laws and regulations. We believe that our operations are in material compliance with applicable environmental laws and regulations.

Item 4.                        Submission of Matters to a Vote of Security Holders

No matters were submitted to vote of security holders during the fourth quarter of 2006.

PART II

Item 5.                        Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Mac-Gray common stock is traded on the New York Stock Exchange, or NYSE, under the symbol “TUC.”

The following table sets forth the high and low sales prices for Mac-Gray common stock on the NYSE for the periods indicated.

 

As of March 8, 2007 there were 141 shareholders of record of Mac-Gray common stock.

The Company does not currently pay dividends to the holders of Mac-Gray common stock. The Company currently intends to retain future earnings, if any, for the development of its businesses and does not anticipate paying cash dividends on its common stock in the foreseeable future. Future determinations by the Board of Directors to pay dividends on the Company’s common stock would be based primarily upon the financial condition, results of operations, and business requirements of the Company. Dividends, if any, would be payable at the sole discretion of the Board of Directors out of the funds legally available therefor. In addition, the payment of dividends is restricted under the Company’s senior credit facilities.

For information related to our stock option plans and employee stock purchase plans, see Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” below.

The information appearing under the caption “Executive Compensation” in the Company’s definitive proxy statement for its 2006 annual meeting of stockholders is incorporated herein by reference.

14

Item 6.                        Selected Financial Data (Dollars in thousands, except per share data)

Set forth below are selected historical financial data as of the dates and for the periods indicated. The selected financial data set forth below should be read in conjunction with, and are qualified by reference to, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements of Mac-Gray and the notes thereto included elsewhere in this report.

 

15

---

 

(1)          Includes the results of operations of the eastern region laundry facilities management assets acquired on January 16, 2004 from Web Service Company, Inc. for approximately $42,000.

(2)          Includes the results of operations of the western region laundry facilities management assets acquired on January 10, 2005 from Web Service Company, Inc. for approximately $113,000.

(3)          EBITDA is defined as net income before provision for income taxes, depreciation and amortization expense and interest expense. Adjusted EBITDA is EBITDA further adjusted to exclude the items described in the table below. We have excluded these items because we believe they are not reflective of our ongoing operating performance. EBITDA and Adjusted EBIDTA are included in this report because they are a basis upon which our management assesses our operating performance. EBITDA and Adjusted EBITDA are not measures of our liquidity or financial performance under GAAP and should not be considered as alternatives to net income or any other performance measure derived in accordance with GAAP, or as an alternative to cash flows from operating activities as a measure of our liquidity. The use of EBITDA and Adjusted EBITDA instead of net income has limitations as an analytical tool, including the exclusion of interest expense and depreciation and amortization expense, which represent significant and unavoidable operating costs given the level of indebtedness and the capital expenditures needed to maintain our business. Management compensates for these limitations by relying primarily on our GAAP results and by using EBITDA and Adjusted EBITDA only supplementally. Our management believes EBITDA and Adjusted EBITDA are useful to investors because they help enable investors to evaluate our business in the same manner as our management and because they are frequently used by securities analysts, investors and other interested parties in the evaluation of companies with substantial financial leverage. Our measures of EBITDA and Adjusted EBITDA are not necessarily comparable to other similarly titled captions of other companies due to potential inconsistencies in the methods of calculation.

(4)          Excludes $915, $1,380, $1,579, $1,499 and $1,776 in 2002, 2003, 2004, 2005, and 2006, respectively, of capital leases associated with vehicles acquired and used in the operation of the Company.

16

---

The following is a reconciliation of net income to EBITDA and Adjusted EBITDA:

(a)           Represents a pretax gain recognized in connection with the sale of certain laundry facilities management assets and related contracts.

(b)          Represents a pretax gain recognized in connection with the sale of our corporate headquarters in Cambridge, Massachusetts on June 30, 2005.

Following is the impact on earnings of implementing FAS 142 on the years ended December 31, 2002 through 2006:

 

17

Item 7.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations. (Dollars in Thousands)

The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes thereto presented elsewhere in this Report.

This report contains, in addition to historical information, forward-looking statements that involve risks and uncertainties. These forward-looking statements reflect our current views about future events and financial performance. Investors should not rely on forward-looking statements because they are subject to a variety of factors that could cause actual results to differ materially from our expectations. Factors that could cause or contribute to such differences include, without limitation, the factors described under Item 1A “Risk Factors.”

Our actual results, performance or achievement could differ materially from those expressed in, or implied by, these forward-looking statements, and accordingly, we can give no assurances that any of the events anticipated by the forward-looking statements will occur or, if any of them do, what impact they will have on our results of operations or financial condition. In view of these uncertainties, investors are cautioned not to place undue reliance on these forward-looking statements. We assume no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.

Overview

Mac-Gray was founded in 1927 and incorporated in Delaware in 1997. We conduct our business in the following four units: (1) the laundry facilities management business unit, through which we manage laundry facilities in multi-unit housing; (2) the MicroFridge® business unit, through which we sell a line of combination refrigerator/freezer/microwave oven units under the MicroFridge® brand to multi-unit housing facilities such as hospitality and assisted living facilities, military housing, and colleges and universities; (3) the laundry equipment sales business unit, through which we sell commercial laundry equipment; and (4) the reprographics business unit, through which we provide card- and coin-operated reprographics equipment and services to the academic and public library markets. We report our business in two segments: facilities management and product sales. Facilities management consists of our laundry facilities management and reprographics business units. Product sales consists of our laundry equipment sales and MicroFridge® business units.

Our business model is built on a stable demand for laundry services, combined with long-term leases, strong customer relationships, a broad customer base and predictable capital needs. For the years ended December 31, 2005 and 2006 our total revenues were $260,600 and $279,300, respectively. Approximately 81% and 82% of our total revenue for these periods, respectively, was generated by our laundry facilities management business unit. We generate laundry facilities management revenue primarily by entering into long-term leases with property owners or property management companies for the exclusive right to install and maintain laundry equipment in common area laundry rooms within their properties, in exchange for a negotiated portion of the revenue we collect. As of December 31, 2006, approximately 90% of our installed machine base was located in laundry facilities subject to long-term leases, which have a weighted average remaining term of approximately five years. Our capital costs are typically incurred in connection with new or renewed leases, and include investments in laundry equipment and card- and coin-operated systems, incentive payments to property owners or property management companies and expenses to refurbish laundry facilities. Our capital costs consist of a large number of relatively small amounts, which are associated with our entry into or renewal of leases. Accordingly, our capital needs are predictable and largely within our control. For the years ended December 31, 2005 and 2006, we incurred approximately $26,400 and $26,500 of capital expenditures, respectively. In addition, we make incentive payments to property owners and property management companies to secure our lease arrangements. We paid approximately $4.5 million of incentive payments in each of the years ended December 31, 2005 and 2006.

18

---

In addition, through our product sales segment, we generate revenue by selling commercial laundry equipment, our line of combination refrigerator/freezer/microwave oven units under the MicroFridge® brand and the full lines of Maytag, Amana and Magic Chef domestic laundry and kitchen appliances under our Maytag Direct program. For the years ended December 31, 2005 and 2006, our product sales segment accounted for approximately 18% and 17% of our total revenue, respectively, and 18% of our gross margin for each year.

Our financial objective is to maintain and enhance profitability by retaining existing customers, adding customers in areas in which we currently operate, selectively expanding our geographic footprint and density through acquisitions, and controlling costs. One of the key challenges we face is maintaining and expanding our customer base in a competitive industry. We experience competition from other industry participants, including national, regional and local laundry facilities management operators and from property owners and property management companies who self-operate their laundry facilities. We devote substantial resources to our sales efforts and are focused on continued innovation in order to distinguish us from competitors. Approximately 10% to 15% of such laundry room leases are up for renewal each year. Over the past five calendar years, we have been able to retain, on average, approximately 97% of our total installed equipment base each year. For the years ended December 31, 2005 and 2006, we have been able to add 5% and 4%, respectively, to our equipment base through internally generated growth.

The MicroFridge® business unit derives revenue through the sale and rental of its MicroFridge® appliances to the hospitality industry and assisted living market, military bases and colleges and universities. The MicroFridge® business unit also derives revenue through the sales of laundry equipment to the United States government and sales of kitchen appliances to the multi-housing market.

Recent Developments

On January 20, 2006 we acquired the laundry facilities management assets of a regional operator for approximately $11,500. We estimate that the operations, located primarily in the Southern New England area, will add approximately $8,000 of annual revenue.

On May 23, 2006, we acquired the laundry facilities management assets of a regional operator in the Philadelphia area. On July 7, 2006, we acquired the laundry facilities management assets of a regional operator in southern New England. The combined cost of these acquisitions was approximately $7,500 and was funded by borrowings under our revolving credit facility. We estimate that the two combined acquisitions will add approximately $5,000 of annual revenue.

Effective December 29, 2006, we amended our senior bank credit facilities, reducing the credit line to $65,000 (with the option, subject to customary terms and conditions, to increase the line up to $100,000, in increments of not less than $10,000, over the life of the facility), reducing the interest rate on outstanding borrowings, modifying certain covenants and extending the maturity date to December 29, 2011. The senior credit facilities are collateralized by a blanket lien on all of our assets and our two main subsidiaries, Mac-Gray Services, Inc. and Intirion Corporation, as well as a pledge by us of all of the capital stock of our two subsidiaries.

We used approximately $25,000 of the revolver under the senior credit facilities, as amended, to repay the outstanding obligations under the prior credit facility and to pay fees and expenses relating to the amendment.

On February 28, 2007, we acquired the laundry facilities management assets and distribution rights of a regional operator in the southeast for approximately $2,500 in cash.

Results of Operations (Dollars in thousands, except per share data)

The information presented below for the years ended December 31, 2005 and 2006 is derived from Mac-Gray’s consolidated financial statements and related notes included in this report.

19

---

Revenue

 

Fiscal year ended December 31, 2006 compared to fiscal year ended December 31, 2005

Total revenue increased by $18,704, or 7%, to $279,327 for the year ended December 31, 2006 compared to $260,623 for the year ended December 31, 2005. This growth in revenue is primarily attributable to an increase in laundry facilities management revenue associated with several acquisitions in 2006, additional laundry leases through organic growth, and vend increases.

Facilities management revenue.   Total facilities management revenue increased $17,365, or 8%, to $232,181 for the year ended December 31, 2006 compared to $214,816 for the year ended December 31, 2005. This increase is attributable to increases in revenue in the laundry facilities management business unit, primarily due to the impact of several acquisitions during 2006, organic growth in the number of management contracts and vend increases partially offset to a small extent by decreases in revenue in the reprographics business unit.

Within the facilities management segment, revenue in the laundry facilities management business unit increased $17,827, or 8%, to $229,719 for the year ended December 31, 2006 compared to $211,892 for the year ended December 31, 2005. The increase is attributable primarily to the revenue generated by the assets acquired during 2006, which accounted for approximately 50% of the 2006 increase over 2005. The remaining 50% is attributable to organic growth in the number of management contracts signed, increases in the vend prices charged for use of the equipment and an increase in revenue associated with the conversion of coin-operated locations to card-operated locations. Due to the convenience of card-operated systems, usage, and therefore revenue, typically increases upon the conversion from a coin operated system.

Revenue in the reprographics business unit decreased $462, or 16%, to $2,462 for the year ended December 31, 2006 compared to $2,924 for the year ended December 31, 2005. In the year ended December 31, 2006 the reprographics business unit accounted for less than 1% of consolidated revenue. Due to the continued decline in the use of copiers in libraries and similar facilities, the reduction in the number of locations we operate, the difficulty of servicing fewer accounts over a wider territory, and the difficulty of predicting future income generation, in the fourth quarter of 2006 the Company decided not to renew contracts which will expire in the next twelve months in selected geographic markets. This decision, in addition to the Company’s inability to predict success at negotiating profitable contracts going forward for this business in any of its present markets, resulted in the Company taking a non-cash impairment charge of $1.6 million, net of tax, in the fourth quarter.

Product sales revenue.   Product sales revenue increased $1,339, or 3%, to $47,146 for the year ended December 31, 2006 compared to $45,807 for the year ended December 31, 2005. The increase in revenue for the year ended December 31, 2006 as compared to the same period in 2005 is attributable to increases in revenue in the laundry equipment sales business unit.

20

---

Revenue in the MicroFridge® business unit decreased $103, or less than 1%, to $30,410 for the year ended December 31, 2006 compared to $30,513 for the year ended December 31, 2005. The decrease is primarily attributable to a decrease in sales to the academic market and government market, partially offset by a increase in hospitality and assisted living sales. The hospitality sales increase is attributable to an increase in capital spending by the industry and a full year of sales to several new distributors added by our Company in 2005. We believe the decrease in academic sales can be attributed to constraints by academic institutions on capital spending on amenity items. Our sales to the government are continually affected by changes in government spending priorities. We believe current spending on military housing improvements has been delayed as a result of current military efforts in the Middle East.

Revenue in the laundry equipment sales business unit increased $1,442, or 9%, to $16,736 for the year ended December 31, 2006 compared to $15,294 for the year ended December 31, 2005. Sales in the laundry equipment sales business unit are sensitive to the strength of the economy, consumer confidence, local permitting and the availability of financing to small businesses, and therefore tend to fluctuate from period to period. The combination of these factors, coupled with the Company’s marketing efforts, contributed to the increase in sales.

Cost of revenue

Cost of facilities management revenue.   Cost of facilities management revenue includes rent paid to customers as well as costs associated with installing and servicing machines and costs of collecting, counting, and depositing facilities management revenue, and the costs of purchasing, delivering and servicing rented facilities management equipment. Salaries, warehousing and other operating expenses include $1,104 which had been included in facilities management costs in 2005 have been reclassified to cost of sales for the product sales segment to conform to 2006’s presentation. The following references to 2005 give effect to the reclassification. Cost of facilities management revenue increased $11,809, or 8%, to $153,861 for the year ended December 31, 2006, as compared to $142,052 for the year ended December 31, 2005. This increase is attributable primarily to the cost, primarily facilities management rent, associated with the increase in facilities management revenue of $17,365, partially offset by the costs associated with the 2005 hurricanes which did not recur in 2006. Included in the cost for the year ended December 31, 2005 are costs associated with the 2005 hurricanes. Adjusting 2005 total costs to exclude the hurricane costs, cost of facilities management as a percentage of facilities management revenue remained consistent at 66% for the years ended December 31, 2006 and 2005. Changes in facilities management rent as a percentage of facilities management revenue can be affected by new and renewed laundry leases and by other factors such as the amount of incentive payments and laundry room betterments invested in new or renewed laundry leases. As we vary the amount invested in a facility, the facilities management rent as a function of facilities management revenue can vary. Incentive payments and betterments are amortized over the life of the laundry lease.

Depreciation and amortization.   Depreciation and amortization increased by $3,819, or 12%, to $35,156 for the year ended December 31, 2006 as compared to $31,337 for the year ended December 31, 2005. Laundry facilities management equipment and contract rights are depreciated and amortized using the straight-line method. The increased depreciation expense is attributable to new equipment placed in laundry facilities at new locations and replacement of older equipment as contracts were renegotiated. In addition, due to management’s decision not to recondition and redeploy equipment which is not as energy efficient as newer equipment, we disposed of certain laundry equipment in 2006 that had a remaining net book value of $847. This cost is included in depreciation expense.

Cost of product sales.   Cost of product sales consists primarily of the cost of laundry equipment, MicroFridge® equipment and parts and supplies sold, as well as salaries and related warehousing expenses as part of the product sales segment. Costs of $1,104 consisting of salaries and other operating expenses, which were included in the cost of facilities management revenue in 2005, have been reclassified to the

21

---

product sales segment to conform to 2006’s presentation. The following references to 2005 give effect to the reclassification. Cost of product sales increased by $1,179, or 3%, to $37,352 for the year ended December 31, 2006 as compared to $36,173 for the year ended December 31, 2005. As a percentage of sales, cost of product sold was consistent at 79% for the years ended December 31, 2006 and 2005. The gross margin on product sales includes the gross margins from the laundry equipment sales and MicroFridge® business units. The gross margin in the laundry equipment sales business unit decreased to 20% for the year ended December 31, 2006 as compared to 24% for the same period in 2005. The decrease in margin is attributable to product mix and increased costs from our suppliers. The gross margin in the MicroFridge® business unit increased to 20% for the year ended December 31, 2006 as compared to 18% for the same period in 2005. The slight increase in margin is attributable to the mix of products sold as well as the Company’s ability to pass on some of the increased fuel costs.

Operating expenses

General, administration, sales, marketing and depreciation expense.   General, administration, sales, marketing and depreciation expense increased by $4,213, or 13%, to $35,663 for the year ended December 31, 2006 as compared to $31,450 for the year ended December 31, 2005. As a percentage of total revenue, general, administration, sales, marketing and depreciation expense increased from 12% for the year ended December 31, 2005 to 13% for the year ended December 31, 2006. The increase in total expenses is primarily attributable to the costs incurred to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 and the non-cash expense related to stock compensation, which was required to be recorded in 2006 in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payments”, (“FAS123R”).

Loss on early extinguishment of debt.   Unamortized financing costs of $461 related to the term loan were expensed in 2005. In connection with the senior credit facilities we repaid in full and terminated our 2003 senior credit facilities. Unamortized financing costs of $207 associated with our 2003 senior credit facilities were also expensed in 2005. Effective December 29, 2006, the Company amended its bank credit facilities. As a result of this amendment, a portion of the unamortized financing costs amounting to $73, which had been incurred as part of the prior credit facility, were expensed.

Gain on sale of assets.   Gain on sale of assets represents the gain from the sale of vehicles and other non-inventory assets in the ordinary course of business. In the year ended December 31, 2005, the gain included $10,588 from the sale of our corporate headquarters.

Impairment of assets.   The revenue and corresponding operating income in our reprographics business unit have been declining since 1999 when college libraries, followed by public libraries, began to make reference material electronically available to patrons. Electronic availability, widespread conversion to laser printers (free of charge in many school libraries) and other technical advancements have led to reduced use of vended copy machines resulting in reduced revenue at several accounts. During the fourth quarter of 2006, the Company performed an evaluation of the reprographics business unit and its long-term prospects. As a result of this evaluation, management determined that the carrying amount of the business unit’s long lived assets exceeded the estimated undiscounted cash flows expected to result from operating this business unit, and recognized a non-cash, non-recurring impairment charge of $2,502, or $0.19 per diluted share before taxes ($1,639, or $0.12 per diluted share net of taxes). This charge was calculated in accordance with SFAS No. 144, “Accounting for the Impairment or disposal of Long-Lived Assets”, (“FAS 144”). Accordingly, the Company used a discounted cash flow model to calculate the amount of the impairment charge after it was determined that, pre-write-down, the carrying amount of the business unit’s long lived assets exceeded the estimated undiscounted future cash flows expected to result from operating this business unit.

22

---

Income from operations

Income from operations decreased by $14,926, or 50%, to $14,752 for the year ended December 31, 2006 as compared to $29,678 for the year ended December 31, 2005. Excluding the cost of non-cash compensation recorded in 2006, impairment of assets, loss on early extinguishment of debt and the gain on sale of certain assets, income from operations, as adjusted, would have been $18,474 for the year ended December 31, 2006, compared to $19,758 for the year ended 2005, or a decrease of 6%. This decrease is due primarily to the reasons discussed above. To supplement the consolidated financial statements presented according to generally accepted accounting principles (GAAP), we have used a non-GAAP financial measure of adjusted income from operations. Management believes presentation of this measure is useful to investors to enhance an overall understanding of our historical financial performance and future prospects. Adjusted income from operations, which is adjusted to exclude certain gains and losses from the comparable GAAP income from operations, is an indication of our baseline performance before gains, losses or other charges that are considered by management to be outside of our core operating results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for income from operations or other measures prepared in accordance with GAAP.

A reconciliation of income from operations in accordance with GAAP to income from operations, as adjusted, is provided below:

(1)          On January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payments”, (“FAS123(R)”). These amounts represent expenses relating to issuances of equity awards in the periods presented.

(2)          Represents a pre-tax charge associated with the reprographics business unit.

(3)          Represents unamortized costs related to terminated credit facilities.

(4)          Represents a pre-tax gain recognized in connection with the sale of the Company’s office and warehouse facility in Cambridge, Massachusetts on June 30, 2005.

Interest expense, net

Interest expense, net of interest income, increased by $2,714, or 25%, to $13,653 for the year ended December 31, 2006 as compared to $10,939 for the year ended December 31, 2005. The increase is primarily attributable to an increase in the average borrowing rates to 7.2% for the year ended December 31, 2006 as compared to 5.9% for the year ended December 31, 2005. The increase in average borrowing rates is due, in large part, to the $150,000 of senior notes that we issued on August 16, 2005 and which bear interest at the rate of 7.625% per annum for which we recognized a full year’s expense in 2006. Also contributing to the increase is our increased borrowing in 2006 of approximately $19,000 attributable to our 2006 acquisitions.

23

Gain or loss related to derivative instruments

The Company is party to interest rate swap agreements that it had accounted for as cash flow hedges. The fair value of these swaps has been included in other comprehensive income in the equity section of the balance sheet. As a result of the reduction in the amount outstanding under our senior credit facilities, certain swap agreements no longer qualified for cash flow hedge accounting treatment. The revised accounting treatment resulted in an expense of $96 and a gain of $1,876 in the income statement for the years ended December 31, 2006 and 2005, respectively.

Provision for income taxes

The provision for income taxes decreased by $8,416, or 98%, to $147 for the year ended December 31, 2006 compared to $8,563 for the year ended December 31, 2005. The decrease is the combination of a decrease in taxable income, an increase in the effective tax rate and a reduction in the reserve for uncertain tax positions. The effective tax rate, without considering the impact of the reduction in the reserve, increased to 54.5% from 41.5% for the year ended December 31, 2006 compared to the same period in 2005. The increase in the effective tax rate is due primarily to the impact of permanent book/tax differences on the decreased taxable income in 2006 compared to 2005. The reduction in the reserve for uncertain tax provisions further reduced the effective rate to 14.7% for the year ended December 31, 2006. This reduction relates to the expiration of the statute of limitations as of September 15, 2006 for certain state tax exposures.

Net income

As a result of the foregoing, net income decreased $11,196, or 93%, to $856 for the year ended December 31, 2006 as compared to $12,052 for the year ended December 31, 2005. Net income, as adjusted for the items in the table below, decreased $1,125, or 21%, to $4,114 for the year ended December 31, 2006 as compared to $5,239 for the year ended December 31, 2005. A reconciliation of net income, as reported to net income, as adjusted is provided below:

(1)          On January 1, 2006, the Company adopted FAS 123(R). These amounts represent expenses relating to issuances of equity awards in the periods presented.

(2)          Represents a pre-tax gain recognized in connection with the sale of the Company’s office and warehouse facility in Cambridge, Massachusetts on June 30, 2005.

(3)          Represents a pre-tax charge associated with the reprographics business unit.

24

---

(4)          Represents the un-realized (gain) loss on interest rate protection contracts, which do not qualify for hedge accounting treatment.

(5)          Represents unamortized costs related to terminated credit facilities.

To supplement the Company’s unaudited consolidated financial statements presented on a generally accepted accounting principles (GAAP) basis, management has used a non-GAAP measure of net income. Management believes presentation of this measure is appropriate to enhance an overall understanding of our historical financial performance and future prospects. Adjusted net income, which is adjusted to exclude certain gains and losses from the comparable GAAP net income, is an indication of our baseline performance before gains, losses or other charges that are considered by management to be outside of our core operating results. These non-GAAP results are among the primary indicators management uses as a basis for evaluating the Company’s financial performance as well as for forecasting future periods. For these reasons, management believes these non-GAAP measures can be useful to investors, potential investors and others.

Non-GAAP financial measures are not in accordance with, or an alternative for, generally accepted accounting principles in the United States. The Company’s non-GAAP financial measures are not meant to be considered in isolation or as a substitute for comparable GAAP financial measures, and should be read only in conjunction with the Company’s consolidated financial statements prepared in accordance with GAAP.

Fiscal year ended December 31, 2005 compared to fiscal year ended December 31, 2004

The information presented below for the years ended December 31, 2004 and 2005 is derived from Mac-Gray’s consolidated financial statements and related notes thereto.

Revenue

 

Total revenue increased by $77,929, or 43%, to $260,623 for the year ended December 31, 2005 compared to $182,694 for the year ended December 31, 2004. The increase in total revenue for the year ended December 31, 2005 is primarily attributable to the revenue associated with our acquisition on January 10, 2005 of the laundry facilities management assets of Web Service Company, Inc. in several western and southern states for approximately $112,700 (the “2005 Acquisition”). This acquisition added approximately $70,000 of revenue in 2005, representing approximately 33% of our 2005 revenue derived from laundry facilities management operations.

Facilities management revenue.   Total facilities management revenue increased $74,336, or 53%, to $214,816 for the year ended December 31, 2005 compared to $140,480 for the year ended December 31, 2004. This increase is attributable to increases in revenue in the laundry facilities management business unit, primarily due to the 2005 Acquisition, partially offset by decreases in revenue in the reprographics business unit.

25

---

Within the facilities management segment, revenue in the laundry facilities management business unit increased $75,167, or 55%, to $211,892 for the year ended December 31, 2005 compared to $136,725 for the year ended December 31, 2004. The increase is attributable primarily to the revenue generated by the assets acquired in the 2005 Acquisition. The acquired assets generated $69,776, or 93%, of the increase in laundry facilities management revenue for the year ended December 31, 2005. The remainder of the increase is attributable primarily to the net increase in the number of revenue generating laundry installed equipment, selected vend price increases, a net increase in the usage of installed equipment and an increase in revenue associated with the conversion of coin-operated systems to card-operated systems. Due to the convenience of card-operated systems, usage, and therefore revenue, typically increases upon the conversion from a coin operated system.

Revenue in the reprographics business unit decreased $831, or 22%, to $2,924 for the year ended December 31, 2005 compared to $3,755 for the year ended December 31, 2004. The decline is primarily attributable to the continued decline in the use of copiers in libraries and similar facilities and a reduction in the number of locations we operate. We expect the decreases in revenue from our reprographics business unit to continue, as the usage of vended copiers declines and we continue our strategy of not renewing contracts that we predict will have a negative impact on income.

Product sales revenue.   Product sales revenue increased $3,593, or 9%, to $45,807 for the year ended December 31, 2005 compared to $42,214 for the year ended December 31, 2004. The increase in revenue for the year ended December 31, 2005 as compared to the same period in 2004 is attributable primarily to increases in revenue in the MicroFridge® business unit.

Revenue in the MicroFridge® business unit increased $3,226, or 12%, to $30,513 for the year ended December 31, 2005 compared to $27,287 for the year ended December 31, 2004. The increase is primarily attributable to an increase in sales to the academic market and hospitality and assisted living market, partially offset by a decrease in government sales. The increase in academic sales can be attributed to a more aggressive sales and marketing effort coupled with cross selling opportunities with laundry route sales. We believe that the hospitality sales increase is attributable to an increase in capital spending by the industry and the addition of several new distributors by our Company. Our sales to the government are continually affected by changes in government spending priorities. We believe current spending is directed away from military housing improvements and toward the current military efforts in the Middle East.

Revenue in the laundry equipment sales business unit increased $367, or 2%, to $15,294 for the year ended December 31, 2005 compared to $14,927 for the year ended December 31, 2004. Sales in the laundry equipment sales business unit are sensitive to the strength of the economy, consumer confidence, local permitting and the availability of financing to small businesses, and therefore tend to fluctuate from period to period.

Cost of revenue

Cost of facilities management revenue.   Cost of facilities management revenue includes rent paid to customers as well as costs associated with installing and servicing machines and costs of collecting, counting, and depositing facilities management revenue, and the costs of purchasing, delivering and servicing rented facilities management equipment and MicroFridge® equipment. Salaries, warehousing and other operating expenses amounting to $947 which had been included in facilities management costs in 2004 have been reclassified to cost of sales for the product sales segment to conform to 2005’s presentation. The following references to 2004 give effect to the reclassification. Cost of facilities management revenue increased by $48,540, or 52%, to $142,052 for the year ended December 31, 2005 as compared to $93,512 for the year ended December 31, 2004. This increase is attributable primarily to the cost associated with the revenue generated by the assets acquired in the 2005 Acquisition. Included in the cost for the year ended December 31, 2005 is $316 related to losses incurred as a result of the 2005

26

---

hurricanes. As a percentage of facilities management revenue, cost of facilities management revenue was consistent at 67% for the years ended December 31, 2005 and 2004. Changes in facilities management rent as a percentage of facilities management revenue can be affected by new and renewed laundry leases and by other factors such as the amount of incentive payments and laundry room betterments invested in new or renewed laundry leases. As we vary the amount invested in a facility, the facilities management rent as a function of facilities management revenue can vary. Incentive payments and betterments are amortized over the life of the laundry lease. The percentage of facilities management rent to facilities management revenue is also impacted by the facilities management rent rate structure in the reprographics business unit. Because this business unit has a much lower facilities management rent rate structure than the laundry facilities management business unit, the reduction in the size of the reprographics business unit through the non-renewal of leases will result in an increase in the overall facilities management rent as a percentage of revenue.

Depreciation and amortization.   Depreciation and amortization increased by $10,590, or 51%, to $31,337 for the year ended December 31, 2005 as compared to $20,747 for the year ended December 31, 2004. This increase was primarily attributable to the addition of the assets and contracts acquired in the 2005 Acquisition. The laundry facilities management equipment acquired had an assigned value of $25,099 as of the acquisition date, which is being depreciated over five years and accounted for $5,020 of the increase in depreciation and amortization for the year ended December 31, 2005. The laundry facility contract rights acquired had an assigned value of $68,638 (prior to recording deferred taxes) as of the acquisition date, which is being amortized over twenty years and accounted for $3,432 of the increase in depreciation and amortization for the year ended December 31, 2005. The laundry facilities management equipment and contract rights are depreciated and amortized using the straight-line method. Also contributing to the increased depreciation expense was new equipment placed in laundry facilities at new locations and replacement of older equipment as contracts were renegotiated.

Cost of product sales.   Cost of product sales consists primarily of the cost of laundry equipment, MicroFridge® equipment and parts and supplies sold as well as salaries and related warehousing expenses as part of the product sales segment. Costs of $947 consisting of salaries and other operating expenses, which were included in the cost of facilities management revenue in 2004 have been reclassified to the product sales segment to conform with 2005’s presentation. The following references to 2004 give effect to the reclassification.  Cost of product sales increased by $5,352, or 17%, to $36,173 for the year ended December 31, 2005 as compared to $30,821 for the year ended December 31, 2004. As a percentage of sales, cost of product sold was approximately 77% and 71% for the years ended December 31, 2005 and 2004, respectively. The gross margin on product sales includes the gross margins from the laundry equipment sales and MicroFridge® business units. The gross margin in the laundry equipment sales business unit decreased to 31% for the year ended December 31, 2005 as compared to 32% for the same period in 2004. The gross margin in the MicroFridge® business unit decreased to 20% for the year ended December 31, 2005 as compared to 25% for the same period in 2004. The erosion of margins is attributable to the increased cost of product, fuel cost surcharges passed through to us and the cost of carrying more inventory than in prior years due to supplier shortages. The Company was unable to recover all of these expenses.

27