**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**x**                               ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition period from          to        **

**COMMISSION FILE NUMBER 1-13495**

**MAC-GRAY CORPORATION**

(Exact name of registrant as specified in its charter)

| **DELAWARE**                                                 |   | **04-3361982**                       |
|--------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction incorporation or  organization) |   | (I.R.S. Employer Identification No.) |
| **404 WYMAN STREET, SUITE 400**                              |   | **02451-1212**                       |
| **WALTHAM, MASSACHUSETTS**                                   |   | (Zip Code)                           |
| (Address of principal executive offices)                     |   |                                 |

**Registrant’stelephone number, including area code:** (781) 487-7600

Securities Registered Pursuant to Section 12(b) ofthe Act:

|                                         | ** **               | **Name of Each Exchange** |
|-----------------------------------------|--------------------------|---------------------------|
|                                         | **Title  of Each Class** | ** **                | ** ** |  | **On Which Registered** | ** ** |
| Common Stock, par value  $.01 per share |                     | New  York Stock Exchange  |
| Preferred Stock Purchase Rights         |                     | New York Stock  Exchange  |
|                                         |                          |                           |  |  |  |  |

Securities Registered Pursuant to Section 12(g) ofthe Act: None

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o  No x

Indicateby check mark whether the registrant is not required to file reports pursuantto Section 13 or Section 15(d) of the Act. Yes o  No x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof the registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer (as defined in Rule 12b-2of the Act).

LargeAccelerated Filer o               AcceleratedFiler x               Non-AcceleratedFiler o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act). Yes o  No x

Theaggregate market value of the voting stock of the registrant held bynon-affiliates of the registrant as of June 30, 2006 was $96,608,777.

As ofMarch 1, 2007, 13,141,597 shares of common stock of the registrant, parvalue $.01 per share, were outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the Registrants’Proxy Statement for the Annual Meeting of Stockholders to be held on May 24,2007, are incorporated by reference into Part III of this report.

 

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**MAC-GRAYCORPORATIONAnnual Report on Form 10-KTable of Contents**

|                   | ** ** | ** **                                                                                                              | ** ** | **Page**   | ** ** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **Part I**   | ** ** |                                                                                                                    | ** ** | ** ** |       |
| Item 1.           |       | Business                                                                                                                |       |       | 1          | ** ** |   |
| Item  1A.         |       | Risk  Factors                                                                                                           |       |       | 6          | ** ** |   |
| Item 1B.          |       | Unresolved SEC Staff  Comments                                                                                          |       |       | 12         | ** ** |   |
| Item  2.          |       | Properties                                                                                                              |       |       | 13         | ** ** |   |
| Item  3.          |       | Legal  Proceedings                                                                                                      |       |       | 14         | ** ** |   |
| Item 4.           |       | Submission of  Matters to a Vote of Security Holders                                                                    |       |       | 14         | ** ** |   |
| **Part II**  | ** ** |                                                                                                                    | ** ** | ** ** |       |
| Item 5.           |       | Market for the  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |       |       | 14         | ** ** |   |
| Item 6.           |       | Selected  Financial Data                                                                                                |       |       | 15         | ** ** |   |
| Item 7.           |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             |       |       | 18         | ** ** |   |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                                                             |       |       | 37         | ** ** |   |
| Item 8.           |       | Financial  Statements and Supplementary Data                                                                            |       |       | 38         | ** ** |   |
| Item 9.           |       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                                   |       |       | 38         | ** ** |   |
| Item 9A.          |       | Controls and  Procedures                                                                                                |       |       | 38         | ** ** |   |
| Item 9B.          |       | Other Information                                                                                                       |       |       | 39         | ** ** |   |
| **Part III** | ** ** |                                                                                                                    | ** ** | ** ** |       |
| Item 10.          |       | Directors,  Executive Officers and Corporate Governance                                                                 |       |       | 40         | ** ** |   |
| Item 11.          |       | Executive  Compensation                                                                                                 |       |       | 40         | ** ** |   |
| Item 12.          |       | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                        |       |       | 40         | ** ** |   |
| Item 13.          |       | Certain  Relationships and Related Transactions, and Director Independence                                              |       |       | 41         | ** ** |   |
| Item 14.          |       | Principal  Accountant Fees and Services                                                                                 |       |       | 41         | ** ** |   |
| **Part IV**  | ** ** |                                                                                                                    | ** ** | ** ** |       |
| Item 15.          |       | Exhibits,  Financial Statements, Financial Statement Schedules                                                          |       |       | 41         | ** ** |   |

 

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**PART I**

**Forward-LookingStatements**

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

**Item 1.   Business**

**Overview**

Since its founding in 1927, Mac-Gray Corporation hasgrown to become the second largest laundry facilities management business inthe United States. Through our portfolio of card- and coin-operated laundryequipment located in laundry facilities across the country, we provide laundryconvenience 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 thelargest provider of such services to the college and university market in theUnited States. Unless the context requires otherwise, all references in thisreport to “we,” “our,” “Mac-Gray,” the “Company,” or “us” means Mac-GrayCorporation and its subsidiaries and predecessors. Mac-Gray Corporation wasincorporated in Delaware in 1997.

We derive our revenue principally as a laundryfacilities 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, collegesand universities and governmental agencies. We refer to these leases as “laundryleases” or “management contracts” and this business as “laundry facilitiesmanagement.” As of December 31, 2006, our laundry facilities managementbusiness had revenue-generating laundry equipment operating in 43 states andthe District of Columbia.

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

Our laundry equipment sales unit sells and servicescommercial laundry equipment manufactured by Whirlpool Corporation, DexterLaundry Company, and American Dryer Corporation. This business unit sellscommercial laundry equipment to retail laundromats, restaurants, hotels, healthclubs and similar institutional users that operate their own on-premise laundryfacilities. We refer to this business as our “equipment sales business.”

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

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

***SegmentInformation***

The following is adiscussion of each of our reportable business segments: (i) FacilitiesManagement and (ii) Product Sales. Financial information with regard toeach business segment is reported under Note 16 to the Company’s consolidatedfinancial statements included in this report.

**FacilitiesManagement Segment**

Mac-Gray’s FacilitiesManagement segment includes both our laundry facilities management business andreprographics facilities management business. For the years ended December 31,2005 and 2006, our facilities management segment accounted for approximately82% and 83% of our total revenue, respectively, and 82% of our gross margin foreach year.

***LaundryFacilities Management Business***

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

Mac-Gray has centralized its administrative andmarketing 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 (twolocations), New York (two locations), North Carolina, Tennessee, New Jersey,Arizona (two locations), Colorado, Louisiana, New Mexico, Oregon, Texas (threelocations), Utah, and Washington.

Mac-Gray also generates revenue by leasing equipmentto commercial laundry customers who choose neither to purchase equipment nor tobecome a laundry facilities management customer, but instead wish to maintaintheir own laundry rooms. This leasing business generated revenue of $3.6million and $4.0 million for the years ended December 31, 2005 and2006, respectively, and is included in the laundry facilities managementbusiness unit.

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

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

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manager. In each of thepast five years, we have retained approximately 97% of our equipment base peryear.

*Customers.*   Asof February 1, 2007, Mac-Gray provided laundry equipment and relatedservices to approximately 58,000 laundry rooms located in 43 states in thenortheast, south, midwest, and northwest United States, as well as the Districtof Columbia. As of February 1, 2007, no customer contract accounted formore than 1% of Mac-Gray’s laundry facilities management revenue. Mac-Grayserves customers in multi-unit housing facilities, including apartmentbuildings, college and university residence halls, condominiums andpublic-housing complexes.

*Seasonality.*   TheCompany experiences moderate seasonality as a result of its operations in thecollege and university market. Revenues derived from the college and universitymarket represented approximately 16% of the laundry facilities managementrevenue for 2006. Academic facilities management revenues are derivedsubstantially during the school year in the first, second and fourth calendarquarters. Conversely, the Company increases its operating and capitalexpenditures during a significant portion of the third calendar quarter, whenit has its greatest product installation activities, which is when mostcolleges and universities are not in session. Product sales, principally ofMicroFridge® products, to this market are typically higherduring the third calendar quarter as compared to the rest of the calendar year,somewhat offsetting the seasonality effect of the laundry facilities managementbusiness unit.

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

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*Impactof Occupancy Rates.*   The Company’s laundryfacilities management revenue is affected by changes in the multi-unit housingoccupancy rates. Occupancy rates in the multi-unit housing industry areaffected by several factors. These factors include local economic conditions,local unemployment levels and mortgage interest rates as they relate tofirst-time homebuyers, and the supply of apartments in specific markets,particularly the conversion of apartments to condominiums. The Company is somewhatprotected from revenue decreases caused by declining occupancy rates due to thevariation of markets served, the various types of multi-unit housing facilitiestherein, and the high percentage of revenue derived from colleges anduniversities. The Company monitors independent market research data regardingtrends in occupancy rates in all of its significant markets, to betterunderstand laundry facilities revenue trends and variations.

*Suppliers.*   TheCompany currently purchases substantially all of the equipment that it uses inits laundry facilities management business from Whirlpool. In addition, theCompany derives a portion of its revenue, as well as certain competitiveadvantages, from its position as a distributor of Whirlpool commercial laundryproducts. The Company has maintained a relationship with Whirlpool and itspredecessor corporation, Maytag, since 1927. Either party upon written noticemay terminate the purchase and distribution agreements between the Company andWhirlpool. A termination of, or substantial revision of the terms of, thecontractual arrangements or business relationships with Whirlpool could have amaterial adverse effect on the Company’s business, results of operations,financial condition and prospects.

***ReprographicsFacilities Management Business***

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

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

**Product SalesSegment**

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

***MicroFridge****® Sales Business*

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

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2005 and2006, our MicroFridge® business unit accounted for approximately 12%and 11% of our total revenue, respectively.

*Products.*   TheMicroFridge® product line withSafe PlugTM is a family of patented combination refrigerator/freezer/microwaveovens. The Units’ patented circuitry has proven to be an important feature forthose customers who have concerns about electrical capacity and seek a saferalternative 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 anduniversities and assisted living facilities.

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

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

*Competition.*   Inaddition to large direct sellers, the MicroFridge® business unit also competes with the majorretail stores and local and regional distributors who sell various brand-namecompact refrigerators as well as microwave ovens in the markets served byMicroFridge®. Although we jointly hold a patent on combination unitsutilizing internal circuitry, there has been continuing competition from “similarlook” products utilizing an external circuitry control mechanism. There alsoexists local and regional competition in the MicroFridge® rental business. Management believes that itsexpertise gained from being the first entrant in the market enables it tocompete 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.*   TheMicroFridge® business unitmaintains original equipment manufacturer, or “OEM,” arrangements with twoprimary manufacturers: Sanyo E&E Corporation, and Nisshin Industry Co. Ltd.The principal patent underlying the MicroFridge® product is held jointly by Sanyo and us. Thepatented circuitry of the MicroFridge® Units is marketed under the trade name SafePlugTM. In 1997 Sanyo signed a non-competition agreement with us whereby Sanyois precluded from entering the MicroFridge® market, provided that certain minimum annualquantities of products are purchased from Sanyo. These quantity requirementswere met in 2006. The OEM agreement with Nisshin Industry Co. Ltd. is renewableyear to year unless terminated with proper notice.

***Laundry Equipment Sales and Services Business***

**Through its equipment sales andservices business, Mac-Gray is a significant distributor for several commerciallaundry equipment manufacturers, primarily Whirlpool. Mac-Gray does notmanufacture any of the commercial laundry equipment that it sells. As anequipment distributor, Mac-Gray sells commercial laundry equipment to publicretail laundromats, as well as to the multi-unit housing industry. In addition,Mac-Gray sells commercial laundry equipment directly to institutionalpurchasers, including hospitals, restaurants, and hotels, for use in their ownon-premise laundry facilities. Mac-Gray is certified by the**

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**manufacturersto service the commercial laundry equipment that it sells. All installation andrepair services are provided on an occurrence basis, not on a contractualbasis. Related revenue is recognized at the time the installation service, orother service, is provided to the customer. For the years endedDecember 31, 2005 and 2006, our laundry equipment sales business unit accountedfor 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 acollective bargaining agreement and the Company believes that its relationshipwith its employees is good.

**OperatingCharacteristics**

The Company maintains a corporate staff as well ascentralized finance, human resources, legal services, information technologyand marketing departments. Regionally, the Company maintains service centersand warehouses staffed by service technicians, collectors, customer servicerepresentatives and inventory handlers. These facilities service the FacilitiesManagement segment as well as laundry equipment sales.

The Facilities Managementsegment’s sales and marketing efforts are conducted primarily by employees ofthe Company. Outside service providers are used periodically for variousmatters, including advertising, research, and equipment installation. TheProduct Sales segment uses an internal sales force and independent distributorsin parts of the United States where business opportunities do not warrant adirect sales force.

**Backlog**

Due to the nature of theCompany’s laundry facilities management business, backlogs do not exist. Thereis 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 withthe Securities and Exchange Commission, or “SEC.” Company reports filed withthe SEC are available at the SEC’s website at www.sec.gov and the Company’swebsite at www.macgray.com. The information contained on our website is notincluded as a part of, or incorporated by reference into, this annual report onForm 10-K.

The Company’s corporateoffices are located at 404 Wyman Street, Suite 400, Waltham,Massachusetts, 02451-1212. The Company’s telephone number is (781) 4877600, its fax number is (781) 487 7606, and its email address for investorrelations is ir@macgray.com.

**Item 1A.   RiskFactors**

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

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performance orachievements expressed or implied by the forward-looking statements. Some ofthe 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 customerswho are not subject to leases, our business, results of operations, cash flowsand financial condition could be adversely affected.*

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

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

*We face strong competition in the outsourcedlaundry facilities management industry.*

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

*Our cash flows may not be sufficient to finance thesignificant capital expenditures required to replace equipment and implementnew technology or make incentive payments to property managers.*

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

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case ofequity financings, could result in dilution to stockholders. If we cannotmaintain or replace our equipment as we require or implement our newtechnologies, our results of operations, cash flows and financial conditioncould be materially and adversely affected.

*If we are unable to continue our relationships withWhirlpool and other equipment suppliers, our revenues could be reduced, and ourability to meet customer requirements could be materially and adverselyaffected.*

We purchase substantially all of the equipment that weuse in our laundry facilities management business unit from Whirlpool. Inaddition, we derive a significant amount of our product sales revenue from ourposition as a distributor of Whirlpool commercial laundry products. We cannotassure you that Whirlpool will continue its relationship with us. If Whirlpoolterminates its relationship with us, our results of operations, cash flows andfinancial condition could be materially and adversely affected, and further, wemay be unable to replace our relationship with Whirlpool with a comparablecompany on favorable terms, or at all. Whirlpool has become our largestsupplier of laundry equipment following its acquisition of Maytag Corporationin March 2006. There have been no significant changes in our relationshipas a result of the acquisition.

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

The MicroFridge businesshas a non-competition agreement with Sanyo whereby Sanyo is precluded fromentering the MicroFridge market provided that certain minimum annual quantitiesof products are purchased from Sanyo. If we are unable to meet the minimum requirementsstipulated in the agreement, Sanyo may enter the MicroFridge market and, as aresult, our market share may decrease. In addition, as our agreement with Sanyohas a one year term and is renegotiated annually, there is a possibility thatSanyo may choose not to renew the agreement.

*A decrease in multi-unit housing sector occupancyrates in the markets in which we conduct business could adversely affect ourfacilities management revenue.*

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

·       localeconomic recessions and increases in the unemployment rate;

·       oversupplyof apartments; and

·       conversion of apartmentunits to condominiums.

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

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

·       useof common stock as acquisition consideration may result in dilution tostockholders;

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·       ifour common stock does not maintain a sufficient valuation or if potentialacquisition candidates are unwilling to accept shares of our common stock, thenwe would be required to increase our use of cash resources or otherconsideration to consummate acquisitions;

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

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

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

*We may have difficulties integrating futureacquisitions into our business.*

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

Any future acquisitions could involve numerous risks,including:

·       potentialdisruption of our ongoing business and distraction of management;

·       difficultyintegrating the operations of the acquired businesses;

·       unanticipatedexpenses related to equipment, maintenance and technology integration;

·       exposureto unknown liabilities, including litigation against the companies that we mayacquire;

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

·       potentialloss of key employees or customers of the acquired businesses;

·       theinability to achieve anticipated synergies or increase the revenue and profitof the acquired business; and

·       theexpenditure of a disproportionate amount of money and time integrating acquiredbusinesses, particularly operations located in new geographic regions andoperations involving new lines of business.

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

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

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

9

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*Our MicroFridge*® *products may besusceptible to product liability claims for which our current levels ofinsurance coverage may not be adequate.*

Through our MicroFridge® business, we market and distribute combinationrefrigerator/freezer/ microwave oven units under the brand name MicroFridge®. The sale and distribution ofMicroFridge® units, as well as other products, entails arisk of product liability claims. Although MicroFridge® units are manufactured by third parties undercontract with us, we may still be subject to risks of product liability claimsrelated to MicroFridge® units. Potential product liability claims mayexceed the amount of our product liability insurance coverage or may beexcluded from that coverage. We cannot assure you that we will be able to renewour existing product liability insurance at a cost and level of coveragecomparable to that currently in place, if at all. In the event that ourMicroFridge® business is held liable for a claim for whichit is not indemnified or for damages exceeding the limits of our productliability insurance coverage, the claim could have a material adverse effect onour business, results of operations and financial condition.

*Inabilityto protect our trademarks and other proprietary rights could adversely impactour competitive position.*

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

We own or license severalregistered 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 ofour products. However, the degree of protection that these trademarks afford usis unknown and these trademarks may expire or be terminated. In the event thatsomeone infringes on or misappropriates our trademarks, the brand images andreputations, which we have developed, could be damaged and could have amaterial adverse effect on our business, results of operations and financialcondition.

*We aredependent on key personnel, and the loss of any of our key personnel could havea material adverse effect on our business, results of operations and financialcondition.*

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

*We have significant intangibleassets and goodwill, the value of which might not be realized in the event ofan 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 intangibleassets, consisting primarily of contract rights and goodwill. In the event of asale or liquidation, there can be no assurance that the value of our intangibleassets would be realized.

10

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*We face risks associated withenvironmental regulation.*

Our business andoperations are subject to federal, state and local environmental laws andregulations, including those governing the discharge of pollutants, thehandling, generation, storage and disposal of hazardous materials, substancesand wastes and the cleanup of contaminated sites. In connection with current orhistorical operations by us or at our sites, we could incur substantial costs,including clean up costs, fines and civil or criminal sanctions, and thirdparty claims for property damage or personal injury, as a result of violationsof, or liabilities under, environmental laws and regulations. While we are notaware of any existing or potential environmental claims against us that arelikely to have a material adverse effect on our business or financialcondition, we cannot guarantee you that we will not in the future incurliability or other costs under environmental laws and regulations that couldhave a material adverse effect on our business or financial condition.

*We arecontrolled by a concentrated group of stockholders, whose interests could be inconflict with yours.*

As of December 31,2006, our directors, executive officers, and certain of our stockholdersrelated to such persons and their affiliates beneficially owned in theaggregate approximately 35.3% of the outstanding shares of our common stock.See Item 12, “Security Ownership of Certain Beneficial Owners and Managementand Related Stockholders Matters” below. This percentage ownership does notinclude options to purchase 485,000 shares of our common stock held by some ofthese 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 owned40.0% of the outstanding shares of our common stock. Additionally, we haveentered into a stockholders’ agreement, dated June 26, 1997, with some ofthese stockholders that gives them rights of first offer to purchase shares ofour common stock offered for sale by another stockholder party thereto. SeeItem 13, “Certain Relationships and Related Transactions and DirectorIndependence” below. As a result of this concentration in ownership, thesestockholders, acting together, have the ability to significantly influence theoutcome of the election of directors and all other matters requiring approvalby a majority of stockholders. Circumstances may arise in which the interestsof this group of stockholders could be in conflict with interests of otherstockholders.

*Provisionsin our charter and bylaws, Delaware law, and the stockholder rights agreementcould have the effect of discouraging takeovers.*

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

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

·       aclassified Board of Directors serving staggered three-year terms;

·       theelimination of stockholder voting by written consent;

·       theabsence of cumulative voting for directors;

11

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·       theremoval of directors only for cause;

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

·       thevesting of exclusive authority in our Board of Directors, except as otherwiserequired by law, to call special meetings of stockholders;

·       advancenotice requirements for stockholder proposals and nominations for election tothe Board of Directors;

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

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

**Item 1B.   UnresolvedSEC Staff Comments**

None.

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**Item 2.**                        Properties

Mac-Grayrents approximately 32,000 square feet in Waltham, Massachusetts that it usesas its corporate headquarters and which houses the Company’s administrative andcentral services. Mac-Gray owns a sales and service facility in Tampa, Floridaconsisting of approximately 12,000 square feet. At December 31, 2006,Mac-Gray leased the following regional facilities, which are largely operatedas sales and service facilities, although limited administrative functions arealso performed at many of them:

| **Location**                | ** ** | ** ** | ** ** | **Approximate  Square Footage** | ** ** | **Annual  Rental Rate** | ** ** | **Expiration  Date** | ** ** |
|-----------------------------|------------|------------|------------|--------------------------------------|------------|------------------------------|------------|----------------------|------------|
| Albuquerque, New  Mexico    |       |       | 6,600      |                                 |       |                         | $          | 43,800               |       |   |   | 4/2007 |   |   |
| Auburn,  Washington         |       |       | 7,253      |                                 |       |                         | 51,842     |                 |       |   | 4/2009 |   |   |
| Buda, Texas                 |       |       | 7,000      |                                 |       |                         | 46,200     |                 |       |   | 1/2009 |   |   |
| Buffalo, New York           |       |       | 10,000     |                                 |       |                         | 52,800     |                 |       |   | 9/2008 |   |   |
| Charlotte, North  Carolina  |       |       | 10,640     |                                 |       |                         | 51,072     |                 |       |   | 3/2008 |   |   |
| College Station,  Texas     |       |       | 1,250      |                                 |       |                         | 6,660      |                 |       |   | 12/2007 |   |   |
| Deerfield Beach,  Florida   |       |       | 8,300      |                                 |       |                         | 68,475     |                 |       |   | 5/2007 |   |   |
| Denver, Colorado            |       |       | 5,000      |                                 |       |                         | 28,750     |                 |       |   | 9/2010 |   |   |
| East Brunswick,  New Jersey |       |       | 9,600      |                                 |       |                         | 60,720     |                 |       |   | 7/2010 |   |   |
| East Hartford,  Connecticut |       |       | 14,900     |                                 |       |                         | 66,992     |                 |       |   | 5/2013 |   |   |
| Eugene, Oregon              |       |       | 2,500      |                                 |       |                         | 17,580     |                 |       |   | 6/2008 |   |   |
| Euless, Texas               |       |       | 10,000     |                                 |       |                         | 43,200     |                 |       |   | 4/2007 |   |   |
| Gurnee, Illinois            |       |       | 22,521     |                                 |       |                         | 131,856    |                 |       |   | 4/2011 |   |   |
| Gurnee, Illinois            |       |       | 12,000     |                                 |       |                         | 66,000     |                 |       |   | 7/2011 |   |   |
| Hendersonville,  Tennessee  |       |       | 11,000     |                                 |       |                         | 51,000     |                 |       |   | 4/2008 |   |   |
| Houston, Texas              |       |       | 10,687     |                                 |       |                         | 43,603     |                 |       |   | 10/2010 |   |   |
| Jessup, Maryland            |       |       | 10,361     |                                 |       |                         | 64,138     |                 |       |   | 3/2007 |   |   |
| Lake City,  Florida         |       |       | 1,125      |                                 |       |                         | 7,704      |                 |       |   | 4/2007 |   |   |
| Lithia Springs,  Georgia    |       |       | 10,675     |                                 |       |                         | 56,044     |                 |       |   | 2/2011 |   |   |
| Metairie,  Louisiana        |       |       | 4,000      |                                 |       |                         | 43,800     |                 |       |   | 4/2007 |   |   |
| Oklahoma City,  Oklahoma    |       |       | 2,250      |                                 |       |                         | 11,475     |                 |       |   | 11/2007 |   |   |
| Orlando, Florida            |       |       | 2,100      |                                 |       |                         | 20,168     |                 |       |   | 12/2007 |   |   |
| Phoenix, Arizona            |       |       | 25,920     |                                 |       |                         | 102,000    |                 |       |   | 4/2007 |   |   |
| Portland, Oregon            |       |       | 10,000     |                                 |       |                         | 62,904     |                 |       |   | 3/2011 |   |   |
| Salt Lake City,  Utah       |       |       | 4,750      |                                 |       |                         | 29,580     |                 |       |   | 6/2008 |   |   |
| Syracuse, New  York         |       |       | 8,400      |                                 |       |                         | 44,520     |                 |       |   | 10/2008 |   |   |
| Tucson, Arizona             |       |       | 4,676      |                                 |       |                         | 37,325     |                 |       |   | 4/2007 |   |   |
| Walpole,  Massachusetts     |       |       | 19,000     |                                 |       |                         | 151,920    |                 |       |   | 5/2011 |   |   |
| Waltham,  Massachusetts     |       |       | 32,000     |                                 |       |                         | 945,360    |                 |       |   | 11/2015 |   |   |
| Westbrook, Maine            |       |       | 5,625      |                                 |       |                         | 39,375     |                 |       |   | 7/2011 |   |   |
| Woburn, Massachusetts       |       |       | 40,000     |                                 |       |                         | 190,000    |                 |       |   | 2/2016 |   |   |

 

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

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

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**Item 3.**                        LegalProceedings

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

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

**Item 4.**                        Submissionof Matters to a Vote of Security Holders

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

**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities

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

Thefollowing table sets forth the high and low sales prices for Mac-Gray commonstock on the NYSE for the periods indicated.

| ** **     | ** ** | **December 31,**2005 | ** ** | **December 31,**2006 | ** ** |
|----------------|------------|---------------------------|------------|---------------------------|------------|
| ** **     | ** ** | **High**                  | ** ** | **Low**                   | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                         | 8.74       |                      | $          | 7.77 |   | $ | 12.70 |   | $ | 10.95 |   |
| Second Quarter |       | $                         | 9.17       |                      | $          | 8.50 |   | $ | 13.10 |   | $ | 11.51 |   |
| Third Quarter  |       | $                         | 12.95      |                      | $          | 9.30 |   | $ | 12.35 |   | $ | 10.91 |   |
| Fourth Quarter |       | $                         | 13.24      |                      | $          | 10.70 |   | $ | 11.98 |   | $ | 10.53 |   |

 

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

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

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

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

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**Item 6.**                        SelectedFinancial Data (Dollars in thousands, except per share data)

Setforth below are selected historical financial data as of the dates and for theperiods indicated. The selected financial data set forth below should be readin conjunction with, and are qualified by reference to, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andthe consolidated financial statements of Mac-Gray and the notes theretoincluded elsewhere in this report.

| ** **                                                                                    | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004(1)** | ** ** | **2005(2)** | ** ** | **2006** | ** ** |
| Statement of Income  Data:                                                                    |       |                                       |       |   |   |   |   |   |   |   |   |
| Revenue                                                                                       |       | $                                          | 150,368    |   | $ | 149,656 |   | $ | 182,694 |   | $ | 260,623 |   | $ | 279,327 |   |
| Cost of revenue:                                                                              |       |                                       |       |   |   |   |   |   |   |   |   |
| Cost of facilities management revenues                                                        |       | 73,402                                     |       | 72,823 |   | 93,512 |   | 142,052 |   | 153,861 |   |
| Depreciation and amortization                                                                 |       | 16,501                                     |       | 16,723 |   | 20,747 |   | 31,337 |   | 35,156 |   |
| Cost of product sales                                                                         |       | 28,053                                     |       | 28,803 |   | 30,821 |   | 36,173 |   | 37,352 |   |
| Total cost of revenue                                                                         |       | 117,956                                    |       | 118,349 |   | 145,080 |   | 209,562 |   | 226,369 |   |
| Operating expenses:                                                                           |       |                                       |       |   |   |   |   |   |   |   |   |
| General and administration                                                                    |       | 9,359                                      |       | 9,519 |   | 11,078 |   | 14,164 |   | 17,826 |   |
| Sales and marketing                                                                           |       | 11,125                                     |       | 11,341 |   | 13,005 |   | 16,097 |   | 16,248 |   |
| Depreciation                                                                                  |       | 1,197                                      |       | 1,100 |   | 1,047 |   | 1,189 |   | 1,589 |   |
| Gain on sale of assets                                                                        |       | (192                                       | )          | (145 | ) | (1,208 | ) | (10,735 | ) | (32 | ) |
| Loss on early extinguishment of debt                                                          |       | —                                     |       | 381 |   | 183 |   | 668 |   | 73 |   |
| Impairment of assets                                                                          |       | —                                     |       | — |   | — |   | — |   | 2,502 |   |
| Total operating expenses                                                                      |       | 21,489                                     |       | 22,196 |   | 24,105 |   | 21,383 |   | 38,206 |   |
| Income from  operations                                                                       |       | 10,923                                     |       | 9,111 |   | 13,509 |   | 29,678 |   | 14,752 |   |
| Interest expense, net                                                                         |       | (4,578                                     | )          | (2,807 | ) | (4,312 | ) | (10,939 | ) | (13,653 | ) |
| Gain (loss) related to derivative instruments                                                 |       | —                                     |       | — |   | — |   | 1,876 |   | (96 | ) |
| Gain on sale of lease receivables                                                             |       | —                                     |       | 836 |   | — |   | — |   | — |   |
| Other expense, net                                                                            |       | (4                                         | )          | — |   | — |   | — |   | — |   |
| Income before provision for income taxes and effect  of change in accounting principle        |       | 6,341                                      |       | 7,140 |   | 9,197 |   | 20,615 |   | 1,003 |   |
| Provision for  income taxes                                                                   |       | (2,567                                     | )          | (3,036 | ) | (3,934 | ) | (8,563 | ) | (147 | ) |
| Net income before effect of change in accounting  principle                                   |       | 3,774                                      |       | 4,104 |   | 5,263 |   | 12,052 |   | 856 |   |
| Effect of change  in accounting principle, net of tax                                         |       | (906                                       | )          | — |   | — |   | — |   | — |   |
| Net income  available to common stockholders                                                  |       | $                                          | 2,868      |   | $ | 4,104 |   | $ | 5,263 |   | $ | 12,052 |   | $ | 856 |   |
| Net income per common share before the effect of  change in accounting principle—basic   |       | $                                          | 0.30       |   | $ | 0.32 |   | $ | 0.41 |   | $ | 0.94 |   | $ | 0.07 |   |
| Net income per common share before the effect of  change in accounting principle—diluted |       | $                                          | 0.30       |   | $ | 0.32 |   | $ | 0.40 |   | $ | 0.91 |   | $ | 0.06 |   |
| Net income per common share—basic                                                        |       | $                                          | 0.23       |   | $ | 0.32 |   | $ | 0.41 |   | $ | 0.94 |   | $ | 0.07 |   |
| Net income per  common share—diluted                                                     |       | $                                          | 0.23       |   | $ | 0.32 |   | $ | 0.40 |   | $ | 0.91 |   | $ | 0.06 |   |
| Weighted average  common shares outstanding—basic                                        |       | 12,661                                     |       | 12,635 |   | 12,702 |   | 12,864 |   | 13,008 |   |
| Weighted average common  shares outstanding—diluted                                      |       | 12,664                                     |       | 12,741 |   | 13,028 |   | 13,283 |   | 13,448 |   |

 

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| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004(**1) | ** ** | **2005(**2) | ** ** | **2006** | ** ** |
| Other Financial  Data:                                                   |       |                                       |       |   |   |   |   |   |   |   |   |
| EBITDA(3)                                                                |       | 27,711                                     |       | 27,770 |   | 35,303 |   | 64,080 |   | 51,401 |   |
| Depreciation and amortization                                            |       | 17,698                                     |       | 17,823 |   | 21,794 |   | 32,526 |   | 36,745 |   |
| Capital expenditures(4)                                                  |       | 13,334                                     |       | 15,372 |   | 17,826 |   | 26,380 |   | 26,487 |   |
| Cash flows provided by operating activities                              |       | 26,835                                     |       | 24,480 |   | 37,108 |   | 37,902 |   | 36,507 |   |
| Cash flows used in investing activities                                  |       | (12,436                                    | )          | (12,802 | ) | (57,101 | ) | (120,251 | ) | (44,975 | ) |
| Cash flows (used in) provided by financing activities                    |       | (14,608                                    | )          | (11,398 | ) | 21,188 |   | 86,904 |   | 9,416 |   |
| Balance Sheet  Data (at end of period):                                  |       |                                       |       |   |   |   |   |   |   |   |   |
| Working capital                                                          |       | (2,601                                     | )          | 5,247 |   | (2,737 | ) | (1,673 | ) | 2,064 |   |
| Long-term debt and capital lease obligations,  including current portion |       | 56,825                                     |       | 50,873 |   | 73,328 |   | 166,678 |   | 177,068 |   |
| Long-term debt and capital lease obligations, net of  current portion    |       | 47,975                                     |       | 47,254 |   | 67,225 |   | 165,493 |   | 175,823 |   |
| Total assets                                                             |       | 162,379                                    |       | 162,005 |   | 202,330 |   | 324,917 |   | 339,004 |   |
| Stockholders’  equity                                               |       | 63,688                                     |       | 68,729 |   | 75,936 |   | 88,601 |   | 91,640 |   |

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

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

(3)          EBITDA is defined as netincome before provision for income taxes, depreciation and amortization expenseand interest expense. Adjusted EBITDA is EBITDA further adjusted to exclude theitems described in the table below. We have excluded these items because webelieve they are not reflective of our ongoing operating performance. EBITDAand Adjusted EBIDTA are included in this report because they are a basis uponwhich our management assesses our operating performance. EBITDA and AdjustedEBITDA are not measures of our liquidity or financial performance under GAAPand should not be considered as alternatives to net income or any otherperformance measure derived in accordance with GAAP, or as an alternative tocash flows from operating activities as a measure of our liquidity. The use ofEBITDA and Adjusted EBITDA instead of net income has limitations as ananalytical tool, including the exclusion of interest expense and depreciationand amortization expense, which represent significant and unavoidable operatingcosts given the level of indebtedness and the capital expenditures needed tomaintain our business. Management compensates for these limitations by relyingprimarily on our GAAP results and by using EBITDA and Adjusted EBITDA onlysupplementally. Our management believes EBITDA and Adjusted EBITDA are usefulto investors because they help enable investors to evaluate our business in thesame manner as our management and because they are frequently used bysecurities analysts, investors and other interested parties in the evaluationof companies with substantial financial leverage. Our measures of EBITDA andAdjusted EBITDA are not necessarily comparable to other similarly titledcaptions of other companies due to potential inconsistencies in the methods ofcalculation.

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

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Thefollowing is a reconciliation of net income to EBITDA and Adjusted EBITDA:

| ** **                                                 | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2002**                                   | ** ** | **2003** | ** ** | **2004(1)** | ** ** | **2005(2)** | ** ** | **2006** | ** ** |
| Net income                                                 |       | $                                          | 2,868      |   | $ | 4,104 |   | $ | 5,263 |   | $ | 12,052 |   | $ | 856 |   |
| Add:                                                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Provision for income taxes                                 |       | 2,567                                      |       | 3,036 |   | 3,934 |   | 8,563 |   | 147 |   |
| Cost of revenue, depreciation and amortization  expense    |       | 16,501                                     |       | 16,723 |   | 20,747 |   | 31,337 |   | 35,156 |   |
| Operating expenses, depreciation and amortization  expense |       | 1,197                                      |       | 1,100 |   | 1,047 |   | 1,189 |   | 1,589 |   |
| Interest expense, net                                      |       | 4,578                                      |       | 2,807 |   | 4,312 |   | 10,939 |   | 13,653 |   |
| EBITDA                                                     |       | $                                          | 27,711     |   | $ | 27,770 |   | $ | 35,303 |   | $ | 64,080 |   | $ | 51,401 |   |
| Add (Subtract):                                            |       |                                       |       |   |   |   |   |   |   |   |   |
| Gain on sale of certain assets, net                        |       | $                                          | —     |   | $ | — |   | ($1,218 | )(a) | ($10,767 | )(b) | — |   |
| Stock compensation expense                                 |       | —                                     |       | — |   | — |   | — |   | 1,147 |   |
| Impairment of assets                                       |       | —                                     |       | — |   | — |   | — |   | 2,502 |   |
| (Gain) loss related to derivative instruments              |       | —                                     |       | — |   | — |   | (1,876 | ) | 96 |   |
| Loss related to 2005 hurricanes                            |       | —                                     |       | — |   | — |   | 316 |   | — |   |
| Loss on early extinguishment of debt                       |       | —                                     |       | 381 |   | 183 |   | 668 |   | 73 |   |
| Effect of change in accounting principle                   |       | 906                                        |       | — |   | — |   | — |   | — |   |
| Adjusted EBITDA                                            |       | $                                          | 28,617     |   | $ | 28,151 |   | $ | 34,268 |   | $ | 52,421 |   | $ | 55,219 |   |

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(a)           Represents a pretaxgain recognized in connection with the sale of certain laundry facilitiesmanagement assets and related contracts.

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

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

| ** **                                                                            | ** ** | **For the year ended December 31, (In thousands, except per share data)** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2002**                                                                                                                         | ** ** | **2002  per  share** | ** ** | **2003** | ** ** | **2003  per  share** | ** ** | **2004** | ** ** | **2004  per  share** | ** ** | **2005** | ** ** | **2005  per  share** | ** ** | **2006** | ** ** | **2006  per  share** | ** ** |
| Reported earnings                                                                     |       | $                                                                                                                                | 2,868      |   | $ | 0.23 |   | $ | 4,104 |   | $ | 0.32 |   | $ | 5,263 |   | $ | 0.40 |   | $ | 12,052 |   | $ | 0.91 |   | $ | 856 |   | $ | 0.06 |   |
| Add: Impairment  charge to comply with new accounting standard—net of taxes |       | 906                                                                                                                              |       | 0.07 |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                                                                                  |       | $                                                                                                                                | 3,774      |   | $ | 0.30 |   | $ | 4,104 |   | $ | 0.32 |   | $ | 5,263 |   | $ | 0.40 |   | $ | 12,052 |   | $ | 0.91 |   | $ | 856 |   | $ | 0.06 |   |

 

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**Item7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations. (Dollarsin Thousands)

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

This report contains, inaddition to historical information, forward-looking statements that involverisks and uncertainties. These forward-looking statements reflect our currentviews about future events and financial performance. Investors should not relyon forward-looking statements because they are subject to a variety of factorsthat could cause actual results to differ materially from our expectations.Factors that could cause or contribute to such differences include, withoutlimitation, the factors described under Item 1A “Risk Factors.”

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

**Overview**

Mac-Gray was founded in1927 and incorporated in Delaware in 1997. We conduct our business in thefollowing four units: (1) the laundry facilities management business unit,through which we manage laundry facilities in multi-unit housing; (2) theMicroFridge® business unit, through which we sell a line ofcombination refrigerator/freezer/microwave oven units under the MicroFridge® brand to multi-unit housing facilities such ashospitality and assisted living facilities, military housing, and colleges anduniversities; (3) the laundry equipment sales business unit, through whichwe sell commercial laundry equipment; and (4) the reprographics businessunit, through which we provide card- and coin-operated reprographics equipmentand services to the academic and public library markets. We report our businessin two segments: facilities management and product sales. Facilities managementconsists of our laundry facilities management and reprographics business units.Product sales consists of our laundry equipment sales and MicroFridge® business units.

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

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

Our financial objective isto maintain and enhance profitability by retaining existing customers, addingcustomers in areas in which we currently operate, selectively expanding ourgeographic footprint and density through acquisitions, and controlling costs.One of the key challenges we face is maintaining and expanding our customerbase in a competitive industry. We experience competition from other industryparticipants, including national, regional and local laundry facilitiesmanagement operators and from property owners and property management companieswho self-operate their laundry facilities. We devote substantial resources to oursales efforts and are focused on continued innovation in order to distinguishus from competitors. Approximately 10% to 15% of such laundry room leases areup for renewal each year. Over the past five calendar years, we have been ableto retain, on average, approximately 97% of our total installed equipment baseeach year. For the years ended December 31, 2005 and 2006, we have beenable to add 5% and 4%, respectively, to our equipment base through internallygenerated growth.

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

**Recent Developments**

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

On May 23, 2006, we acquired the laundry facilities managementassets of a regional operator in the Philadelphia area. On July 7, 2006,we acquired the laundry facilities management assets of a regional operator insouthern New England. The combined cost of these acquisitions was approximately$7,500 and was funded by borrowings under our revolving credit facility. Weestimate that the two combined acquisitions will add approximately $5,000 ofannual 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 increasethe line up to $100,000, in increments of not less than $10,000, over the lifeof 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 allof our assets and our two main subsidiaries, Mac-Gray Services, Inc. andIntirion Corporation, as well as a pledge by us of all of the capital stock ofour two subsidiaries.

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

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

**Results of Operations (Dollars in thousands, exceptper share data)**

The information presentedbelow for the years ended December 31, 2005 and 2006 is derived fromMac-Gray’s consolidated financial statements and related notes included in thisreport.

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***Revenue***

| ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | **2006 to 2005** | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|----------------------------|------------|
| ** **                           | ** ** | **2005**   | ** ** | **2006**   | ** ** | **Increase  (Decrease)**   | ** ** | **%  Change** | ** ** |
| Laundry  facilities management       |       | $          | 211,892    |       | $          | 229,719                    |       |   | $ | 17,827 |   |   |   | 8 | % |   |
| Reprographics  revenue               |       | 2,924      |       | 2,462      |       |                       | (462       | ) |   |   | (16 | % | ) |
| Total facilities management revenue. |       | 214,816    |       | 232,181    |       |                       | 17,365     |   |   |   | 8 | % |   |
| MicroFridge® revenue       |       | 30,513     |       | 30,410     |       |                       | (103       | ) |   |   | 0 | % |   |
| Laundry equipment  sales revenue     |       | 15,294     |       | 16,736     |       |                       | 1,442      |   |   |   | 9 | % |   |
| Total product sales revenue          |       | 45,807     |       | 47,146     |       |                       | 1,339      |   |   |   | 3 | % |   |
| Total revenue                        |       | $          | 260,623    |       | $          | 279,327                    |       |   | $ | 18,704 |   |   |   | 7 | % |   |

 

**Fiscal year ended December 31, 2006 compared tofiscal year ended December 31, 2005**

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

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

Within the facilitiesmanagement segment, revenue in the laundry facilities management business unitincreased $17,827, or 8%, to $229,719 for the year ended December 31, 2006compared to $211,892 for the year ended December 31, 2005. The increase isattributable primarily to the revenue generated by the assets acquired during2006, which accounted for approximately 50% of the 2006 increase over 2005. Theremaining 50% is attributable to organic growth in the number of managementcontracts signed, increases in the vend prices charged for use of the equipmentand an increase in revenue associated with the conversion of coin-operatedlocations to card-operated locations. Due to the convenience of card-operatedsystems, usage, and therefore revenue, typically increases upon the conversionfrom a coin operated system.

Revenue in thereprographics business unit decreased $462, or 16%, to $2,462 for the yearended December 31, 2006 compared to $2,924 for the year ended December 31,2005. In the year ended December 31, 2006 the reprographics business unitaccounted for less than 1% of consolidated revenue. Due to the continueddecline in the use of copiers in libraries and similar facilities, thereduction in the number of locations we operate, the difficulty of servicingfewer accounts over a wider territory, and the difficulty of predicting futureincome generation, in the fourth quarter of 2006 the Company decided not torenew contracts which will expire in the next twelve months in selectedgeographic markets. This decision, in addition to the Company’s inability topredict success at negotiating profitable contracts going forward for thisbusiness in any of its present markets, resulted in the Company taking anon-cash impairment charge of $1.6 million, net of tax, in the fourth quarter.

*Product sales revenue.*   Productsales 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. Theincrease in revenue for the year ended December 31, 2006 as compared tothe same period in 2005 is attributable to increases in revenue in the laundryequipment sales business unit.

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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 forthe year ended December 31, 2005. The decrease is primarily attributableto a decrease in sales to the academic market and government market, partiallyoffset by a increase in hospitality and assisted living sales. The hospitalitysales increase is attributable to an increase in capital spending by theindustry and a full year of sales to several new distributors added by ourCompany in 2005. We believe the decrease in academic sales can be attributed toconstraints by academic institutions on capital spending on amenity items. Oursales to the government are continually affected by changes in governmentspending priorities. We believe current spending on military housingimprovements has been delayed as a result of current military efforts in theMiddle East.

Revenue in the laundryequipment sales business unit increased $1,442, or 9%, to $16,736 for the yearended 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 thestrength of the economy, consumer confidence, local permitting and theavailability of financing to small businesses, and therefore tend to fluctuatefrom period to period. The combination of these factors, coupled with theCompany’s marketing efforts, contributed to the increase in sales.

***Cost of revenue***

*Cost of facilitiesmanagement revenue.*   Cost of facilitiesmanagement revenue includes rent paid to customers as well as costs associatedwith installing and servicing machines and costs of collecting, counting, anddepositing 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 includedin facilities management costs in 2005 have been reclassified to cost of salesfor the product sales segment to conform to 2006’s presentation. The followingreferences to 2005 give effect to the reclassification. Cost of facilitiesmanagement 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. Thisincrease is attributable primarily to the cost, primarily facilities managementrent, associated with the increase in facilities management revenue of $17,365,partially offset by the costs associated with the 2005 hurricanes which did notrecur in 2006. Included in the cost for the year ended December 31, 2005are costs associated with the 2005 hurricanes. Adjusting 2005 total costs toexclude the hurricane costs, cost of facilities management as a percentage offacilities management revenue remained consistent at 66% for the years ended December 31,2006 and 2005. Changes in facilities management rent as a percentage offacilities management revenue can be affected by new and renewed laundry leasesand by other factors such as the amount of incentive payments and laundry roombetterments invested in new or renewed laundry leases. As we vary the amountinvested in a facility, the facilities management rent as a function offacilities management revenue can vary. Incentive payments and betterments areamortized over the life of the laundry lease.

*Depreciation andamortization.*   Depreciation and amortizationincreased 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. Laundryfacilities management equipment and contract rights are depreciated and amortizedusing the straight-line method. The increased depreciation expense isattributable to new equipment placed in laundry facilities at new locations andreplacement of older equipment as contracts were renegotiated. In addition, dueto management’s decision not to recondition and redeploy equipment which is notas energy efficient as newer equipment, we disposed of certain laundryequipment in 2006 that had a remaining net book value of $847. This cost isincluded in depreciation expense.

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

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product salessegment to conform to 2006’s presentation. The following references to 2005give 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 marginsfrom the laundry equipment sales and MicroFridge® business units. The gross margin in thelaundry 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 isattributable to product mix and increased costs from our suppliers. The grossmargin in the MicroFridge® business unit increased to 20% for the yearended 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 aswell 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 totalrevenue, general, administration, sales, marketing and depreciation expenseincreased from 12% for the year ended December 31, 2005 to 13% for theyear ended December 31, 2006. The increase in total expenses is primarilyattributable to the costs incurred to comply with the requirements of Section 404of the Sarbanes-Oxley Act of 2002 and the non-cash expense related to stockcompensation, which was required to be recorded in 2006 in accordance withStatement of Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayments”, (“FAS123R”).

*Loss on earlyextinguishment of debt.*   Unamortized financingcosts of $461 related to the term loan were expensed in 2005. In connectionwith the senior credit facilities we repaid in full and terminated our 2003senior credit facilities. Unamortized financing costs of $207 associated withour 2003 senior credit facilities were also expensed in 2005. Effective December 29,2006, the Company amended its bank credit facilities. As a result of thisamendment, a portion of the unamortized financing costs amounting to $73, whichhad been incurred as part of the prior credit facility, were expensed.

*Gain on sale of assets.*   Gainon sale of assets represents the gain from the sale of vehicles and othernon-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 correspondingoperating income in our reprographics business unit have been declining since1999 when college libraries, followed by public libraries, began to makereference material electronically available to patrons. Electronicavailability, widespread conversion to laser printers (free of charge in manyschool libraries) and other technical advancements have led to reduced use ofvended copy machines resulting in reduced revenue at several accounts. Duringthe fourth quarter of 2006, the Company performed an evaluation of thereprographics business unit and its long-term prospects. As a result of thisevaluation, management determined that the carrying amount of the business unit’slong lived assets exceeded the estimated undiscounted cash flows expected toresult from operating this business unit, and recognized a non-cash,non-recurring impairment charge of $2,502, or $0.19 per diluted share beforetaxes ($1,639, or $0.12 per diluted share net of taxes). This charge was calculatedin accordance with SFAS No. 144, “Accounting for the Impairment ordisposal of Long-Lived Assets”, (“FAS 144”). Accordingly, the Company used adiscounted cash flow model to calculate the amount of the impairment chargeafter it was determined that, pre-write-down, the carrying amount of thebusiness unit’s long lived assets exceeded the estimated undiscounted futurecash flows expected to result from operating this business unit.

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***Income fromoperations***

Income from operationsdecreased 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 ofassets, loss on early extinguishment of debt and the gain on sale of certainassets, income from operations, as adjusted, would have been $18,474 for theyear 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 discussedabove. To supplement the consolidated financial statements presented accordingto generally accepted accounting principles (GAAP), we have used a non-GAAPfinancial measure of adjusted income from operations. Management believespresentation of this measure is useful to investors to enhance an overallunderstanding of our historical financial performance and future prospects.Adjusted income from operations, which is adjusted to exclude certain gains andlosses from the comparable GAAP income from operations, is an indication of ourbaseline performance before gains, losses or other charges that are consideredby management to be outside of our core operating results. The presentation ofthis additional information is not meant to be considered in isolation or as asubstitute for income from operations or other measures prepared in accordancewith GAAP.

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

| ** **                               | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                    | ** ** | **2006** | ** ** |
| Income from  operations                  |       | $                                           | 29,678     |   | $ | 14,752 |   |
| Non-cash  compensation(1)                |       | —                                      |       | 1,147 |   |
| Impairment of  assets(2)                 |       | —                                      |       | 2,502 |   |
| Loss on early  extinguishment of debt(3) |       | 668                                         |       | 73 |   |
| Gain on sale of  certain fixed assets(4) |       | (10,588                                     | )          | — |   |
| Income from operations,  as adjusted     |       | $                                           | 19,758     |   | $ | 18,474 |   |

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(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 equityawards in the periods presented.

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

(3)          Represents unamortizedcosts related to terminated credit facilities.

(4)          Represents a pre-taxgain recognized in connection with the sale of the Company’s office andwarehouse 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 ascompared to $10,939 for the year ended December 31, 2005. The increase isprimarily 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 yearended December 31, 2005. The increase in average borrowing rates is due,in large part, to the $150,000 of senior notes that we issued onAugust 16, 2005 and which bear interest at the rate of 7.625% per annumfor which we recognized a full year’s expense in 2006. Also contributing to theincrease is our increased borrowing in 2006 of approximately $19,000attributable to our 2006 acquisitions.

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***Gain or loss related to derivative instruments***

The Company is party tointerest rate swap agreements that it had accounted for as cash flow hedges.The fair value of these swaps has been included in other comprehensive incomein the equity section of the balance sheet. As a result of the reduction in theamount outstanding under our senior credit facilities, certain swap agreementsno longer qualified for cash flow hedge accounting treatment. The revisedaccounting treatment resulted in an expense of $96 and a gain of $1,876 in theincome statement for the years ended December 31, 2006 and 2005,respectively.

***Provision for income taxes***

The provision for incometaxes 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 decreaseis the combination of a decrease in taxable income, an increase in theeffective tax rate and a reduction in the reserve for uncertain tax positions.The effective tax rate, without considering the impact of the reduction in thereserve, 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 taxrate is due primarily to the impact of permanent book/tax differences on thedecreased taxable income in 2006 compared to 2005. The reduction in the reservefor uncertain tax provisions further reduced the effective rate to 14.7% forthe year ended December 31, 2006. This reduction relates to the expirationof the statute of limitations as of September 15, 2006 for certain statetax exposures.

***Net income***

As aresult of the foregoing, net income decreased $11,196, or 93%, to $856 for theyear 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 comparedto $5,239 for the year ended December 31, 2005. A reconciliation of netincome, as reported to net income, as adjusted is provided below:

| ** **                                             | ** ** | **Years Ended**  | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **December 31,** | ** ** |
| ** **                                             | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Net income, as  reported                               |       | $                     | 12,052     |   | $ | 856 |   |
| Income before  provision for income taxes, as reported |       | $                     | 20,615     |   | $ | 1,003 |   |
| Non-cash  compensation expense(1)                      |       | —                |       | 1,147 |   |
| Gain on  non-recurring sale of assets(2)               |       | (10,767               | )          | — |   |
| Impairment of  assets(3)                               |       | —                |       | 2,502 |   |
| (Gain) loss  related to derivative instruments(4)      |       | (1,876                | )          | 96 |   |
| Loss related to  2005 hurricanes                       |       | 316                   |       | — |   |
| Loss on early  extinguishment of debt(5)               |       | 668                   |       | 73 |   |
| Income before  provision for income taxes, as adjusted |       | 8,956                 |       | 4,821 |   |
| Provision for  income taxes, as adjusted               |       | 3,717                 |       | 707 |   |
| Net income, as  adjusted                               |       | $                     | 5,239      |   | $ | 4,114 |   |
| Diluted earnings per  share, as adjusted               |       | $                     | 0.39       |   | $ | 0.31 |   |

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

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

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

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(4)          Represents theun-realized (gain) loss on interest rate protection contracts, which do notqualify for hedge accounting treatment.

(5)          Represents unamortizedcosts related to terminated credit facilities.

To supplement the Company’s unaudited consolidatedfinancial statements presented on a generally accepted accounting principles(GAAP) basis, management has used a non-GAAP measure of net income. Managementbelieves presentation of this measure is appropriate to enhance an overallunderstanding of our historical financial performance and future prospects. Adjustednet income, which is adjusted to exclude certain gains and losses from thecomparable GAAP net income, is an indication of our baseline performance beforegains, losses or other charges that are considered by management to be outsideof our core operating results. These non-GAAP results are among the primaryindicators management uses as a basis for evaluating the Company’s financialperformance 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 financialmeasures are not in accordance with, or an alternative for, generally acceptedaccounting principles in the United States. The Company’s non-GAAP financialmeasures are not meant to be considered in isolation or as a substitute forcomparable GAAP financial measures, and should be read only in conjunction withthe Company’s consolidated financial statements prepared in accordance withGAAP.

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

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

***Revenue***

| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Increase**   | ** ** | **%**      | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|----------------|------------|------------|------------|
| ** **                          | ** ** | **2004**   | ** ** | **2005**   | ** ** | **(Decrease)** | ** ** | **Change** | ** ** |
| Laundry  facilities management      |       | $          | 136,725    |       | $          | 211,892        |       |       | $          | 75,167 |   |   |   | 55 | % |   |
| Reprographics  revenue              |       | 3,755      |       | 2,924      |       |           | (831       | )          |       |   | (22 | )% |   |
| Total facilities management revenue |       | 140,480    |       | 214,816    |       |           | 74,336     |       |       |   | 53 | % |   |
| MicroFridge® revenue      |       | 27,287     |       | 30,513     |       |           | 3,226      |       |       |   | 12 | % |   |
| Laundry equipment  sales revenue    |       | 14,927     |       | 15,294     |       |           | 367        |       |       |   | 2 | % |   |
| Total product sales revenue         |       | 42,214     |       | 45,807     |       |           | 3,593      |       |       |   | 9 | % |   |
| Total revenue                       |       | $          | 182,694    |       | $          | 260,623        |       |       | $          | 77,929 |   |   |   | 43 | % |   |

 

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

*Facilitiesmanagement revenue.*   Total facilities managementrevenue 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. Thisincrease is attributable to increases in revenue in the laundry facilitiesmanagement business unit, primarily due to the 2005 Acquisition, partiallyoffset by decreases in revenue in the reprographics business unit.

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Within the facilities management segment, revenue inthe 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 theyear ended December 31, 2004. The increase is attributable primarily tothe revenue generated by the assets acquired in the 2005 Acquisition. Theacquired assets generated $69,776, or 93%, of the increase in laundryfacilities management revenue for the year ended December 31, 2005. Theremainder of the increase is attributable primarily to the net increase in thenumber of revenue generating laundry installed equipment, selected vend priceincreases, a net increase in the usage of installed equipment and an increasein revenue associated with the conversion of coin-operated systems tocard-operated systems. Due to the convenience of card-operated systems, usage,and therefore revenue, typically increases upon the conversion from a coinoperated 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 primarilyattributable to the continued decline in the use of copiers in libraries andsimilar facilities and a reduction in the number of locations we operate. Weexpect the decreases in revenue from our reprographics business unit to continue,as the usage of vended copiers declines and we continue our strategy of notrenewing contracts that we predict will have a negative impact on income.

*Productsales 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 forthe year ended December 31, 2005 as compared to the same period in 2004 isattributable 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 theyear ended December 31, 2004. The increase is primarily attributable to anincrease in sales to the academic market and hospitality and assisted livingmarket, partially offset by a decrease in government sales. The increase inacademic sales can be attributed to a more aggressive sales and marketingeffort coupled with cross selling opportunities with laundry route sales. Webelieve that the hospitality sales increase is attributable to an increase incapital spending by the industry and the addition of several new distributorsby our Company. Our sales to the government are continually affected by changesin government spending priorities. We believe current spending is directed awayfrom military housing improvements and toward the current military efforts inthe Middle East.

Revenue in the laundryequipment sales business unit increased $367, or 2%, to $15,294 for the yearended 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 thestrength of the economy, consumer confidence, local permitting and theavailability of financing to small businesses, and therefore tend to fluctuatefrom period to period.

***Cost of revenue***

*Costof facilities management revenue.*   Cost offacilities management revenue includes rent paid to customers as well as costsassociated with installing and servicing machines and costs of collecting,counting, and depositing facilities management revenue, and the costs ofpurchasing, delivering and servicing rented facilities management equipment andMicroFridge® equipment. Salaries, warehousing and otheroperating expenses amounting to $947 which had been included in facilitiesmanagement costs in 2004 have been reclassified to cost of sales for theproduct sales segment to conform to 2005’s presentation. The followingreferences to 2004 give effect to the reclassification. Cost of facilitiesmanagement revenue increased by $48,540, or 52%, to $142,052 for the year endedDecember 31, 2005 as compared to $93,512 for the year ended December 31,2004. This increase is attributable primarily to the cost associated with therevenue generated by the assets acquired in the 2005 Acquisition. Included inthe cost for the year ended December 31, 2005 is $316 related to lossesincurred as a result of the 2005 

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hurricanes. As apercentage of facilities management revenue, cost of facilities managementrevenue was consistent at 67% for the years ended December 31, 2005 and2004. Changes in facilities management rent as a percentage of facilitiesmanagement revenue can be affected by new and renewed laundry leases and byother factors such as the amount of incentive payments and laundry roombetterments invested in new or renewed laundry leases. As we vary the amountinvested in a facility, the facilities management rent as a function offacilities management revenue can vary. Incentive payments and betterments areamortized over the life of the laundry lease. The percentage of facilitiesmanagement rent to facilities management revenue is also impacted by thefacilities management rent rate structure in the reprographics business unit.Because this business unit has a much lower facilities management rent ratestructure than the laundry facilities management business unit, the reductionin the size of the reprographics business unit through the non-renewal ofleases will result in an increase in the overall facilities management rent asa percentage of revenue.

*Depreciationand amortization.*   Depreciation and amortizationincreased 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. Thisincrease was primarily attributable to the addition of the assets and contractsacquired in the 2005 Acquisition. The laundry facilities management equipmentacquired had an assigned value of $25,099 as of the acquisition date, which isbeing depreciated over five years and accounted for $5,020 of the increase indepreciation and amortization for the year ended December 31, 2005. Thelaundry facility contract rights acquired had an assigned value of $68,638(prior to recording deferred taxes) as of the acquisition date, which is beingamortized over twenty years and accounted for $3,432 of the increase indepreciation and amortization for the year ended December 31, 2005. Thelaundry facilities management equipment and contract rights are depreciated andamortized using the straight-line method. Also contributing to the increaseddepreciation expense was new equipment placed in laundry facilities at newlocations and replacement of older equipment as contracts were renegotiated.

*Costof product sales.*   Cost of product sales consistsprimarily of the cost of laundry equipment, MicroFridge® equipment and parts and supplies sold as wellas salaries and related warehousing expenses as part of the product salessegment. Costs of $947 consisting of salaries and other operating expenses,which were included in the cost of facilities management revenue in 2004 havebeen reclassified to the product sales segment to conform with 2005’spresentation. The following references to 2004 give effect to thereclassification.  Cost of product salesincreased 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 apercentage of sales, cost of product sold was approximately 77% and 71% for theyears ended December 31, 2005 and 2004, respectively. The gross margin onproduct sales includes the gross margins from the laundry equipment sales andMicroFridge® business units. The gross margin in thelaundry equipment sales business unit decreased to 31% for the year endedDecember 31, 2005 as compared to 32% for the same period in 2004. Thegross margin in the MicroFridge® business unit decreased to 20% for the year endedDecember 31, 2005 as compared to 25% for the same period in 2004. Theerosion of margins is attributable to the increased cost of product, fuel costsurcharges passed through to us and the cost of carrying more inventory than inprior years due to supplier shortages. The Company was unable to recover all ofthese expenses.

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***Operating expenses***

*General,administration, sales, marketing and depreciation expense.*   General,administration, sales, marketing and depreciation expense increased by $6,320,or 25%, to $31,450 for the year ended December 31, 2005 as compared to$25,130 for the year ended December 31, 2004. As a percentage of totalrevenue, general, administration, sales, marketing and depreciation expensedecreased by 2% from 14% for the year ended December 31, 2004 to 12% forthe year ended December 31, 2005. The increase in total expenses isprimarily attributable to increases in sales personnel and related costsresulting from the 2005 Acquisition.

*Losson early extinguishment of debt.*   We used aportion of the proceeds from our $150,000 senior note offering to repay theterm loan portion of the senior credit facility. Unamortized financing costs of$461 related to the term loan were expensed in the third quarter of 2005. Inconnection with the senior credit facilities we repaid in full and terminatedour 2003 senior credit facilities. Unamortized financing costs of $207associated with our 2003 senior credit facilities were expensed in the firstquarter of 2005. In connection with an amendment to our 2003 senior creditfacilities, unamortized financing costs of $183 were expensed in the firstquarter of 2004.

*Gain on sale of assets.*   Gainon sale of assets represents the gain from the sale of vehicles and othernon-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. Inthe year ended December 31, 2004, the gain included $1,218 from the saleof certain laundry facilities management equipment and contracts.

***Income from operations***

Income from operations increased by $16,169, or 120%,to $29,678 for the year ended December 31, 2005 as compared to $13,509 forthe year ended December 31, 2004. To supplement the consolidated financialstatements 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 toenhance an overall understanding of our historical financial performance andfuture prospects. Adjusted income from operations, which is adjusted to excludecertain gains and losses from the comparable GAAP income from operations, is anindication of our baseline performance before gains, losses or other chargesthat are considered by management to be outside of our core operating results.The presentation of this additional information is not meant to be consideredin isolation or as a substitute for income from operations or other measuresprepared in accordance with GAAP. Excluding the loss on early extinguishment ofdebt and the gain on sale of assets, income from operations, as adjusted, wouldhave been $19,758 for the year ended December 31, 2005, compared to$12,474 for the year ended 2004, or an increase of 58%. This increase is dueprimarily to the reasons discussed above.

Areconciliation of income from operations in accordance with GAAP to adjustedincome from operations is provided below:

| ** **                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2004**                                    | ** ** | **2005** | ** ** |
| Income from  operations               |       | $                                           | 13,509     |   | $ | 29,678 |   |
| Loss on early  extinguishment of debt |       | 183                                         |       | 668 |   |
| Gain on sale of  certain fixed assets |       | (1,218                                      | )          | (10,588 | ) |
| Income from operations,  as adjusted  |       | $                                           | 12,474     |   | $ | 19,758 |   |

 

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***Interest expense, net***

Interest expense, net ofinterest income, increased by $6,627, or 154%, to $10,939 for the year ended December 31,2005 as compared to $4,312 for the year ended December 31, 2004. Theincrease is primarily attributable to the increased borrowings in January 2005to finance the 2005 Acquisition and an increase in the average borrowing ratesto 5.9% for the year ended December 31, 2005 as compared to 4.5% for theyear ended December 31, 2004. The increase in average borrowing rates isdue, 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. Non-cash interestassociated with the accounting treatment of our interest rate swap agreementsresulted in interest expense of  $196 forthe year ended December 31, 2005, as compared to interest expense of$1,368 for the year ended December 31, 2004.

***Gain related to derivative instruments***

The Company is party tointerest rate swap agreements that it had accounted for as cash flow hedges.The fair value of these swaps has been included in other comprehensive incomein the equity section of the balance sheet. As a result of the reductionin the amount outstanding under the 2005 senior credit facilities, certain swapagreements no longer qualified for cash flow hedge accounting treatment. Therevised accounting treatment resulted in a gain of $1,876 in the incomestatement for the year ended December 31, 2005.

***Provision for income taxes***

The provision for incometaxes increased by $4,629, or 118%, to $8,563 for the year ended December 31,2005 compared to $3,934 for the year ended December 31, 2004. Thisincrease is the net of an increase in taxable income and a decrease in theeffective tax rate. Taxable income for the year ended December 31, 2005was significantly impacted by the $10,588 pre-tax gain on the sale of ourcorporate headquarters. The effective tax rate decrease of 1.3% to 41.5% from42.8% for the year ended December 31, 2005 compared to the same periodended December 31, 2004 is primarily attributable to adjustments relatedto the alternative minimum tax credit.

***Net income***

As a result of the foregoing, net income increased$6,789, or 129%, to $12,052 for the year ended December 31, 2005 ascompared to $5,263 for the year ended December 31, 2004.

Areconciliation of net income, as reported to net income, as adjusted isprovided below:

| ** **                                             | ** ** | **Years Ended**  | ** ** |
|--------------------------------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **December 31,** | ** ** |
| ** **                                             | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Net income, as  reported                               |       | $                     | 5,263      |   | $ | 12,052 |   |
| Income before  provision for income taxes, as reported |       | $                     | 9,197      |   | $ | 20,615 |   |
| Gain on  non-recurring sale of assets                  |       | (1,218                | )          | (10,767 | ) |
| (Gain) loss  related to derivative instruments         |       | —                |       | (1,876 | ) |
| Loss related to  2005 hurricanes                       |       | —                |       | 316 |   |
| Loss on early  extinguishment of debt                  |       | 183                   |       | 668 |   |
| Income before  provision for income taxes, as adjusted |       | 8,162                 |       | 8,956 |   |
| Provision for  income taxes, as adjusted               |       | 3,491                 |       | 3,717 |   |
| Net income, as  adjusted                               |       | $                     | 4,671      |   | $ | 5,239 |   |
| Diluted earnings per  share, as adjusted               |       | $                     | 0.36       |   | $ | 0.39 |   |

 

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To supplement the Company’sunaudited consolidated financial statements presented on a generally acceptedaccounting principles (GAAP) basis, management has used a non-GAAP measure ofnet income. Management believes presentation of this measure is appropriate toenhance an overall understanding of our historical financial performance andfuture prospects. Adjusted net income, which is adjusted to exclude certaingains and losses from the comparable GAAP net income, is an indication of ourbaseline performance before gains, losses or other charges that are consideredby management to be outside of our core operating results. These non-GAAPresults are among the primary indicators management uses as a basis forevaluating the Company’s financial performance as well as for forecastingfuture periods. For these reasons, management believes these non-GAAP measurescan be useful to investors, potential investors and others. Non-GAAP financialmeasures are not in accordance with, or an alternative for, generally acceptedaccounting principles in the United States. The Company’s non-GAAP financialmeasures are not meant to be considered in isolation or as a substitute forcomparable GAAP financial measures, and should be read only in conjunction withthe Company’s consolidated financial statements prepared in accordance withGAAP.

**Liquidity andCapital Resources (Dollars in thousands)**

We believe that we can satisfy our working capitalrequirements and funding of capital needs with internally generated cash flowand, as necessary, borrowings under our revolving loan facility describedbelow. Included in the capital requirements that we expect to be able to fundduring 2007 is approximately $30,000 of laundry equipment and laundry roombetterments incurred in connection with new customer leases and the renewal ofexisting leases.

During 2005, we required substantial amounts of newdebt financing to fund our 2005 Acquisition. Absent extraordinary transactionssuch as these, we historically have not needed sources of financing other thanour internally generated cash flow and our revolving credit facility to fundour working capital, capital expenditures and investment requirements. As aresult, we anticipate that our cash flow from operations and revolving creditfacility will be sufficient to meet our anticipated cash requirements for atleast the next twelve months.

From time to time, we consider potential acquisitions.We believe that any future acquisitions of significant size would likelyrequire us to obtain additional debt or equity financing. In the past, we havebeen able to obtain such financing for other material transactions on termsthat we believed to be reasonable. However, it is possible that we may not beable to find acquisition financing on favorable terms in the future.

Our current long-termliquidity needs are principally the repayment of the outstanding principalamounts of our long-term indebtedness, including borrowings under our seniorcredit facilities. We are unable to project with certainty whether ourlong-term cash flow from operations will be sufficient to repay our long-termdebt when it comes due. If this cash flow were insufficient, then we would needto refinance such indebtedness or otherwise amend its terms to extend thematurity dates. We cannot make any assurances that such refinancing oramendments, if necessary, would be available on reasonable terms, if at all.

**OperatingActivities**

For the years ended December 31,2004, 2005, and 2006, cash flows provided by operating activities were $37,108,$37,902 and $36,507, respectively. Cash flows from operations consist primarilyof facilities management revenue and equipment sales, offset by the cost offacilities management revenues, cost of product sold, and selling, general andadministration expenses. The decrease for the year ended December 31, 2006as compared to the year ended December 31, 2005 is primarily attributableto ordinary changes in working capital. The most significant increases in cashflows provided by operating activities 

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weredepreciation and amortization expense and expenses related to the impairment ofassets and non-cash compensation expense as well as a decrease in accountsreceivable. The increase in depreciation and amortization expense is primarilyattributable to the equipment acquired in our 2006 acquisitions, additionallaundry facilities management equipment placed in service in 2006 and thedisposal of equipment with a remaining net book value . The decrease in accountsreceivable was primarily attributable to the timing of sales of laundryequipment and MicroFridge® equipment. Themost significant decreases in cash flows provided by operating activities werecaused by increases in prepaid expenses, facilities management rent and otherassets. The increase in prepaid expenses is primarily attributable to anincrease in prepaid facilities management rent as a result of the 2005Acquisition and the income tax receivable attributable to the tax losscarryback.

**Investing Activities**

For the years ended December 31,2004, 2005, and 2006, cash flows used in investing activities were $57,101,$120,251 and $44,975, respectively. The decrease for the year ended December 31,2006 as compared to the year ended December 31, 2005 is primarilyattributable to the payment for certain acquisitions of laundry facilitiesmanagement assets during 2005 of $112,680. Other capital expenditures for theyears ended December 31, 2006 and 2005 were consistent at $26,487 and$26,380, respectively.

**FinancingActivities**

For the years ended December 31, 2004, 2005, and2006, cash flows provided by financing activities were $21,188, $86,904 and$9,416, respectively. Cash flows provided by financing activities consistprimarily of proceeds from and repayments of bank borrowings, and otherlong-term debt which increased in 2005 and 2004 due to borrowings to fund the2005 Acquisition and the 2004 Acquisition. Also included in the years ended December 31,2005 and 2004 are the financing costs related to the 2005 senior note offering,senior credit facilities and an amendment to our 2003 senior credit facilitiesobtained in January 2004, in connection with the 2005 Acquisition and the2004 Acquisition.

In connection with the 2005 Acquisition, on January 10,2005, we and various lenders entered into senior credit facilities consistingof an $80,000 term loan facility and a $120,000 revolving loan facility, eachof which was to mature on January 10, 2010. We used $80,000 of the termloan facility (which was subsequently retired in August 2005 as discussedbelow) and approximately $93,400 of the revolving loan facility to finance the2005 Acquisition, pay related costs and expenses, and repay the outstandingobligations under and terminate our 2003 senior credit facilities.

Effective December 29, 2006, we amended oursenior bank credit facilities, reducing the credit line to  $65,000 (with the option, subject tocustomary terms and conditions, to increase the line up to $100,000, inincrements of not less than $10,000, over the life of the facility), reducingthe interest rate on outstanding borrowings, modifying certaincovenants and extending the maturity date to December 29, 2011. Thesenior credit facilities are collateralized by a blanket lien on all of ourassets and our two main subsidiaries, Mac-Gray Services, Inc. and IntirionCorporation, as well as a pledge by us of all of the capital stock of our twosubsidiaries. Borrowings outstanding under the senior credit facilities bearinterest at a fluctuating rate equal to (i) in the case of Eurodollar rateloans, the LIBOR rate (adjusted for statutory reserves) plus an applicablepercentage, ranging from 1.00% to 1.50% (1.25% as of December 31, 2006),determined quarterly by reference to the funded debt ratio or (ii) in thecase of alternate base rate loans and swing line loans, the higher of (a) thefederal funds rate plus 0.5% or (b) the annual rate of interest announcedby JPMorgan Chase Bank, N.A. as its “prime rate,” in each case, plus anapplicable percentage, ranging from 0.00% to 0.50% (0.25% as of December 31,2006), determined quarterly by reference to the funded debt ratio. The averageinterest rates of our borrowings under the senior credit facilities at December 31,2005 and December 31, 2006 were 5.4% and 5.9%, respectively.

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Under the senior creditfacilities, we pay a commitment fee equal to a percentage, ranging from 0.25%to 0.30%, determined quarterly by reference to the funded debt ratio, of theaverage daily-unused portion of the senior credit facilities. This commitmentfee percentage was 0.275% as of December 31, 2006.

The credit agreement forthe senior credit facilities includes customary covenants, including, but notlimited to, restrictions pertaining to: (i) the incurrence of additionalindebtedness, (ii) limitations on liens, (iii) making distributions,dividends and other payments, (iv) the making of certain investments andloans, (v) mergers, consolidations and acquisitions,(vi) dispositions of assets, (vii) the maintenance of minimum consolidatednet worth, maximum funded debt ratios, minimum consolidated cash flow coverageratios, and maximum senior secured leverage ratios, (viii) transactionswith affiliates, (ix) sale and leaseback transactions, (x) enteringinto swap agreements and (xi) changes to governing documents, in each casesubject to numerous baskets, exceptions and thresholds. The funded debt ratio,consolidated cash flow coverage ratio and senior secured leverage ratio that wewere required to meet as of December 31, 2006 were 4.25 to 1.00, 1.10 to 1.00,and 2.50 to 1.00, respectively. We were in compliance with these and all otherfinancial covenants at December 31, 2006.

The credit agreement forthe senior credit facilities provides for customary events of default,including, but not limited to:(i) failure to pay any principal or interestwhen due, (ii) failure to comply with covenants, (iii) any materialrepresentation or warranty made by us proving to be incorrect in any materialrespect, (iv) defaults relating to or acceleration of other materialindebtedness, (v) certain insolvency or receivership events affecting usor any of our subsidiaries, (vi) a change in control, (vii) materialjudgments, claims or liabilities against us or (viii) a material defect inthe lenders’ lien against the collateral securing the obligations under thecredit agreement. There were no events of default under the 2005 senior creditfacilities at December 31, 2006.

As of December 31, 2006, there was $24,000outstanding under the revolving line of credit and $760 in outstanding lettersof credit under the senior credit facilities. The available balance under therevolving line of credit was $40,240 at December 31, 2006.  The average interest rate on the borrowingsoutstanding at December 31, 2006 was approximately 5.9%, including theapplicable spread paid to the banks.

On August 16,2005, we issued $150,000 of senior unsecured notes maturing on August 15,2015. Interest on the notes will accrue at the rate of 7.625% per annum payablesemiannually in arrears. On and after August 15, 2010, we will be entitledat our option to redeem all or a portion of these notes at the redemptionprices set forth below (expressed in percentages of principal amount on theredemption date), plus accrued interest to the redemption date, if redeemed,during the 12 month period commencing on August 15 of the years set forthbelow:

| ** **          | ** ** | **Redemption** | ** ** |
|---------------------|------------|----------------|------------|
| **Period**          | ** ** | ** **     | ** ** | **Price** | ** ** |
| 2010                |       |           | 103.813    | % |   |
| 2011                |       |           | 102.542    | % |   |
| 2012                |       |           | 101.271    | % |   |
| 2013 and thereafter |       |           | 100.000    | % |   |
|                     |            |                |            |  |  |  |  |

 

Subject to certainconditions, we will be entitled at our option on one or more occasions prior toAugust 15, 2008 to redeem notes in an aggregate principal amount not toexceed 35% of the aggregate principal amount of the notes originally issued ata redemption price (expressed as a percentage of principal amount on theredemption date) of 107.625%, plus accrued and unpaid interest to theredemption date, with the net cash proceeds from one or more equity offerings.

The terms of senior notesinclude customary covenants, including, but not limited to, restrictionspertaining to: (i) incurrence of additional indebtedness and issuance ofpreferred stock; (ii) payment of dividends on or making of distributionsin respect of capital stock or making certain other restricted 

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paymentsor investments; (iii) entering into agreements that restrict distributionsfrom restricted subsidiaries; (iv) sale or other disposition of assets,including capital stock of restricted subsidiaries; (v) transactions withaffiliates; (vi) incurrence of liens; (vii) sale/leasebacktransactions and (viii) merger, consolidation or sale of substantially allof our assets, in each case subject to numerous baskets, exceptions andthresholds. We were in compliance with all financial covenants at December 31,2006.

The terms of senior notesprovide for customary events of default, including, but not limited to: (i) failureto pay any principal or interest when due, (ii) failure to comply withcovenants and limitations, (iii) certain insolvency or receivership eventsaffecting us or any of our subsidiaries and (iv) unsatisfied materialjudgments, claims or liabilities against us. There were no events of defaultunder the senior notes at December 31, 2006.

The net proceeds of thesenior notes were used to retire the term loan and reduce the revolving loanbalance outstanding under the senior credit facilities.

We have entered intostandard International Swaps and Derivatives Association, or ISDA, interestrate swap agreements to manage the interest rate risk associated with oursenior credit facilities. For a description of our interest rate swapagreements see “Item 3. Quantitative and Qualitative Disclosures About MarketRisk.”

**ContractualObligations**

Asummary of the Company’s contractual obligations and commitments related to itsoutstanding long-term debt and future minimum lease payments related to theCompany’s vehicle fleet, corporate headquarters and warehouse rent and minimumfacilities management rent as of December 31, 2006 is as follows:

| **Fiscal** | ** ** | **Long Term** | ** ** | **Facilities Rent** | ** ** | **Capital Lease** | ** ** | **Operating Lease** | ** ** | ** ** | ** ** |
|------------|------------|--------------------|------------|--------------------------|------------|------------------------|------------|--------------------------|------------|------------|------------|
| **Year**   | ** ** | **Debt**           | ** ** | **Commitments**          | ** ** | **Commitments**        | ** ** | **Commitments**          | ** ** | **Total**  | ** ** |
| 2007       |       |               | $          | —                   |       |                   |       | $                        | 7,362      |       |       |   | $ | 1,237 |   |   |   | $ | 2,459 |   |   | $ | 11,058 |   |
| 2008       |       |               | —     |                     |       |                   | 6,123      |                     |       |       | 893        |   |   |   | 2,203 |   |   | 9,219 |   |
| 2009       |       |               | —     |                     |       |                   | 4,851      |                     |       |       | 612        |   |   |   | 2,009 |   |   | 7,472 |   |
| 2010       |       |               | —     |                     |       |                   | 4,190      |                     |       |       | 326        |   |   |   | 1,959 |   |   | 6,475 |   |
| 2011       |       |               | 24,000     |                     |       |                   | 2,840      |                     |       |       | —     |   |   |   | 1,598 |   |   | 28,438 |   |
| Thereafter |       |               | 150,000    |                     |       |                   | 4,353      |                     |       |       | —     |   |   |   | 5,462 |   |   | 159,815 |   |
| Total      |       |               | $          | 174,000                  |       |                   |       | $                        | 29,719     |       |       |   | $ | 3,068 |   |   |   | $ | 15,690 |   |   | $ | 222,477 |   |

 

We anticipate thatavailable funds from current operations, existing cash and other sources ofliquidity will be sufficient to meet current operating requirements andanticipated capital expenditures. However, we may require external sources offinancing for any significant future acquisitions. Further, our senior creditfacility matures on December 29, 2011. The repayment of this facility mayrequire external financing.

**Off Balance Sheet Arrangements**

At the years ended December 31,2004, 2005 and 2006, the Company had no relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off balance sheet arrangements,or other contractually narrow or limited purposes. The Company is, therefore,not materially exposed to any financing, liquidity, market or credit risk thatcould arise if it had engaged in such relationships.

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**Seasonality**

We experience moderateseasonality as a result of our operations in the college and university market.Revenues derived from the college and university market representedapproximately 16%, or $37,000, of our total facilities management revenue in2006. Academic facilities management and rental revenues are derived substantiallyduring the school year in the first, second and fourth calendar quarters.Conversely, our operating and capital expenditures have historically beenhigher during the third calendar quarter when we install a large amount ofequipment while colleges and universities are generally on summer break.Product sales, principally of MicroFridge products, to this market aretypically higher during the third calendar quarter as compared to the rest ofthe calendar year, somewhat offsetting the seasonality effect of the laundryfacilities management business unit.

**Inflation**

The Company does notbelieve that its financial performance has been materially affected byinflation.

**Critical Accounting Policies and Estimates**

The preparation of ourconsolidated financial statements in accordance with GAAP requires managementto make judgments, assumptions and estimates that affect the amounts reported.A critical accounting estimate is an assumption about highly uncertain mattersand could have a material effect on the consolidated financial statements ifanother, also reasonable, amount was used or a change in the estimate isreasonably likely from period to period. We base our assumptions on historicalexperience and on other estimates that we believe are reasonable under thecircumstances. Actual results could differ significantly from these estimates.

Our critical accountingpolicies, as described in Note 2 to the Mac Gray audited consolidated financialstatements included elsewhere in this report, “Significant Accounting Policies,”state our policies as they relate to significant matters: cash and cashequivalents, revenue recognition, provision for doubtful accounts, inventories,provision for inventory reserves, intangible assets, impairment of long-livedassets, financial instruments and fair value of financial instruments.

*Cash and cash equivalents.*   Weconsider all highly liquid investments with original maturities of three monthsor less to be cash equivalents. On occasion we have excess cash available for ashort period of time; when this occurs, we invest such excess cash inrepurchase agreements and other highly liquid short-term investments.Accordingly, the investments are subject to minimal credit and market risk.Included in cash and cash equivalents is an estimate of cash not yet collectedat period end which remains at laundry facilities management and reprographicscustomer locations. At December 31, 2006 and 2005, this totaled $9,027 and$8,388, respectively. We record the estimated cash not yet collected as cashand cash equivalents and facilities management revenue. We also record the estimatedrelated facilities management rent expense. These estimates are based uponhistorical collection trends, so that total cash at the end of each periodwill be reasonably stated.

*Revenue recognition.*   Werecognize laundry facilities management and reprographics revenue on theaccrual basis. MicroFridge rental revenue is recognized ratably over therelated contractual period. Included in deferred revenue and deposits is anestimate of unused card value. We recognize revenue from product sales uponshipment of the products unless otherwise specified. We offer limited durationwarranties on MicroFridge products and, at the time of sale, provide reservesfor all estimated warranty costs based upon historical warranty costs. Actualcosts have not exceeded our estimates. Shipping and handling fees charged tocustomers are recognized upon shipment of the products and are included inrevenue with related cost included in cost of sales.

We have entered intolong-term lease transactions that meet the qualifications of a sales-type leasefor certain equipment. For these transactions, the amount of revenue recognizedupon product shipment is the present value of the minimum lease payments,excluding executory costs and excluding profits on 

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executorycosts, discounted at the interest rate implicit in the lease. Interest revenueis recognized over the life of the rental agreement. At December 31, 2006and 2005, we had $1,758 and $2,680, respectively, in receivables related tosales-type leases. These receivables have been recorded net of unearnedinterest income of $324 and $300 at December 31, 2006 and 2005. Thesereceivables are primarily due ratably over the next five years and have beenclassified as other current assets and other long-term assets, as appropriate,on the balance sheet. The related reserve for uncollectible lease receivablesat December 31, 2006 and 2005 was $26 and $152, respectively. Allinstallation and repair services are provided on an occurrence basis, not on acontractual basis. Related revenue is recognized at the time the installationservice, or other service, is provided to the customer.

We believe our accountingfor facilities management revenue, rental revenue, service fees and long-termlease transactions are appropriate for us, properly matching the earningsprocess with the proper reporting period.

*Provision for doubtfulaccounts.*   On a regular basis, we review theadequacy of our provision for doubtful accounts for trade accounts receivableand lease receivables based on historical collection results and currenteconomic conditions using factors based on the aging of our trade accountsreceivable and lease receivables. In addition, we estimate specific additionalallowances based on indications that a specific customer may be experiencing financialdifficulties.

*Inventories.*   Inventoriesare stated at the lower of cost (as determined using the average cost method)or market and primarily consist of finished goods. Based on the nature of ourinventory, being laundry and MicroFridge equipment, and our inventory handlingpractices, we believe the lower of cost or market is the most appropriatevaluation method for us.

*Provision for inventoryreserves.*   On a regular basis, we review theadequacy of our reserve for inventory obsolescence based on historical experience,product knowledge and frequency of shipments.

*Goodwill and intangibleassets.*   Intangible assets primarily consist ofvarious non-compete agreements, customer lists, goodwill and contract rightsrecorded in connection with acquisitions. The non-compete agreements areamortized using the straight-line method over the life of the agreements, whichrange from five to fifteen years. Customer lists are amortized using thestraight-line method over fifteen years. Contract rights are amortized usingthe straight-line method over fifteen or twenty years. The life assigned toacquired contracts is based on several factors, including: (i) the seller’srenewal rate of the contract portfolio for the most recent years prior to theacquisition, (ii) the number of years the average contract has been in theseller’s contract portfolio, (iii) the overall level of customersatisfaction within the contract portfolio and (iv) our ability tomaintain or exceed the level of customer satisfaction maintained by the sellerprior to the acquisition by us. We are accounting for acquired contract rightson a pool-basis based on the fact that, in general, no single contract accountsfor more than 2% of the revenue of any acquired portfolio and the fact that fewof the contracts are predicted to be terminated, either prior to or at the endof the contract term. Based on our experience, we believe that these costsassociated with various acquisitions are properly recognized and amortized overa reasonable length of time.

*Impairment of long-livedassets.*   We review long-lived assets, includingfixed assets, acquired contract rights and intangible assets with definitivelives, for impairment whenever events or changes in business circumstancesindicate that the carrying amount of the assets may not be fully recoverable orthat the useful lives of these assets are no longer appropriate. Our annualimpairment test for contract rights assigned a 15 year amortization periodconsists of comparing the current number of machines under contract and thecurrent cash flow of all our contracts in the market where the portfolios wereacquired to the original number of machines acquired and the cash flow aspredicted by us at the time of the acquisition. For those contract rightsassigned a 20 year amortization period, our annual impairment test consistsprimarily of identifying the accumulated retention rate of the specificcontract portfolio in order to assess the appropriateness of the net book valueof the related contract rights. If impairment is indicated, the asset iswritten down to its estimated fair value on a discounted cash flow basis.

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In accordance with FAS142, we test our goodwill annually for impairment and whenever events orchanges in business circumstances indicate that the carrying amount of theassets may not be fully recoverable. The goodwill impairment review consists ofa two-step process of first comparing the fair value of the reporting unit withits carrying value. If this fair value exceeds the carrying value, no furtheranalysis or goodwill impairment charge is required. If the fair value is belowthe carrying value, the Company would proceed to the next step, which is tomeasure the amount of the impairment loss. Any such impairment loss would berecognized in the Company’s results of operations in the period the impairmentloss arose.

In measuring whethergoodwill is impaired, the Company uses an estimate of its future undiscountedcash flows of the business over the estimated remaining life. If the Company’sexpectation of future undiscounted net cash flows indicates an impairment, theCompany would write down the appropriate assets to their estimated realizablevalues based on discounted cash flows. In estimating expected future cash flowsfor determining whether an asset is impaired, assets are grouped at the lowestlevel for which there is identifiable cash flows.

*Financial instruments.*   Weaccount for derivative instruments in accordance with Statement of FinancialAccounting Standard No. 133, “Accounting for Derivative Instruments andHedging Activities” (“FAS 133”), and Statement of Financial Accounting StandardNo. 138, “Accounting for Certain Derivative Instruments and CertainHedging Activities-an amendment of FASB No. 133” (“FAS 138”). Thesestatements require us to recognize derivatives on our balance sheet at fairvalue. Derivatives that are not hedges must be adjusted to fair value throughearnings. If the derivative is a hedge, changes in the fair value ofderivatives will either be offset against the change in fair value of the hedgedassets, liabilities or firm commitments through earnings or recognized in othercomprehensive income until the hedged item is recognized in earnings, dependingon the intended use of the derivative. The ineffective portion of a derivative’schange in fair value will be immediately recognized in earnings. We havedesignated some of our interest rate swap agreements as cash flow hedges.Accordingly, the change in fair value of the agreements is recognized in othercomprehensive income and the ineffective portion of the change is recognized inearnings immediately.

*Fair value of financialinstruments.*   For purposes of financialreporting, we have determined that the fair value of financial instrumentsapproximates book value at December 31, 2006 and 2005, based upon termscurrently available to us in financial markets. The fair value of the interestrate swaps is the estimated amount that we would receive or pay to terminatethe agreement at the reporting date, taking into account current interest ratesand the credit worthiness of the counter party.

**New Accounting Pronouncements**

In July 2006, theFASB issued FASB Interpretation (“FIN”) No. 48, *Accounting for Uncertainty in Income Taxes*, which is aninterpretation of SFAS No. 109. FIN 48 prescribes a comprehensive modelfor how a company should recognize, measure, present, and disclose in itsfinancial statements uncertain tax positions that the company has taken orexpects to take on a tax return. Under FIN 48, the financial statements willreflect expected future tax consequences of such positions presuming the taxingauthorities’ full knowledge of the position and all relevant facts, but withoutconsidering time values. FIN 48 substantially changes the applicable accountingmodel and is likely to cause greater volatility in income statements as moreitems are recognized discretely within income tax expense. FIN 48 also revisesdisclosure requirements and introduces a prescriptive, annual, tabularroll-forward of the unrecognized tax benefits. The new accounting model foruncertain tax positions is effective for annual periods beginning after December 15,2006. Companies need to assess all material open positions in all taxjurisdictions as of the adoption date and determine the appropriate amount oftax benefits that are recognizable under FIN 48. Any difference between theamounts previously recognized and the benefit determined under the newguidance, including changes in accrued interest and penalties, has to berecorded on the date of adoption. For certain types of income taxuncertainties, existing generally accepted accounting principles provide 

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specificguidance on the accounting for modifications of the recognized benefit. Anydifferences in recognized tax benefits on the date of adoption that are notsubject to specific guidance would be an adjustment to retained earnings as ofthe beginning of the adoption period. The Company is currently reviewing thisnew accounting standard but does not expect it to have a material impact on itsfinancial statements.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“FAS 157”). FAS 157 clarifies theprinciple that fair value should be based on the assumptions marketparticipants would use when pricing an asset or liability and establishes afair value hierarchy that prioritizes the information used to develop thoseassumptions. Under the standard, fair value measurements would be separatelydisclosed by level within the fair value hierarchy. FAS 157 is effective forfiscal years beginning after November 15, 2007, with early adoptionpermitted. The Company is currently reviewing this new accounting standard butdoes not expect it to have a material impact on its financial statements.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assetsand Financial Liabilities, including an amendment of No. 115”(“FAS 159”), which is effective for fiscal years beginning afterNovember 15, 2007, with early adoption permitted. FAS 159 expandsopportunities to use fair value measurements in financial reporting and permitsentities to choose to measure many financial instruments and certain otheritems at fair value. The Company is currently reviewing this new accountingstandard and the impact, if any, it will have on its financial statements.

**Item7A.**   Quantitative and QualitativeDisclosures About Market Risk

The Company is exposed toa variety of risks, including changes in interest rates on its borrowings.In the normal course of its business, the Company manages its exposure tothese risks as described below. The Company does not engage in tradingmarket-risk sensitive instruments for speculative purposes.

*Interest Rates—*

Thetable below provides information about the Company’s debt obligations includingdebt obligations that are sensitive to changes in interest rates. For debtobligations, the table presents principal cash flows and related weightedaverage interest rates by expected maturity dates. The fair market value oflong-term debt approximates book value at December 31, 2006.

| ** **            | ** ** | **December 31, 2006**                               | ** ** |
|-----------------------|------------|---------------------------------------------------------------|------------|
| ** **            | ** ** | **Expected Maturity Date (In Thousands)** | ** ** |
| ** **            | ** ** | **2007**                                                      | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Long-term Debt:       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fixed Rate            |       | $                                                             | —     |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   | $ | 150,000 |   | $ | 150,000 |   |
| Average interest rate |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 7.625 | % |   |   |
| Variable rate         |       | $                                                             | —     |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 24,000 |   | $ | — |   | $ | 24,000 |   |
| Average interest rate |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   | 5.94 | % |   |   |   |   |

 

The Company entered into standard International Swapsand Derivatives Association (“ISDA”) interest rate swap agreements (the “SwapAgreements”) to manage the interest rate risk associated with its debt.Concurrent with the reduction of the amounts due under the senior creditfacilities, eight swap agreements previously designated as cash flow hedges ceasedto qualify as such, of which four were terminated by the Company. The change inthe fair value of the remaining four swap agreements that do not qualify forhedge accounting is recognized in the income statement in the period in which thechange occurs. The change in the fair value of these four contracts resulted ina loss of $96 for the year ended December 31, 2006. The change in the fairvalue of these four contracts together with the gain on termination of the fourcontracts, resulted in a gain of $1,876 for the year ended December 31,2005.

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Thetable below outlines the details of each remaining swap agreement:

| ** **       | ** ** | ** **   | ** ** | ** **     | ** ** | **Notional**          | ** ** | ** **     | ** ** | ** ** | ** ** |
|------------------|------------|--------------|------------|----------------|------------|-----------------------|------------|----------------|------------|------------|------------|
| ** **       | ** ** | **Original** | ** ** | ** **     | ** ** | **Amount**            | ** ** | ** **     | ** ** | ** ** | ** ** |
| **Date of** | ** ** | **Notional** | ** ** | **Fixed/**     | ** ** | **December 31,** | ** ** | **Expiration** | ** ** | **Fixed**  | ** ** |
| **Origin**       | ** ** | **Amount**   | ** ** | **Amortizing** | ** ** | **2006**              | ** ** | **Date**       | ** ** | **Rate**   | ** ** |
| Jun 24, 2003     |       | $            | 20,000     |           | Amortizing |                  |       | $              | 10,000     |       |       | Jun 30, 2008 |   |   | 2.34 | % |   |
| Jun 24, 2003     |       | $            | 20,000     |           | Fixed      |                  |       | $              | 20,000     |       |       | Jun 30, 2008 |   |   | 2.69 | % |   |
| May 2, 2005 |       | $            | 17,000     |           | Fixed(1)   |                  |       | $              | —     |       |       | Dec 31, 2011 |   |   | 4.69 | % |   |
| May 2, 2005 |       | $            | 12,000     |           | Fixed(2)   |                  |       | $              | —     |       |       | Dec 31, 2009 |   |   | 4.66 | % |   |
| May 2, 2005 |       | $            | 10,000     |           | Fixed(2)   |                  |       | $              | —     |       |       | Dec 31, 2011 |   |   | 4.77 | % |   |

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(1)          Effective Date isMarch 31, 2007

(2)          Effective Date isJune 30, 2008

In accordance with the Swap Agreements and on aquarterly basis, interest expense is calculated based on the floating 90 dayLIBOR and the fixed rate. If interest expense as calculated is greater based onthe 90 day LIBOR, the financial institution pays the difference to the Company;if interest expense as calculated is greater based on the fixed rate, theCompany pays the difference to the financial institution. Depending onfluctuations in the LIBOR, the Company’s interest rate exposure and its relatedimpact on interest expense and net cash flow may increase or decrease. Thecounter party to the swap agreement exposes the Company to credit loss in theevent of non-performance; however, nonperformance is not anticipated.

The fair value of the Swap Agreements is the estimatedamount that the Company would receive or pay to terminate the agreement at thereporting date, taking into account current interest rates and the creditworthiness of the counter party. At December 31, 2005 and 2006, the fairvalues of the Swap Agreements were $1,647 and $1,335, respectively. Theseamounts have been included in other assets on the consolidated balance sheet.

As of December 31,2006, there was $24,000 outstanding under the revolving line of credit and $760in outstanding letters of credit. The available balance under therevolving line of credit was $40,240 at December 31, 2006. The averageinterest rate on the borrowings outstanding at December 31, 2006 wasapproximately 5.94%, including the applicable spread paid to the banks.

**Item 8.   FinancialStatements and Supplementary Data**

Financial statements andsupplementary data are contained in pages F-1 through F-34 hereto.

**Item 9.   Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

None.

**Item 9A.   Controlsand Procedures**

As of the end of theperiod covered by this report, an evaluation was carried out by our management,with the participation of our chief executive officer and chief financialofficer, of the effectiveness of our disclosure controls and procedures (asdefined in Rule 13a-15(e) under the Securities Exchange Act of1934). Based upon that evaluation, our chief executive officer and chieffinancial officer concluded that these disclosure controls and procedures wereeffective as of December 31, 2006 in providing reasonable assurance thatinformation required to be disclosed by us in the reports that we file or submitunder the Securities and Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms. In addition, no change in our internal control over financial reporting(as defined in Rule 13a-15(f) under the Securities Exchange Actof 1934) occurred during the 

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fourthquarter of our fiscal year ended December 31, 2006 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

**Management’s AnnualReport on Internal Control over Financial Reporting**

The management of the Company is responsible forestablishing and maintaining adequate internal control over financial reportingfor the Company. The Company’s internal control over financial reporting is aprocess designed under the supervision of the Company’s principal executive andprincipal financial officers to provide reasonable assurance regarding thereliability of financial reporting and the preparation of the Company’s financialstatements for external reporting purposes in accordance with generallyaccepted accounting principles in the United States. Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements and even when determined to be effective, can only providereasonable assurance with respect to financial statement preparation andpresentation. Also, projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

As of the end of the Company’s 2006 fiscal year,management conducted assessments of the effectiveness of the Company’s internalcontrol over financial reporting based on the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission in *Internal Control—Integrated Framework*.Based on these assessments, management has determined that the Company’s internalcontrol over financial reporting as of December 31, 2006 was effective.Our internal control over financial reporting includes policies and proceduresthat (1) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect transactions and dispositions of our assets; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with U.S. generallyaccepted accounting principles, and that receipts and expenditures are beingmade only in accordance with authorizations of management and the directorsof the Company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use or dispositionof the Company’s assets that could have a material effect on our financialstatements.

Management’s assessment of the effectiveness of theCompany’s internal controls over financial reporting as of December 31,2006 has been audited by PricewaterhouseCoopers LLP, an independent registered publicaccounting firm, as stated in their report which appears herein.

*NYSE Annual CEOCertification.**  *OnJune 27, 2006, Stewart Gray MacDonald, Jr., Chief Executive Officerof the Company, submitted to the New York Stock Exchange (the “NYSE”) theAnnual CEO Certification required by Section 303A of the CorporateGovernance Rules of the NYSE certifying that he was not aware of anyviolation by the Company of NYSE corporate governance listing standards.

**Item 9B.**   OtherInformation

None.

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**PART III**

**Item 10.**                 Directors,Executive Officers and Corporate Governance

The information appearingunder the captions “Information Regarding Directors/Nominees” and “InformationRegarding Executive Officers” in the Company’s definitive proxy statement for its2006 annual meeting of stockholders is incorporated herein by reference.

**Item 11.**                 ExecutiveCompensation

The information appearingunder the caption “Executive Compensation” in the Company’s definitive proxystatement for its 2006 annual meeting of stockholders is incorporated herein byreference.

**Item 12.**             SecurityOwnership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information appearingunder the captions “Principal and Management Stockholders” and “Executive Compensation”in the Company’s definitive proxy statement for its 2006 annual meeting ofstockholders is incorporated herein by reference.

**Stock Option PlanInformation and Employee Stock Purchase Plan Information**

Thefollowing tables provide information as of December 31, 2006 regardingshares of our common stock that may be issued under the existing equitycompensation plans, including our 1997 Stock Option and Incentive Plan (the “1997Plan”), 2001 Employee Stock Purchase Plan (the “ESPP”) and 2005 Stock Optionand Incentive Plan (the “2005 Plan”). There are no equity compensation plansthat have not been approved by the shareholders.

| ** **                                                  | ** ** | ** **                                 | ** ** | ** **                        | ** ** | **Number of securities**      | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------|------------|-----------------------------------------|------------|
| ** **                                                  | ** ** | ** **                                 | ** ** | ** **                        | ** ** | **remaining available for**   | ** ** |
| ** **                                                  | ** ** | **Number of securities to** | ** ** | **Weighted average**         | ** ** | **future issuance under**     | ** ** |
| ** **                                                  | ** ** | **be issued upon exercise** | ** ** | **exercise price of**   | ** ** | **equity compensation plans** | ** ** |
| ** **                                                  | ** ** | **of outstanding options,**      | ** ** | **outstanding options,**     | ** ** | **(excluding securities**          | ** ** |
| **Plan category**                                      | ** ** | ** **                                 | ** ** | **warrants and rights** | ** ** | **warrants and rights**       | ** ** | **referenced in column (a))** | ** ** |
| ** **                                                  | ** ** | **(a)**                                    | ** ** | **(b)**                           | ** ** | **(c)**                                 | ** ** |
| Equity  compensation plans approved by security holders(1)  |       |                                       | 817,860    |                              |       |                                    | $          | 5.38 |   |   |   | 1,035,717 | (2) |   |
| Equity  compensation plans not approved by security holders |       |                                       | —     |                              |       |                                    | —     |   |   |   | — |   |   |
| Total                                                       |       |                                       | 817,860    |                              |       |                                    | $          | 5.38 |   |   |   | 1,035,717 | (2) |   |
|                                                             |            |                                            |            |                                   |            |                                         |            |  |  |  |  |  |  |  |  |  |

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(1)          Represents outstandingoptions under the 1997 Plan and 2005 Plan. There are no options, warrants orrights outstanding under the ESPP (does not include purchase rights accruingunder the ESPP because the purchase price, and therefore the number of sharesto be purchased, is not determinable until the end of the purchase period).

(2)          Includes126,299 shares available for future issuance under the 1997 Plan, 833,847shares available for future issuance under the 2005 Plan, and 75,571 sharesavailable for future issuance under the ESPP. The 1997 Plan incorporates anevergreen formula pursuant to which the aggregate number of shares reserved forissuance under the 1997 Plan equals the greater of 750,000 shares or 10% of thetotal number of outstanding shares of common stock. The number of sharesreserved for issuance under the 2005 Plan is 1,300,000.

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**Item 13.**                 CertainRelationships and Related Transactions, and Director Independence

The information appearingunder the caption “Certain Relationships and Related Transactions” in theCompany’s definitive proxy statement for its 2006 annual meeting of stockholdersis incorporated herein by reference.

**Item 14.**                 PrincipalAccountant Fees and Services

**Theinformation concerning our principal accountant fees and services required byItem 14 will be included in our definitive proxy statement for our 2006 annualmeeting of stockholders and is incorporated herein by reference.**

**PART IV**

**Item 15.**                 Exhibits,Financial Statements, Financial Statement Schedules

(a)   1. and 2.An Index to Consolidated Financial Statements and Financial Statement Scheduleis on Page F-1 of this Report.

(b)   3.Exhibits:

Exhibits requiredby 601 of Regulation S-K and Additional Exhibits. Unless otherwise indicated,all exhibits are part of Commission File Number 1-13495. Certain exhibitsindicated below are incorporated by reference to documents of Mac-Gray on filewith the Commission.

·       Eachexhibit marked by a cross (+) was previously filed as an exhibit to Mac-Gray’sRegistration Statement on Form S-1 filed on August 14, 1997 (No. 333-33669)and the number in parentheses following the description of the exhibit refersto the exhibit number in the Form S-1.

·       Eachexhibit marked by an asterisk (*) was previously filed as an exhibit toMac-Gray’s Registration Statement on Form S-4 filed on February 9,1998 (No. 333-45899) and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form S-4.

·       Eachexhibit marked by a number sign (#) was previously filed as an exhibit toAmendment No. 1 to Mac-Gray’s Registration Statement on Form S-1,filed on September 25, 1997 (No. 333-33669) and the number inparentheses following the description of the exhibit refers to the exhibitnumber in the Form S-1.

·       Eachexhibit marked by a (z) was previously filed as an exhibit to Amendment No. 1of Mac-Gray’s Registration Statement on Form S-1, filed on April 17,1998 (No. 333-49795) and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form S-1.

·       Eachexhibit marked by a (y) was previously filed as an exhibit to Mac-Gray’s Form 8-K,filed on May 8, 1998 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (x) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on June 18, 1999 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (v) was previously filed as an exhibit to Mac-Gray’s Form 10-Kfiled on March 29, 2002 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 10-K.

·       Eachexhibit marked by a (u) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on July 3, 2003 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

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·       Eachexhibit marked by a (t) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on January 28, 2004 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by an (s) was previously filed as an exhibit to Mac-Gray’s Form 10-K/Afiled on April 11, 2002 and the number in parenthesis following thedescription of the exhibit refers to the exhibit number in the Form 10-K/A.

·       Eachexhibit marked by an (r) was previously filed as an exhibit to Mac-Gray’s Form 10-Kfiled on March 31, 2005, and the number in parenthesis following thedescription of the exhibit refers to the exhibit number in the Form 10-K.

·       Eachexhibit marked by a (q) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on April 21, 2005 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (p) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on May 31, 2005 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (o) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on July 28, 2005 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (n) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on August 18, 2005 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (m) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on March 2, 2006 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (l) was previously filed as an exhibit to Mac-Gray’s Form 10-Qfiled on November 14, 2005 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 10-Q.

·       Eachexhibit marked by a (k) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on November 13, 2006 and the number in parentheses following thedescription of the exhibit refers to the exhibit number in the Form 8-K.

·       Eachexhibit marked by a (j) was previously filed as an exhibit to Mac-Gray’s Form 8-Kfiled on December 28, 2006 and the number in parentheses following the descriptionof the exhibit refers to the exhibit number in the Form 8-K.

Thefollowing is a complete list of exhibits filed or incorporated by reference aspart of this Annual Report on Form 10-K.
| 3.10 |   | Amended and Restated Certificate of Incorporation  (3.1) +                                                                                                               |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.20 |   | By-laws, as amended  (3.2) v                                                                                                                                             |
| 4.10 |   | Specimen certificate for  shares of Common Stock, $.01 par value, of the Registrant (4.1) #                                                                              |
| 4.20 |   | Shareholder Rights  Agreement, dated as of June 15, 1999, by and between the Registrant and  State Street Bank and Trust Company (4.1) x                            |
| 4.30 |   | Indenture, dated  August 16, 2005, among Mac-Gray Corporation, Mac-Gray  Services, Inc., Intirion Corporation and Wachovia Bank, National  Association (4.1) n |

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| 10.01 |   | Stockholders’ Agreement  dated as of June 26, 1997 by and among the Registrant and certain  stockholders of the Registrant (10.2) +                                                                       |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.02 |   | Form of Maytag  Distributorship Agreements (10.13) +                                                                                                                                                           |
| 10.03 |   | The Registrant’s 1997  Stock Option and Incentive Plan (with form of option agreements attached as  exhibits) (10.16) + ***                                                                                    |
| 10.04 |   | Credit Agreement, dated  January 10, 2005, by and among the Registrant, the other Borrowers (as  defined therein), the lenders named therein and JPMorgan Chase Bank, N.A., as  administrative agent (10.04) r |
| 10.05 |   | Amendment No. 1 to  the Credit Agreement dated August 2, 2005 (99.2) n                                                                                                                                    |
| 10.06 |   | Guarantee and Collateral  Agreement dated as of January 10, 2005 among Mac-Gray Corporation and  Subsidiaries and JPMorgan Chase Bank, N.A., as Collateral Agent (10.05) r                                     |
| 10.07 |   | Form of Revolving  Credit Note issued by the Registrant in favor of the Banks (as defined  therein) (10.06) r                                                                                                  |
| 10.08 |   | Form of Term Note  issued by the Registrant in favor of the Banks (as defined therein)  (10.07) r                                                                                                         |
| 10.09 |   | Form of  Noncompetition Agreement between the Registrant and its executive officers  (10.15) v ***                                                                                                   |
| 10.10 |   | Form of Director  Indemnification Agreement between the Registrant and each of its Directors  (10.16) v ***                                                                                                    |
| 10.11 |   | April 2001  Amendment to the Mac-Gray Corporation 1997 Stock Option and Incentive Plan  (10.17) v ***                                                                                                          |
| 10.12 |   | 2005 Directors  Compensation Arrangements (10.11) l ***                                                                                                                                                             |
| 10.13 |   | Senior Executive  Compensation Plan (2004) (10.12) r ***                                                                                                                                                            |
| 10.14 |   | Form of executive  severance agreement between the Registrant and its chief financial officer  and chief operating officer (10.18) s ***                                                                       |
| 10.15 |   | Form of executive  severance agreement between the Registrant and its chief executive officer  (10.19) s ***                                                                                                   |
| 10.16 |   | Asset Purchase  Agreement, dated as of January 16, 2004, between Mac-Gray Services, Inc.  and Web Service Company (2.1) t                                                                                 |
| 10.17 |   | Asset Purchase  Agreement, dated as of January 10, 2005, between Mac-Gray  Services, Inc. and Web Service Company (10.18) r                                                                               |
| 10.18 |   | Trademark License  Agreement dated January 10, 2005 by and between Web Service  Company, Inc., (“Licensor”) and Mac-Gray Services, Inc.,  (“Licensee”) (10.19) r                 |
| 10.19 |   | Mac-Gray Corporation  2005 Stock Option and Incentive Plan (10.1) p ***                                                                                                                                             |
| 10.20 |   | Form of Stock  Option Agreement for incentive stock option grants under the 2005 Stock Option  and Incentive Plan (10.2) p                                                                                     |
| 10.21 |   | Form of Stock  Option Agreement for nonqualified stock option grants to employees under the  2005 Stock Option and Incentive Plan (10.3) p                                                                     |
| 10.22 |   | Form of Stock  Option Agreement for nonqualified stock option grants to Directors under the  2005 Stock Option and Incentive Plan (10.4) p                                                                     |
| 10.23 |   | Form of Restricted  Stock Award Agreement for awards under the 2005 Stock Option and Incentive  Plan (10.5) p                                                                                                  |

43

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| 10.24 |   | Lease Agreement, dated  July 22, 2005, between Mac-Gray Services, Inc., and 404 Wyman LLC  (99.1) o                                                                                                                            |
|-------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.25 |   | Registration Rights  Agreement, dated August 16, 2005, by and among Mac-Gray Corporation,  Mac-Gray Services, Inc., Intirion Corporation and J.P. Morgan Securities  Inc. (99.1) n                                             |
| 10.26 |   | Form of Mac-Gray  Corporation 7 5/8% Senior Notes due 2015 (4.2) n                                                                                                                                                                  |
| 10.27 |   | Mac-Gray Corporation  Long Term Incentive Plan (10.1) m                                                                                                                                                                                  |
| 10.28 |   | Form of executive  severance agreement between the Registrant and its executive vice president,  operations (99.1) k***                                                                                                             |
| 10.29 |   | Amended and Restated Credit  Agreement, dated December 21, 2006, by and among the Registrant, the  other Borrowers (as defined therein), the lenders named therein and JPMorgan  Chase Bank, N.A., as administrative agent (10.1) j |
| 21.1  |   | Subsidiaries of the  Registrant (21.1) z                                                                                                                                                                                                 |
| 23.1  |   | Consent of  PricewaterhouseCoopers LLP (filed herewith)                                                                                                                                                                                  |
| 31.1  |   | Certification of  Principal Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 (filed herewith)                                                                                                           |
| 31.2  |   | Certification of  Principal Financial Officer pursuant to Section 302 of the Sarbanes  Oxley Act of 2002 (filed herewith)                                                                                                           |
| 32.1  |   | Certification of  Principal Executive Officer and Principal Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)                                                                           |

----

***      Management compensatory planor arrangement

44

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**SIGNATURES**

PURSUANTTO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITSBEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, THIS 16th  DAY OF MARCH, 2007.

|                                      | MAC-GRAY CORPORATION |
|--------------------------------------|----------------------|
|                                 |                 |   |
|                                 |                 |   |
|                                 | By:                  | STEWART GRAY  MACDONALD, JR. |
|                                 |                 | Stewart Gray MacDonald, Jr. |
|                                 |                 | *Chairman, Chief Executive Office  and Director* |
|                                 |                 | *(Principal Executive Officer)* |
| Date:  March 16, 2007 |                 | * * |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

|                              | **Signature** | ** **                       | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|------------------------------|---------------|----------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/ DAVID  W. BRYAN     |          | Director                         |       | March 16, 2007 |
| David W. Bryan               |          |                             |       |                |
| /s/ THOMAS  E. BULLOCK  |          | Director                         |       | March 16, 2007 |
| Thomas E. Bullock            |          |                             |       |                |
| /s/ CHRISTOPHER  JENNY  |          | Director                         |       | March 16, 2007 |
| Christopher Jenny            |          |                             |       |                |
| /s/ EDWARD  F. MCCAULEY |          | Director                         |       | March 16, 2007 |
| Edward F.  McCauley          |          |                             |       |                |
| /s/ JERRY  A. SCHILLER  |          | Director                         |       | March 16, 2007 |
| Jerry A. Schiller            |          |                             |       |                |
| /s/ MARY  ANN TOCIO     |          | Director                         |       | March 16, 2007 |
| Mary Ann Tocio               |          |                             |       |                |
| /s/ MICHAEL  J. SHEA    |          | Executive Vice  President, Chief |       | March 16, 2007 |
| Michael J. Shea              |          | Financial Officer And  Treasurer |       |                |
|                         |          | (Principal Financial and         |       |                |
|                         |          | Accounting Officer)              |       |                |

 

45

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**Items 15(a)(1) and(2)**

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE**

Thefollowing consolidated financial statements of the registrant and itssubsidiaries required to be included in Item 8 are listed below.

| MAC-GRAY CORPORATION                                                                                                                                                                                  | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                                                                                              |       | F-2        |       |
| Consolidated Balance Sheets at December 31, 2005  and 2006                                                                                                                                       |       | F-4        |       |
| Consolidated Income Statements for the Years Ended  December 31, 2004, 2005 and 2006                                                                                                             |       | F-5        |       |
| Consolidated Statements of Stockholders’ Equity for  the Years Ended December 31 2004, 2005 and 2006                                                                                        |       | F-6        |       |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2004, 2005, and 2006                                                                                                     |       | F-7        |       |
| Notes to Consolidated Financial Statements                                                                                                                                                            |       | F-8        |       |
| The following consolidated financial statement  schedule of Mac-Gray Corporation is included in Item 15 (a)(2) and  should be read in conjunction with the financial statements included herein. |       |       |       |
| Schedule II  Valuation and Qualifying Accounts                                                                                                                                                        |       | F-34       |       |

 

All other schedules for which provision is made in theapplicable accounting regulations of the Securities and Exchange Commission arenot required under the related instructions or are not material, and thereforehave been omitted.

F-1

----

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board ofDirectors andStockholders of Mac-Gray Corporation:

We have completed anintegrated audit of Mac-Gray Corporation’s December 31, 2006 consolidatedfinancial statements and of its internal control over financial reporting as ofDecember 31, 2006 and audits of its December 31, 2005 and December 31,2004 consolidated financial statements in accordance with the standards of thePublic Company Accounting Oversight Board (United States). Our opinions, basedon our audits, are presented below.

*Consolidatedfinancial statements and financial statement schedule*

In our opinion, the consolidated financial statementslisted in the index appearing under Item 15(a)(1)  present fairly, in allmaterial respects, the financial position of Mac-Gray Corporation and itssubsidiaries at December 31, 2006 and December 31, 2005, and theresults of their operations and their cash flows for each of the three years inthe period ended December 31, 2006 in conformity with accountingprinciples generally accepted in the United States of America. In addition, inour opinion, the financial statement schedule listed in the index appearingunder 15(a)(2) presents fairly, in all material respects, the informationset forth therein when read in conjunction with the related consolidatedfinancial statements. These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements and financial statementschedule based on our audits. We conducted our audits of these statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit of financial statements includes examining, ona test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 2 tothe consolidated financial statements, effective January 1, 2006, theCompany adopted Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment.*

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment, includedin “Management’s Annual Report on Internal Control Over Financial Reporting”appearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of December 31, 2006 based on criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2006, based on criteria established in *InternalControl—Integrated Framework* issued by the COSO. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express opinions onmanagement’s assessment and on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit. We conducted our audit ofinternal control over financial reporting in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s 

F-2

----

assessment, testing andevaluating the design and operating effectiveness of internal control, andperforming such other procedures as we consider necessary in the circumstances.We believe that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accounting principles,and that receipts and expenditures of the company are being made only inaccordance with authorizations of management and directors of the company; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

/s/ PricewaterhouseCoopersLLP

Boston, MassachusettsMarch 16, 2007

F-3

----

**MAC-GRAY CORPORATION CONSOLIDATED BALANCE SHEETS (In thousands, except share data)**

| ** **                                                                                                                                                                                                                                           | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                           | ** ** | **2005**              | ** ** | **2006**              | ** ** |
| ASSETS                                                                                                                                                                                                                                               | ** ** |                  | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current assets:                                                                                                                                                                                                                                      |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                            |       |                  | $          | 11,046                |       |   |   | $ | 11,994 |   |   |
| Trade receivables, net of allowance for doubtful  accounts                                                                                                                                                                                           |       |                  | 10,308     |                  |       |   | 9,176 |   |   |
| Inventory of finished goods, net                                                                                                                                                                                                                     |       |                  | 6,398      |                  |       |   | 7,237 |   |   |
| Deferred income taxes                                                                                                                                                                                                                                |       |                  | 909        |                  |       |   | 961 |   |   |
| Prepaid facilities management rent and other current  assets                                                                                                                                                                                         |       |                  | 9,886      |                  |       |   | 12,951 |   |   |
| Total current assets                                                                                                                                                                                                                                 |       |                  | 38,547     |                  |       |   | 42,319 |   |   |
| Property, plant  and equipment, net                                                                                                                                                                                                                  |       |                  | 118,459    |                  |       |   | 118,654 |   |   |
| Goodwill                                                                                                                                                                                                                                             |       |                  | 37,941     |                  |       |   | 38,454 |   |   |
| Intangible assets,  net                                                                                                                                                                                                                              |       |                  | 116,793    |                  |       |   | 125,543 |   |   |
| Prepaid facilities  management rent and other assets                                                                                                                                                                                                 |       |                  | 13,177     |                  |       |   | 14,034 |   |   |
| Total assets                                                                                                                                                                                                                                         |       |                  | $          | 324,917               |       |   |   | $ | 339,004 |   |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                                                                                           | ** ** |                  | ** ** | ** **            |       |   | ** ** | ** ** |   |
| Current liabilities:                                                                                                                                                                                                                                 |       |                  |       |                  |       |   |   |   |   |
| Current portion of capital lease obligations                                                                                                                                                                                                         |       |                  | $          | 1,185                 |       |   |   | $ | 1,245 |   |   |
| Trade accounts payable                                                                                                                                                                                                                               |       |                  | 10,252     |                  |       |   | 10,447 |   |   |
| Accrued facilities management rent                                                                                                                                                                                                                   |       |                  | 15,629     |                  |       |   | 16,527 |   |   |
| Accrued expenses                                                                                                                                                                                                                                     |       |                  | 12,472     |                  |       |   | 11,445 |   |   |
| Deferred revenues and deposits                                                                                                                                                                                                                       |       |                  | 682        |                  |       |   | 591 |   |   |
| Total current liabilities                                                                                                                                                                                                                            |       |                  | 40,220     |                  |       |   | 40,255 |   |   |
| Long-term debt                                                                                                                                                                                                                                       |       |                  | 164,000    |                  |       |   | 174,000 |   |   |
| Long-term capital  lease obligations                                                                                                                                                                                                                 |       |                  | 1,493      |                  |       |   | 1,823 |   |   |
| Deferred income  taxes                                                                                                                                                                                                                               |       |                  | 29,010     |                  |       |   | 29,620 |   |   |
| Deferred  retirement obligation                                                                                                                                                                                                                      |       |                  | 229        |                  |       |   | 125 |   |   |
| Other liabilities                                                                                                                                                                                                                                    |       |                  | 1,364      |                  |       |   | 1,541 |   |   |
| Commitments and  contingencies (Note 17)                                                                                                                                                                                                             |       |                  |       |                  |       |   |   |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                           |       |                  |       |                  |       |   |   |   |   |
| Preferred stock of Mac-Gray Corporation  ($.01 par value, 5 million shares authorized, no shares  outstanding)                                                                                                                             |       |                  | —     |                  |       |   | — |   |   |
| Common stock of Mac-Gray Corporation ($.01 par  value, 30 million shares authorized, 13,443,754 issued and 12,924,340  outstanding at December 31, 2005, and 13,443,754 issued and 13,077,694  outstanding at December 31, 2006) |       |                  | 134        |                  |       |   | 134 |   |   |
| Additional paid in capital                                                                                                                                                                                                                           |       |                  | 69,032     |                  |       |   | 70,553 |   |   |
| Accumulated other comprehensive income                                                                                                                                                                                                               |       |                  | 315        |                  |       |   | 183 |   |   |
| Retained earnings                                                                                                                                                                                                                                    |       |                  | 24,513     |                  |       |   | 24,571 |   |   |
|                                                                                                                                                                                                                                                 |       |                  | 93,994     |                  |       |   | 95,441 |   |   |
| Less common stock in treasury, at cost (519,414 shares  at December 31, 2005 and 366,060 shares at December 31, 2006)                                                                                                                      |       |                  | (5,393     | )                     |       |   | (3,801 | ) |   |
| Total stockholders’ equity                                                                                                                                                                                                                      |       |                  | 88,601     |                  |       |   | 91,640 |   |   |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                                     |       |                  | $          | 324,917               |       |   |   | $ | 339,004 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

F-4

----

**MAC-GRAY CORPORATIONCONSOLIDATED INCOME STATEMENTS(In thousands, except share data)**

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenue:                                                 |       |                                        |       |   |   |   |   |
| Facilities management revenue                            |       | $                                           | 140,480    |   | $ | 214,816 |   | $ | 232,181 |   |
| Product sales                                            |       | 42,214                                      |       | 45,807 |   | 47,146 |   |
| Total revenue                                            |       | 182,694                                     |       | 260,623 |   | 279,327 |   |
| Cost of revenue:                                         |       |                                        |       |   |   |   |   |
| Cost of facilities management revenue                    |       | 93,512                                      |       | 142,052 |   | 153,861 |   |
| Depreciation and amortization                            |       | 20,747                                      |       | 31,337 |   | 35,156 |   |
| Cost of product sales                                    |       | 30,821                                      |       | 36,173 |   | 37,352 |   |
| Total cost of revenue                                    |       | 145,080                                     |       | 209,562 |   | 226,369 |   |
| Gross margin                                             |       | 37,614                                      |       | 51,061 |   | 52,958 |   |
| Operating  expenses:                                     |       |                                        |       |   |   |   |   |
| General and administration                               |       | 11,078                                      |       | 14,164 |   | 17,826 |   |
| Sales and marketing                                      |       | 13,005                                      |       | 16,097 |   | 16,248 |   |
| Depreciation and amortization                            |       | 1,047                                       |       | 1,189 |   | 1,589 |   |
| Gain on sale of assets, net                              |       | (1,208                                      | )          | (10,735 | ) | (32 | ) |
| Loss on early extinguishment of debt                     |       | 183                                         |       | 668 |   | 73 |   |
| Impairment of assets                                     |       | —                                      |       | — |   | 2,502 |   |
| Total operating expenses                                 |       | 24,105                                      |       | 21,383 |   | 38,206 |   |
| Income from operations                                   |       | 13,509                                      |       | 29,678 |   | 14,752 |   |
| Interest expense, net                                    |       | (4,312                                      | )          | (10,939 | ) | (13,653 | ) |
| Gain (loss) related to derivative instruments            |       | —                                      |       | 1,876 |   | (96 | ) |
| Income before  provision for income taxes                |       | 9,197                                       |       | 20,615 |   | 1,003 |   |
| Provision for  income taxes                              |       | (3,934                                      | )          | (8,563 | ) | (147 | ) |
| Net income                                               |       | $                                           | 5,263      |   | $ | 12,052 |   | $ | 856 |   |
| Net income per common share—basic                   |       | $                                           | 0.41       |   | $ | 0.94 |   | $ | 0.07 |   |
| Net income per common share—diluted                 |       | $                                           | 0.40       |   | $ | 0.91 |   | $ | 0.06 |   |
| Weighted average common shares outstanding—basic    |       | 12,702                                      |       | 12,864 |   | 13,008 |   |
| Weighted average  common shares outstanding—diluted |       | 13,028                                      |       | 13,283 |   | 13,448 |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

F-5

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**MAC-GRAYCORPORATIONCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands, except share data)**

| ** **                                                                                                       | ** ** | ** **                                                                        | ** ** | ** **     | ** ** | **Accumulated**  | ** ** | ** **           | ** ** | ** **        | ** ** | ** **                                                                          | ** ** | ** **         | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|----------------|------------|------------------|------------|----------------------|------------|-------------------|------------|-------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                       | ** ** | **     Common stock     ** | ** ** | **Additional** | ** ** | **Other**        | ** ** | ** **           | ** ** | ** **        | ** ** | **     Treasury Stock     ** | ** ** | ** **         | ** ** |
| ** **                                                                                                       | ** ** | **Number**                                                                        | ** ** | ** **     | ** ** | **Paid in** | ** ** | **Comprehensive**    | ** ** | **Comprehensive** | ** ** | **Retained**                                                                        | ** ** | **Number**         | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                                       | ** ** | **of shares**                                                                | ** ** | **Value**      | ** ** | **Capital**      | ** ** | **(Loss) Gain** | ** ** | **Income**        | ** ** | **Earnings**                                                                        | ** ** | **of shares** | ** ** | **Cost** | ** ** | **Total** | ** ** |
| Balance,  December 31, 2003                                                                                 |       | 13,449,354                                                                        |       |           | $          | 134              |       |                 |       | $                 | 68,561     |                                                                                |       |               | $          | (372 | ) |   |   |   |   |   |   | $ | 9,439 |   |   |   | 869,860 |   |   | $ | (9,033 | ) | $ | 68,729 |   |
| Net income                                                                                                       |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   | $ | 5,263 |   |   |   | 5,263 |   |   |   | — |   |   | — |   | 5,263 |   |
| Other comprehensive  income:                                                                                     |       |                                                                              |       |           |       |             |       |                 |       |              |       |                                                                                |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized gain on  derivative instruments and reclassification adjustment, net of tax of $796  (Note 7)         |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | 1,194      |               |       |   | 1,194 |   |   |   | — |   |   |   | — |   |   | — |   | 1,194 |   |
| Comprehensive  income                                                                                            |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   | $ | 6,457 |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Stock  issuance—Employee Stock Purchase Plan                                                                |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (152 | ) |   |   | (23,855 | ) |   | 247 |   | 95 |   |
| Options exercised                                                                                                |       | 2,000                                                                             |       |           | —     |             |       |                 | 7          |              |       |                                                                                | —     |               |       |   |   |   |   |   | (1,164 | ) |   |   | (170,833 | ) |   | 1,775 |   | 618 |   |
| Retirement of  treasury stock                                                                                    |       | (7,600                                                                            | )          |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (79 | ) |   |   | (7,600 | ) |   | 79 |   | — |   |
| Stock granted                                                                                                    |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (24 | ) |   |   | (5,907 | ) |   | 61 |   | 37 |   |
| Balance,  December 31, 2004                                                                                 |       | 13,443,754                                                                        |       |           | 134        |             |       |                 | 68,568     |              |       |                                                                                | 822        |               |       |   |   |   |   |   | 13,283 |   |   |   | 661,665 |   |   | (6,871 | ) | 75,936 |   |
| Net income                                                                                                       |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   | $ | 12,052 |   |   |   | 12,052 |   |   |   | — |   |   | — |   | 12,052 |   |
| Other comprehensive  income:                                                                                     |       |                                                                              |       |           |       |             |       |                 |       |              |       |                                                                                |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized loss on  derivative instruments and reclassification adjustment, net of tax benefit of  $338 (Note 7) |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | (507       | )                  |       |   | (507 | ) |   |   | — |   |   |   | — |   |   | — |   | (507 | ) |
| Comprehensive  income                                                                                            |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   | $ | 11,545 |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Stock  issuance—Employee Stock Purchase Plan                                                                |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (127 | ) |   |   | (31,610 | ) |   | 328 |   | 201 |   |
| Options exercised                                                                                                |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (693 | ) |   |   | (104,583 | ) |   | 1,086 |   | 393 |   |
| Windfall tax  benefit                                                                                            |       | —                                                                            |       |           | —     |             |       |                 | 464        |              |       |                                                                                | —     |               |       |   |   |   |   |   | — |   |   |   | — |   |   | — |   | 464 |   |
| Stock granted                                                                                                    |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (2 | ) |   |   | (6,058 | ) |   | 64 |   | 62 |   |
| Balance,  December 31, 2005                                                                                 |       | 13,443,754                                                                        |       |           | 134        |             |       |                 | 69,032     |              |       |                                                                                | 315        |               |       |   |   |   |   |   | 24,513 |   |   |   | 519,414 |   |   | (5,393 | ) | 88,601 |   |
| Net income                                                                                                       |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   | $ | 856 |   |   |   | 856 |   |   |   | — |   |   | — |   | 856 |   |
| Other comprehensive  income:                                                                                     |       |                                                                              |       |           |       |             |       |                 |       |              |       |                                                                                |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized loss on  derivative instruments and reclassification adjustment, net of tax benefit of  $84 (Note 7)  |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | (132       | )                  |       |   | (132 | ) |   |   | — |   |   |   | — |   |   | — |   | (132 | ) |
| Comprehensive  income                                                                                            |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   | $ | 724 |   |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Options exercised                                                                                                |       |                                                                              |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (754 | ) |   |   | (129,967 | ) |   | 1,350 |   | 596 |   |
| Stock compensation  expense                                                                                      |       | —                                                                            |       |           | —     |             |       |                 | 1,147      |              |       |                                                                                | —     |               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 1,147 |   |
| Windfall tax  benefit                                                                                            |       | —                                                                            |       |           | —     |             |       |                 | 365        |              |       |                                                                                |       |               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   | 365 |   |
| Stock  issuance—Employee Stock Purchase Plan                                                                |       | —                                                                            |       |           | —     |             |       |                 | —     |              |       |                                                                                | —     |               |       |   |   |   |   |   | (44 | ) |   |   | (17,534 | ) |   | 182 |   | 138 |   |
| Stock granted                                                                                                    |       | —                                                                            |       |           | —     |             |       |                 | 9          |              |       |                                                                                | —     |               |       |   |   |   |   |   | — |   |   |   | (5,853 | ) |   | 60 |   | 69 |   |
| Balance,  December 31, 2006                                                                                 |       | 13,443,754                                                                        |       |           | $          | 134              |       |                 |       | $                 | 70,553     |                                                                                |       |               | $          | 183 |   |   |   |   |   |   |   | $ | 24,571 |   |   |   | 366,060 |   |   | $ | (3,801 | ) | $ | 91,640 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

F-6

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**MAC-GRAY CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**

| ** **                                                                                                                | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Cash flows from operating activities:                                                                                     |       |                                        |       |   |   |   |   |
| Net income                                                                                                                |       | $                                           | 5,263      |   | $ | 12,052 |   | $ | 856 |   |
| Adjustments to reconcile  net income to net cash flows provided by operating activities, net of effects  of acquisitions: |       |                                        |       |   |   |   |   |
| Depreciation and  amortization                                                                                            |       | 21,794                                      |       | 32,526 |   | 36,745 |   |
| Impairment of  assets                                                                                                     |       | —                                      |       | — |   | 2,502 |   |
| Loss on early  extinguishment of debt                                                                                     |       | 183                                         |       | 668 |   | 73 |   |
| (Decrease)  increase in allowance for doubtful accounts and lease reserves                                                |       | (553                                        | )          | 206 |   | (154 | ) |
| Gain on  disposition of assets                                                                                            |       | (1,208                                      | )          | (10,735 | ) | (33 | ) |
| Director stock  grants                                                                                                    |       | 37                                          |       | 62 |   | 69 |   |
| Non-cash interest  (income) expense                                                                                       |       | 1,368                                       |       | (1,680 | ) | 96 |   |
| Deferred income  taxes                                                                                                    |       | 4,219                                       |       | 2,188 |   | 944 |   |
| Stock compensation                                                                                                        |       | —                                      |       | — |   | 1,147 |   |
| Windfall tax  benefit                                                                                                     |       | —                                      |       | 464 |   | — |   |
| Decrease  (increase) in accounts receivable                                                                               |       | 821                                         |       | (2,077 | ) | 1,294 |   |
| Decrease  (increase) in inventory                                                                                         |       | 563                                         |       | (300 | ) | (714 | ) |
| Increase in prepaid  facilities management rent and other assets                                                          |       | (913                                        | )          | (5,888 | ) | (7,519 | ) |
| Increase in  accounts payable, accrued facilities rent, accrued expenses and other  liabilities                           |       | 5,736                                       |       | 10,537 |   | 1,292 |   |
| Decrease in  deferred revenues and customer deposits                                                                      |       | (202                                        | )          | (121 | ) | (91 | ) |
| Net cash flows  provided by operating activities                                                                          |       | 37,108                                      |       | 37,902 |   | 36,507 |   |
| Cash flows from investing activities:                                                                                     |       |                                        |       |   |   |   |   |
| Capital  expenditures                                                                                                     |       | (17,826                                     | )          | (26,380 | ) | (25,911 | ) |
| Payments for  acquisitions                                                                                                |       | (41,454                                     | )          | (106,244 | ) | (19,356 | ) |
| Proceeds from sale  of assets                                                                                             |       | 2,179                                       |       | 12,373 |   | 292 |   |
| Net cash flows  used in investing activities                                                                              |       | (57,101                                     | )          | (120,251 | ) | (44,975 | ) |
| Cash flows from financing activities:                                                                                     |       |                                        |       |   |   |   |   |
| Payments on  capital lease obligations                                                                                    |       | (1,292                                      | )          | (1,286 | ) | (1,386 | ) |
| Borrowings on 2005  Senior Notes                                                                                          |       | —                                      |       | 150,000 |   | — |   |
| Borrowings on 2005  term credit facility                                                                                  |       | —                                      |       | 80,000 |   | — |   |
| Payments on 2005  term credit facility                                                                                    |       | —                                      |       | (80,000 | ) | — |   |
| Borrowings on 2003  term credit facility and mortgage note payable                                                        |       | 22,071                                      |       | — |   | — |   |
| Payments on 2003  term credit facility and mortgage note payable                                                          |       | (5,120                                      | )          | (33,880 | ) | — |   |
| Borrowings on  revolving credit facility, net                                                                             |       | 5,217                                       |       | — |   | — |   |
| Payments on  revolving credit facility                                                                                    |       | —                                      |       | (142,758 | ) | (34,000 | ) |
| Borrowings on  revolving credit facility                                                                                  |       | —                                      |       | 119,774 |   | 44,000 |   |
| Payments on  deferred retirement obligations                                                                              |       | (104                                        | )          | (104 | ) | (104 | ) |
| Financing costs                                                                                                           |       | (297                                        | )          | (6,218 | ) | (193 | ) |
| Windfall tax  benefit                                                                                                     |       | —                                      |       | — |   | 365 |   |
| Proceeds from  termination of derivative instruments                                                                      |       | —                                      |       | 782 |   | — |   |
| Proceeds from  exercise of stock options                                                                                  |       | 618                                         |       | 393 |   | 596 |   |
| Proceeds from  issuance of common stock                                                                                   |       | 95                                          |       | 201 |   | 138 |   |
| Net cash flows  provided by financing activities                                                                          |       | 21,188                                      |       | 86,904 |   | 9,416 |   |
| Increase in cash  and cash equivalents                                                                                    |       | 1,195                                       |       | 4,555 |   | 948 |   |
| Cash and cash  equivalents, beginning of period                                                                           |       | 5,296                                       |       | 6,491 |   | 11,046 |   |
| Cash and cash  equivalents, end of period                                                                                 |       | $                                           | 6,491      |   | $ | 11,046 |   | $ | 11,994 |   |
| Supplemental cash flow information:                                                                                       |       |                                        |       |   |   |   |   |
| Interest paid                                                                                                             |       | $                                           | 3,641      |   | $ | 6,553 |   | $ | 14,015 |   |
| Income taxes paid                                                                                                         |       | $                                           | 646        |   | $ | 6,622 |   | $ | 1,301 |   |

Supplemental disclosure ofnon-cash investing activities:  Duringthe years ended December 31, 2004, 2005 and 2006, the Company acquiredvarious vehicles under capital lease agreements totaling $1,579, $1,499, and$1,776 respectively.

The accompanying notes are an integral part of these consolidated financial statements.

F-7

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (In thousands, except per share data)**

**1.**   Description of the Business andBasis of Presentation

*Description of theBusiness.*   Mac-Gray Corporation (“Mac-Gray” orthe “Company”) generates the majority of its revenue from card- andcoin-operated laundry rooms located in 43 states and the District of Columbia. Aportion of its revenue is also derived from the sale and lease of the Company’sMicroFridge® product lines. The Company’s principalcustomer base is the multi-unit housing market, which includes apartments,condominium units, colleges and universities, and military bases. The Companyalso sells, services and leases commercial laundry equipment to commerciallaundromats, multi-unit housing properties and institutions. The majority ofthe Company’s purchases of laundry equipment is from one supplier.

*Basis of Presentation.*   Theconsolidated financial statements include the accounts of the Company and itswholly owned subsidiaries. All significant intercompany transactions andbalances have been eliminated in consolidation.

**2.**   Significant Accounting Policies

*Cash and Cash Equivalents.*   TheCompany considers all highly liquid investments with original maturities ofthree months or less to be cash equivalents. On occasion the Company has excesscash available for a short period of time; when this occurs, the Companyinvests such excess cash in repurchase agreements and other highly liquidshort-term investments. Accordingly, the investments are subject to minimalcredit and market risk. The Company has cash deposited with financialinstitutions in excess of the $100 insured limit of the Federal DepositInsurance Corporation. Included in cash and cash equivalents is an estimate ofcash not yet collected which remains at laundry customer locations. At December 31,2005 and 2006, this estimate was $8,388 and $9,027, respectively.

*Revenue Recognition.*   TheCompany recognizes facilities management revenue on the accrual basis. Rentalrevenue is recognized ratably over the related contractual period. The Companyrecognizes revenue from product sales upon shipment of the products, unlessotherwise specified. Shipping and handling fees charged to customers arerecognized upon shipment of the products and are included in revenue with therelated cost included in cost of sales. All installation and repair servicesare provided on an occurrence basis, not on a contractual basis. Relatedrevenue is recognized at the time the installation service, or other service,is provided to the customer.

The Company has enteredinto long-term lease transactions that meet the qualifications of a sales-typelease for certain equipment. For these transactions, the amount of revenuerecognized upon product shipment is the present value of the minimum leasepayments, excluding executory costs and excluding profits on executory costs,discounted at the interest rate implicit in the lease. Interest revenue isrecognized over the life of the rental agreement. At December 31, 2005 and2006 the Company had $2,680 and $1,758, respectively, in receivables related tosales-type leases. These receivables have been recorded net of unearnedinterest income of $300 and $324 at December 31, 2005 and 2006,respectively. These receivables are primarily due ratably over the next fiveyears and have been classified as other current assets and other long-termassets, as appropriate, in the consolidated balance sheet. The related reservefor lease receivables was $152 and $26 at December 31, 2005 and 2006,respectively.

*Allowance for DoubtfulAccounts.*   On a regular basis, the Companyreviews the adequacy of its provision for doubtful accounts for trade accountsreceivable and lease receivables based on historical 

F-8

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**2.**   SignificantAccounting Policies (Continued)

collection resultsand current economic conditions using factors based on the aging of its tradeaccounts and lease receivables. In addition, the Company estimates specificadditional allowances based on indications that a specific customer may beexperiencing financial difficulties. The Company maintains an allowance fordoubtful trade accounts receivable of $436 and $408 at December 31, 2005and 2006, respectively.

*Concentration of CreditRisk.*   Financial instruments which potentiallyexpose the Company to concentration of credit risk include trade and leasereceivables generated by the Company as a result of the selling and leasing oflaundry equipment and MicroFridge® products. To minimize this risk, ongoingcredit evaluations of customers’ financial condition are performed and reservesare maintained. The Company typically does not require collateral. Noindividual Product Sales customer accounted for more than 10% of revenues oraccounts receivable for any period presented.

*Fair Value of FinancialInstruments.*   For purposes of financialreporting, the Company has determined that the fair value of financialinstruments approximates book value at December 31, 2005 and 2006, basedupon terms currently available to the Company in financial markets. The fairvalue of the interest rate swaps is the estimated amount that the Company wouldreceive or pay to terminate the agreement at the reporting date, taking intoaccount current interest rates and the credit worthiness of the counter party.

*Inventories.*   Inventoriesare stated at the lower of cost (as determined using the average cost method)or market, and consist primarily of finished goods.

*Provision for InventoryReserves.*   On a regular basis, the Companyreviews the adequacy of its reserve for inventory obsolescence based on historical experience, product knowledgeand frequency of shipments.

*Prepaid FacilitiesManagement Rent.*   Prepaid facilities managementrent consists of cash advances paid to property owners and managers underlaundry service contracts. The prepaid amount is amortized ratably over thelife of the contract.

*Property, Plant andEquipment.*   Property, plant and equipment arestated at cost and depreciated using the straight-line method over theestimated useful lives of the respective assets. Expenditures for maintenanceand repairs are charged to operations as incurred; acquisitions, majorrenewals, and betterments are capitalized. Upon retirement or sale, the cost ofassets disposed of and their related accumulated depreciation or amortizationare removed from the accounts, with the resulting gain or loss reflected inincome.

*Facilities ManagementEquipment—Not Yet Placed in Service.*   Theseassets represent laundry machines that management estimates will be installedin facilities management laundry rooms over the next twelve months and have notbeen purchased for commercial sale. These assets are grouped in Property, Plantand Equipment and are not depreciated until placed in service under afacilities management lease agreement.

*Advertising Costs.*   Advertisingcosts are expensed as incurred. These costs were $1,251, $1,347, and $953 forthe years ended December 31, 2004, 2005 and 2006, respectively.

F-9

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**2.**   SignificantAccounting Policies (Continued)

*Goodwill and IntangibleAssets.*   Intangible assets primarily consist ofvarious non-compete agreements, customer lists, goodwill, trademark andcontract rights recorded in connection with acquisitions. The non-competeagreements are amortized using the straight-line method over the life of theagreements, which range from five to fifteen years. Customer lists areamortized using the straight-line method over fifteen years. The majority ofcontract rights are amortized using the straight-line method over twenty years,with the balance amortized on a straight-line method over fifteen years. Thelife assigned to acquired contracts is based on several factors, including: theseller’s renewal rate of the contract portfolio for the most recent years priorto the acquisition, the number of years the average contract has been in theseller’s contract portfolio, the overall level of customer satisfaction withinthe contract portfolio and the ability of the Company to maintain or exceed thelevel of customer satisfaction maintained by the seller prior to theacquisition by the Company. The Company is accounting for acquired contractrights on a pool-basis based on the fact that, in general, no single contract accountsfor more than 2% of the revenue of any acquired portfolio and the fact that fewof the contracts are predicted to be terminated, either prior to or at the endof the contract term.

*Impairment of Long-LivedAssets.*   The Company reviews long-lived assets,including fixed assets and intangible assets with definitive lives, forimpairment whenever events or changes in business circumstances indicate thatthe carrying amount of the assets may not be fully recoverable or that theuseful lives of these assets are no longer appropriate. The Company’s annualimpairment test for laundry facilities management contract rights assigned a 15year amortization period consists of comparing the current number of machinesunder contract and the current cash flow of all the Company’s contracts in themarket where the portfolios were acquired to the original number of machinesacquired and the cash flow as predicted by the Company at the time of theacquisition. For those contract rights assigned a 20 year amortization period,the Company’s annual impairment test consists primarily of identifying theaccumulated retention rate of the specific acquired contract portfolio in orderto assess the appropriateness of the net book value of the related contractrights. If an impairment is indicated, the asset is written down to itsestimated fair value on a discounted cash flow basis.

The Company tests itsgoodwill annually for impairment. The goodwill impairment review consists of atwo-step process of first comparing the fair value of the reporting unit withits carrying value. If this fair value exceeds the carrying value, no furtheranalysis or goodwill impairment charge is required. If the fair value is belowthe carrying value, the Company would proceed to the next step, which is tomeasure the amount of the impairment loss. Any such impairment loss would berecognized in the Company’s results of operations in the period the impairmentloss arose.

In measuring whethergoodwill is impaired, the Company uses an estimate of its future undiscountedcash flows of the business over the estimated remaining life. If the Company’sexpectation of future undiscounted net cash flows indicates an impairment, theCompany would write down the appropriate assets to their estimated realizablevalues based on discounted cash flows. In estimating expected future cash flowsfor determining whether an asset is impaired, assets are grouped at the lowestlevel for which there is identifiable cash flows.

The Company evaluates itstrademark annually for impairment. If the trademark is still actively used bythe Company and continues to be a recognized brand in the industry, there isdeemed to be no impairment.

F-10

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**2.**   SignificantAccounting Policies (Continued)

*Income Taxes.*   TheCompany accounts for income taxes utilizing the asset and liability method asprescribed by Statement of Financial Accounting Standards (“SFAS”) No. 109,“Accounting for Income Taxes” (“FAS 109”). Under the provisions of FAS 109, thecurrent or deferred tax consequences of a transaction are measured by applyingthe provisions of enacted tax laws to determine the amount of taxes payablecurrently or in future years. The classification of net current and non-currentdeferred tax assets or liabilities depend upon the nature of the related assetor liability. Deferred income taxes are provided for temporary differencesbetween the income tax basis of assets and liabilities and their carryingamounts for financial reporting purposes.

*Stock Compensation.*   OnApril 7, 1997, the Company’s stockholders approved the 1997 Stock Optionand Incentive Plan for the Company (the “1997 Stock Plan”). On May 26,2005, the Company’s stockholders approved the 2005 Stock Option and IncentivePlan for the Company (the “2005 Stock Plan”; together the “Stock Plans”). TheStock Plans are designed and intended as a performance incentive for officers,employees, and directors to promote the financial success and progress of theCompany. All officers, employees and independent directors are eligible toparticipate in the Stock Plans. Awards, when made, may be in the form of stockoptions, restricted stock, unrestricted stock options, and dividend equivalentrights. The Stock Plans require the maximum term of options to be ten years.

Employee options generallyvest such that one third of the options will become exercisable on each of thefirst through third anniversaries of the date of grant of the options; however,the Administrator of the Stock Plans may determine, at its discretion, thevesting schedule for any option award. In the event of termination of theoptionees’ relationship with the Company, vested options not yet exercisedterminate within 90 days. The non-qualified options granted to independentdirectors are exercisable immediately and terminate ten years from the date ofthe grant. The exercise prices are the fair market value of the sharesunderlying the options on the respective dates of the grants. The Company issuesshares upon exercise of options from its treasury shares, if available.

The Company adopted SFAS No. 123(revised 2004), “Share-Based Payments”, (“FAS123(R)”) as of January 1,2006. FAS123(R) establishes standards for the accounting for transactionsin which an entity exchanges its equity instruments for goods or services.FAS123(R) requires the Company to measure the cost of employee servicesreceived in exchange for an award of equity instruments (usually stock options)based on the grant-date fair value of the award. That cost is recognized on astraight-line basis over the period during which an employee is required toprovide service in exchange for the award - the requisite service period(usually the vesting period).

The grant-date fair valueof employee share options and similar instruments is estimated using theBlack-Scholes option-pricing model. During the year ended December 31,2006, six grants of options for 256,520 shares were issued. The fair values ofthe stock options granted were estimated using the following components:

| ** **                           | ** ** | **Employees**   | ** **   | **Directors** | ** ** |
|--------------------------------------|------------|-----------------|--------------|---------------|------------|
| Fair value of options at  grant date |       | $               | 3.44 - $5.41 |          | $          | 3.96 - $4.60 |   |
| Risk free interest rate              |       | 4.63% - 4.88    | %            | 4.60% - 4.91  | %          |
| Estimated forfeiture  rate           |       | 0% - 1.65       | %            | 0             | %          |
| Estimated option term                |       | 5.0 - 9.0 years |         | 6.0 years     |       |
| Expected volatility                  |       | 25.1% - 27.3    | %            | 24.4% - 27.3  | %          |
|                                      |            |                 |              |               |            |  |  |

 

F-11

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**2.**   Significant Accounting Policies(Continued)

The expected volatility of the Company’s stock pricewas based on historical performance over the prior four to six years.

In the year ended December 31, 2006, the Companygranted 59,674 shares of restricted stock with an average fair market value of$11.86 per share. The stock vests evenly over three years upon the achievementof certain performance objectives to be determined by the Board of Directors atthe beginning of each fiscal year.

The allocation of stock compensation expense isconsistent with the allocation of the participants’ salary and othercompensation expenses.

TheCompany is using the modified prospective application (“MPA”) transition methodwithout restatement of prior interim periods in the year of adoption. Prior tothe adoption of FAS123(R) in fiscal 2006, the Company’s stock option planswere accounted for in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB No. 25”). The Company usedthe disclosure requirements of SFAS No. 123, “Accounting for Stock-BasedCompensation” (“FAS123”). Under APB No. 25, the Company did not recognizecompensation expense on stock options granted to employees, because theexercise price of each option was equal to the market price of the underlyingstock on the date of the grant. Had compensation cost for the Company’s stockoption awards and the stock purchase plan been determined based on the fairvalue at the grant dates for the awards under those plans, consistent with theprovisions of FAS123, the Company’s net income and net income per share for theyears ended December 31, 2004 and 2005 would have decreased to the proforma amounts indicated below:

| ** **                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2004**                                   | ** ** | **2005** | ** ** |
| Net income:                    |       |                                       |       |   |   |
| As reported                    |       | $                                          | 5,263      |   | $ | 12,052 |   |
| Pro forma                      |       | $                                          | 5,148      |   | $ | 11,866 |   |
| Basic net income per  share:   |       |                                       |       |   |   |
| As reported                    |       | $                                          | 0.41       |   | $ | 0.94 |   |
| Pro forma                      |       | $                                          | 0.41       |   | $ | 0.92 |   |
| Diluted net  income per share: |       |                                       |       |   |   |
| As reported                    |       | $                                          | 0.40       |   | $ | 0.91 |   |
| Pro forma                      |       | $                                          | 0.40       |   | $ | 0.89 |   |

 

*Useof Estimates.*   The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates.

*EarningsPer Share.*   The Company accounts for earnings pershare in accordance with SFAS No. 128, “Earnings Per Share” (“FAS 128”).FAS 128 requires the presentation of basic earnings per share (“EPS”) 

F-12

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**2.**   Significant Accounting Policies (Continued)

and diluted earnings pershare. Basic EPS includes no dilution and is computed by dividing net incomeavailable to common stockholders by the weighted-average number of commonshares outstanding for the period. Diluted EPS reflects the potential dilutionof securities that could share in the earnings of an entity. Diluted EPS hasbeen calculated using the treasury stock method.

*OtherComprehensive Income.*   The Company accounts forcomprehensive income in accordance with SFAS No. 130, “ReportingComprehensive Income” (“FAS 130”). This statement requires disclosure ofcomprehensive income and its components in interim and annual reports.Comprehensive income includes all changes in stockholders’ equity during aperiod except those resulting from investments by stockholders anddistributions to stockholders.

*FinancialInstruments.*   The Company accounts for derivativeinstruments in accordance with the provisions of SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities” (“FAS 133”), and Statementof Financial Accounting Standard No. 138, “Accounting for CertainDerivative Instruments and Certain Hedging Activities—an amendment of FAS No. 133”(“FAS 138”). These statements require the Company to recognize derivatives onits balance sheet at fair value. Derivatives that are not hedges must beadjusted to fair value through earnings. If the derivative is a hedge, changesin the fair value of derivatives will either be offset against the change infair value of the hedged assets, liabilities or firm commitments throughearnings or recognized in other comprehensive income until the hedged item isrecognized in earnings, depending on the intended use of the derivative. Theineffective portion of a derivative’s change in fair value will be immediatelyrecognized in earnings.

*ProductWarranties.*   The Company offers limited-durationwarranties on MicroFridge® products and, at the time of sale, provides reservesfor all estimated warranty costs based upon historical experience.  These amounts are included in Accrued expensesand Other liabilities on the Company’s balance sheets.

Theactivity for the year ended December 31, 2006 is as follows:

| ** **                             | ** ** | **Accrued**  | ** ** |
|----------------------------------------|------------|--------------|------------|
| ** **                             | ** ** | **Warranty** | ** ** |
| Balance,  December 31, 2004       |       |         | $          | 634 |   |   |
| Accruals for  warranties issued        |       |         | 277        |   |   |
| Settlements made  (in cash or in kind) |       |         | (344       | ) |   |
| Balance,  December 31, 2005       |       |         | 567        |   |   |
| Accruals for  warranties issued        |       |         | 193        |   |   |
| Settlements made  (in cash or in kind) |       |         | (304       | ) |   |
| Balance,  December 31, 2006       |       |         | $          | 456 |   |   |

 

*NewAccounting Pronouncements.****  ******In July 2006, the FASB issuedFASB Interpretation (“FIN”) No. 48, Accounting for Uncertainty in IncomeTaxes, which is an interpretation of SFAS No. 109. FIN 48 prescribes acomprehensive model for how a company should recognize, measure, present, anddisclose in its financial statements uncertain tax positions that the companyhas taken or expects to take on a tax return.***Under FIN48, the financial statements will reflect expected future tax consequences ofsuch positions presuming the taxing authorities’ full knowledge of the positionand all relevant facts, but without considering time values. FIN 48substantially changes the applicable accounting model and is likely to 

F-13

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**2.**   Significant Accounting Policies (Continued)

cause greater volatilityin income statements as more items are recognized discretely within income taxexpense. FIN 48 also revises disclosure requirements and introduces aprescriptive, annual, tabular roll-forward of the unrecognized tax benefits.The new accounting model for uncertain tax positions is effective for annualperiods beginning after December 15, 2006. Companies need to assess allmaterial open positions in all tax jurisdictions as of the adoption date anddetermine the appropriate amount of tax benefits that are recognizable underFIN 48. Any difference between the amounts previously recognized and thebenefit determined under the new guidance, including changes in accruedinterest and penalties, has to be recorded on the date of adoption. For certaintypes of income tax uncertainties, existing generally accepted accountingprinciples provide specific guidance on the accounting for modifications of therecognized benefit. Any differences in recognized tax benefits on the date ofadoption that are not subject to specific guidance would be an adjustment toretained earnings as of the beginning of the adoption period. The Company iscurrently reviewing this new accounting standard but does not expect it to havea material impact on its financial statements.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“FAS No. 157”). FAS No. 157 clarifies theprinciple that fair value should be based on the assumptions market participantswould use when pricing an asset or liability and establishes a fair valuehierarchy that prioritizes the information used to develop those assumptions.Under the standard, fair value measurements would be separately disclosed bylevel within the fair value hierarchy. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007, with early adoption permitted. TheCompany is currently reviewing this new accounting standard but does not expectit to have a material impact on its financial statements.

In February 2007, the FASB issuedSFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities, including an amendment of No. 115”(“FAS 159”), which is effective for fiscal years beginning after November 15,2007, with early adoption permitted. FAS 159 expands opportunities to usefair value measurements in financial reporting and permits entities to chooseto measure many financial instruments and certain other items at fair value.The Company is currently reviewing this new accounting standard and the impact,if any, it will have on its financial statements.

*Reclassifications.*   Certainamounts from prior years have been reclassified to conform to current yearpresentation.

**3.**   Impairment of Assets

The revenue andcorresponding operating income in the Company’s reprographics business unithave been declining since 1999 when college libraries, followed by publiclibraries, began to make reference material electronically available to patrons.Electronic availability, widespread conversion to laser printers (free ofcharge in many school libraries) and other technical advancements have led toreduced use of vended copy machines resulting in reduced revenue at severalaccounts. During the fourth quarter of 2006, the Company performed anevaluation of the reprographics business unit and its long-range prospects. Asa result of this evaluation, management determined that the carrying amount ofthe business unit’s long lived assets exceeded the estimated undiscounted cashflows expected to result from operating this business unit, and recognized anon-cash, non-recurring impairment charge of $2,502. This charge was calculatedin accordance with SFAS No. 144, “Accounting for the Impairment orDisposal of Long Lived Assets”, (“FAS 144”).

F-14

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**4.**   Acquisitions

On January 20, 2006, the Company acquired thelaundry facilities management assets of a regional operator in Southern NewEngland. On May 23, 2006, the Company acquired the laundry facilitiesmanagement assets of a regional operator in the Pennsylvania area. On July 7,2006, the Company acquired the laundry facilities management assets of aregional operator in Southern New England. On January 10, 2005, theCompany acquired the laundry facilities management assets of Web ServiceCompany, Inc., or “Web”, in several western and southern states. Theseacquisitions have been reflected in the accompanying condensed consolidatedfinancial statements from the date of the acquisition, and have been accountedfor as purchase business combinations in accordance with Statement of FinancialAccounting Standards No. 141, “Business Combinations”, (“FAS 141”). Thetotal purchase price for each of these acquisitions has been allocated to theacquired assets and liabilities based on estimates of their related fair value.For the Web assets acquired, a twenty-year amortization period has beenassigned to the acquired contract rights and a five-year depreciation period,on average, has been assigned to the acquired used laundry equipment. Theamount allocated to the Web trade name will not be amortized, as the Companybelieves it will use the name indefinitely. For the 2006 acquisitions, atwenty-year amortization period has been assigned to the acquired contractrights and the acquired used laundry equipment has been assigned a life rangingfrom two to five years.

Thetotal purchase price for each of these acquisitions, including assumedliabilities of  $7,500 related to the January 10,2005 acquisition, which consisted of accrued facilities management rent,accrued notes payable and deferred tax liabilities, was allocated as follows:

| ** **                     | ** ** | **January 10, 2005** | ** ** | **January 20, 2006** | ** ** | **May 23, 2006** | ** ** | **July 7, 2006** | ** ** |
|--------------------------------|------------|--------------------------------|------------|--------------------------------|------------|----------------------------|------------|----------------------------|------------|
| Contract Rights                |       |                           | $          | 71,858                         |       |                       |       | $                          | 10,730     |   |   |   | $ | 2,344 |   |   |   | $ | 2,939 |   |   |
| Goodwill                       |       |                           | —     |                           |       |                       | —     |                       |       |   | — |   |   |   | 513 |   |   |
| Equipment                      |       |                           | 25,099     |                           |       |                       | 885        |                       |       |   | 673 |   |   |   | 497 |   |   |
| Trade Name                     |       |                           | 12,650     |                           |       |                       | —     |                       |       |   | — |   |   |   | — |   |   |
| Accounts  Receivable           |       |                           | —     |                           |       |                       | —     |                       |       |   | 8 |   |   |   | — |   |   |
| Inventory                      |       |                           | 999        |                           |       |                       | 86         |                       |       |   | — |   |   |   | 39 |   |   |
| Accrued  Uncollected Cash      |       |                           | 3,900      |                           |       |                       | —     |                       |       |   | — |   |   |   | — |   |   |
| Furniture &  Fixtures |       |                           | 1,452      |                           |       |                       | —     |                       |       |   | — |   |   |   | 66 |   |   |
| Total Purchase Price           |       |                           | $          | 115,958                        |       |                       |       | $                          | 11,701     |   |   |   | $ | 3,025 |   |   |   | $ | 4,054 |   |   |

 

F-15

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**4.**   Acquisitions (Continued)

Thefollowing unaudited pro forma operating results of the Company assume the 2006acquisitions took place on January 1, 2005. Such information includesadjustments to reflect additional depreciation, amortization and interest expense,and is not necessarily indicative of what the results of operations would havebeen or the results of operations in future periods.

| ** **             | ** ** | **Year Ended**             | ** ** | **Year Ended**             | ** ** |
|------------------------|------------|---------------------------------|------------|---------------------------------|------------|
| ** **             | ** ** | **December 31, 2005** | ** ** | **December 31, 2006** | ** ** |
| Net revenue            |       |                            | $          | 271,451                         |       |   |   | $ | 281,655 |   |   |
| Net income             |       |                            | 12,485     |                            |       |   | 1,137 |   |   |
| Net income per  share: |       |                            |       |                            |       |   |   |   |   |
| Basic                  |       |                            | $          | 0.97                            |       |   |   | $ | 0.09 |   |   |
| Diluted                |       |                            | $          | 0.94                            |       |   |   | $ | 0.08 |   |   |

 

Throughout the year theCompany made certain other acquisitions for a combined purchase price of $576which was allocated to contract rights.

**5.**   Sale of Corporate Headquarters

On June 30, 2005, wecompleted the sale of our corporate headquarters in Cambridge, Massachusettsfor $11,800 in cash. We used the net proceeds from the sale to repay the $3,800balance of the mortgage loan on the property and repay $2,000 under the 2005senior credit facilities. Concurrently with the closing of the sale, we leasedthe property back from the purchaser until March 31, 2006 while werelocated our corporate, warehouse and branch operations to new facilities. Inconnection with this sale, in the second quarter of 2005 we recorded a gain ofapproximately $6,100, net of taxes.

**6.**   Long-Term Debt

In connection with the 2005 Acquisition, on January 10,2005, the Company and various lenders entered into senior credit facilitiesconsisting of an $80,000 term loan facility and a $120,000 revolving loanfacility, each of which was to mature on January 10, 2010. We used $80,000of the term loan facility (which was subsequently retired in August 2005as discussed below) and approximately $93,400 of the revolving loan facility tofinance the 2005 Acquisition, pay related costs and expenses, and repay theoutstanding obligations under and terminate our 2003 senior credit facilities.

On August 16, 2005, the Company restructured itslong-term debt by issuing senior unsecured notes in the amount of $150,000.These notes bear interest at 7.625% payable semi-annually each February andAugust. The maturity date of the notes is August 15, 2015. The seniorcredit facilities were amended to permit the offering of the notes and modifycertain of the covenants applicable to the senior credit facilities. Theproceeds from the senior notes, less financing costs, were used to retire theterm loan and pay down the revolver under the senior credit facilities.

F-16

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**6.**   Long-Term Debt (Continued)

On and after August 15,2010, the Company will be entitled, at its option, to redeem all or a portionof these notes at the redemption prices (expressed in percentages of principalamount on the redemption date), plus accrued interest to the redemption date,if redeemed, during the 12-month period commencing on August 15 ofthe years set forth below:

| **Period**          | ** ** | ** ** | ** ** | **Redemption  Price** | ** ** |
|---------------------|------------|------------|------------|-----------------------|------------|
| 2010                |       |       | 103.813    | %                     |       |
| 2011                |       |       | 102.542    | %                     |       |
| 2012                |       |       | 101.271    | %                     |       |
| 2013 and thereafter |       |       | 100.000    | %                     |       |

 

Subject to certain conditions, the Company will beentitled, at its option, on one or more occasions prior to August 15, 2008to redeem notes in an aggregate principal amount not to exceed 35% of theaggregate principal amount of the notes originally issued at a redemption price(expressed as a percentage of principal amount on the redemption date) of107.625%, plus accrued and unpaid interest to the redemption date, with the netcash proceeds from one or more equity offerings.

The terms of the senior notes include customarycovenants, including, but not limited to, restrictions pertaining to: (i) incurrenceof additional indebtedness and issuance of preferred stock; (ii) paymentof dividends on or making of distributions in respect of capital stock ormaking certain other restricted payments or investments; (iii) enteringinto agreements that restrict distributions from restricted subsidiaries; (iv) saleor other disposition of assets, including capital stock of restrictedsubsidiaries; (v) transactions with affiliates; (vi) incurrence ofliens; (vii) sale/leaseback transactions and (viii) merger,consolidation or sale of substantially all of our assets, in each case subjectto numerous baskets, exceptions and thresholds. The Company was in compliancewith these and all other financial covenants at December 31, 2006.

The terms of the senior notes provide for customaryevents of default, including, but not limited to: (i) failure to pay anyprincipal or interest when due, (ii) failure to comply with covenants andlimitations, (iii) certain insolvency or receivership events affecting usor any of our subsidiaries and (iv) unsatisfied material judgments, claimsor liabilities against us. There were no events of default under the seniornotes at December 31, 2006.

Effective December 29, 2006, the Company amendedits senior bank credit facilities, reducing the credit line to  $65,000 (with the option, subject tocustomary terms and conditions, to increase the line up to $100,000, inincrements of not less than $10,000, over the life of the facility), reducingthe interest rate on outstanding borrowings, modifying certaincovenants and extending the maturity date to December 29, 2011. Thesenior credit facilities are collateralized by a blanket lien on all of ourassets and our two main subsidiaries, Mac-Gray Services, Inc. and IntirionCorporation, as well as a pledge by us of all of the capital stock of our twosubsidiaries. Borrowings outstanding under the revolving line of credit bearinterest at a fluctuating rate equal to (i) in the case of Eurodollar rateloans, the LIBOR rate (adjusted for statutory reserves) plus an applicablepercentage, ranging from 1.00% to 1.50% (1.25% as of December 31, 2006)determined quarterly by reference to the funded debt ratio, or (ii) in thecase of alternate base rate loans and swing line loans, the higher of (a) thefederal funds rate plus 0.5% or (b) the annual rate of interest 

F-17

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**6.**   Long-Term Debt (Continued)

announced by JPMorganChase Bank, N.A. as its “prime rate,” in each case, plus an applicablepercentage, ranging from 0.00% to 0.50% (0.25% as of December 31, 2006),determined and payable quarterly by reference to the funded debt ratio. Underthe senior credit facilities, the Company pays a commitment fee equal to apercentage, ranging from 0.25% to 0.30%, determined and payable quarterly byreference to the funded debt ratio, of the average daily-unused portion of therevolver under the senior credit facility. This commitment fee percentage was0.275% as of December 31, 2006.

As of December 31, 2006, there was $24,000outstanding under the revolving line of credit and $760 in outstanding lettersof credit under the senior credit facilities. The available balance under therevolving line of credit was $40,240 at December 31, 2006. The averageinterest rate on the borrowings outstanding under the senior credit facilitiesat December 31, 2006 was approximately 5.9%, including the applicablespread paid to the banks.

The credit agreement for the senior credit facilitiesincludes customary covenants, including, but not limited to, restrictionspertaining to: (i) the incurrence of additional indebtedness, (ii) limitationson liens, (iii) making distributions, dividends and other payments, (iv) themaking of certain investments and loans, (v) mergers, consolidations andacquisitions, (vi) dispositions of assets, (vii) the maintenance ofminimum consolidated net worth, maximum funded debt ratios, minimumconsolidated cash flow coverage ratios, and maximum senior secured leverageratios, (viii) transactions with affiliates, (ix) sale and leasebacktransactions, (x) entering into swap agreements and (xi) changes togoverning documents, in each case subject to numerous baskets, exceptions andthresholds. The funded debt ratio, consolidated cash flow coverage ratio andsenior secured leverage ratio that the Company was required to meet as of December 31,2006 were 4.25 to 1.00, 1.10 to 1.00, and 2.50 to 1.00, respectively. TheCompany was in compliance with these and all other financial covenants at December 31,2006.

The credit agreement for the senior credit facilitiesprovides for customary events of default, including, but not limited to: (i) failureto pay any principal or interest when due, (ii) failure to comply withcovenants, (iii) any material representation or warranty made by theCompany proving to be incorrect in any material respect, (iv) defaultsrelating to or acceleration of other material indebtedness, (v) certaininsolvency or receivership events affecting the Company or any of its subsidiaries,(vi) a change in control, (vii) material judgments, claims orliabilities against the Company or (viii) a material defect in the lenders’lien against the collateral securing the obligations under the creditagreement. There were no events of default under the senior credit facilitiesat December 31, 2006.

Unamortized financing costs of  $183, $668 and $73, related to amendments tothe Company’s senior credit facilities, were expensed during the years ended December 31,2004, 2005 and 2006, respectively.

The weighted average interest rates of the Company’sborrowings under the senior credit facilities at December 31, 2005 and2006 were 5.44% and 5.94%, respectively.

Long-term debt also includes capital lease obligationson the company’s vehicles totaling $2,678 and $3,068 at December 31, 2005and 2006, respectively.

F-18

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**6.**   Long-Term Debt (Continued)

Required payments underthe Company’s long-term debt and capital lease obligations are as follows:

| ** ** | ** ** | **Amount** | ** ** |
|------------|------------|------------|------------|
| 2007       |       | $          | 1,237      |   |
| 2008       |       | 893        |       |
| 2009       |       | 612        |       |
| 2010       |       | 326        |       |
| 2011       |       | 24,000     |       |
| Thereafter |       | 150,000    |       |
|       |       | $          | 177,068    |   |

 

**7.**   Derivative Instruments

The Company entered into standard International Swapsand Derivatives Association (“ISDA”) interest rate swap agreements (the “SwapAgreements”) to manage the interest rate risk associated with its debt.Concurrent with the reduction of the amounts due under the senior creditfacilities, eight swap agreements previously designated as cash flow hedgesceased to qualify as such, of which four were terminated by the Company. Thechange in the fair value of the remaining four swap agreements that do notqualify for hedge accounting is recognized in the income statement in theperiod in which the change occurs. The change in the fair value of these fourcontracts resulted in a loss of $96 for the year ended December 31, 2006. Oneswap agreement continues to be designated as a cash flow hedge.

Thetable below outlines the details of each remaining swap agreement:

| ** **               | ** ** | ** **   | ** ** | ** ** | ** ** | **Notional**          | ** ** | ** **     | ** ** | ** ** | ** ** |
|--------------------------|------------|--------------|------------|------------|------------|-----------------------|------------|----------------|------------|------------|------------|
| ** **               | ** ** | **Original** | ** ** | ** ** | ** ** | **Amount**            | ** ** | ** **     | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Notional** | ** ** | **Fixed/** | ** ** | **December 31,** | ** ** | **Expiration** | ** ** | **Fixed**  | ** ** |
| **Date of  Origin** | ** ** | ** **   | ** ** | **Amount** | ** ** | **Amortizing**        | ** ** | **2006**       | ** ** | **Date**   | ** ** | **Rate** | ** ** |
| June 24,  2003      |       | $            | 20,000     |       | Amortizing |                  |       | $              | 10,000     |       |       | Jun 30, 2008 |   |   | 2.34 | % |   |
| June 24,  2003      |       | $            | 20,000     |       | Fixed      |                  |       | $              | 20,000     |       |       | Jun 30, 2008 |   |   | 2.69 | % |   |
| May 2, 2005         |       | $            | 17,000     |       | Fixed      | (1)                   |       | $              | —     |       |       | Dec 31, 2011 |   |   | 4.69 | % |   |
| May 2, 2005         |       | $            | 12,000     |       | Fixed      | (2)                   |       | $              | —     |       |       | Dec 31, 2009 |   |   | 4.66 | % |   |
| May 2, 2005         |       | $            | 10,000     |       | Fixed      | (2)                   |       | $              | —     |       |       | Dec 31, 2011 |   |   | 4.77 | % |   |
|                          |            |              |            |            |            |                       |            |                |            |            |            |  |  |  |  |  |  |  |  |

----

(1)          Effective Date isMarch 31, 2007

(2)          Effective Date isJune 30, 2008

F-19

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**7.**   Derivative Instruments (Continued)

In accordance with the Swap Agreements and on aquarterly basis, interest expense is calculated based on the floating 90-dayLIBOR and the fixed rate. If interest expense as calculated is greater based onthe 90-day LIBOR, the financial institution pays the difference to theCompany; if interest expense as calculated is greater based on the fixed rate,the Company pays the difference to the financial institution. Depending onfluctuations in the LIBOR, the Company’s interest rate exposure and its relatedimpact on interest expense and net cash flow may increase or decrease. Thecounter party to the swap agreements expose the Company to credit loss in theevent of non-performance; however, nonperformance is not anticipated.

The fair value of a Swap Agreement is the estimatedamount that the Company would receive or pay to terminate the agreement at thereporting date, taking into account current interest rates and the creditworthiness of the counter party. At December 31, 2005 and 2006, the fairvalues of the Swap Agreements were $1,647 and $1,335, respectively. Theseamounts have been included in other assets on the consolidated balance sheets.

The changes in accumulated other comprehensive incomerelate entirely to the Company’s interest rate swap agreement which isaccounted for as a cash flow hedge. If the Company were to change its hedgingstrategy, it would recognize a gain of approximately $336 based on the fairvalue of this Swap Agreement at December 31, 2006.

The componentsof other comprehensive income are as follows:

| ** **                                                   | ** ** | **For the years ended  December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                                                  | ** ** | **2005** | ** ** | **2006** | ** ** |
| Unrealized gain  (loss) on derivative****instruments         |       | $                                                         | 622        |   | $ | 835 |   | $ | (216 | ) |
| Reclassification  adjustment                                 |       | 1,368                                                     |       | (1,680 | ) | — |   |
| Total other  comprehensive income (loss) before income taxes |       | 1,990                                                     |       | (845 | ) | (216 | ) |
| Income tax  expense (benefit)                                |       | (796                                                      | )          | 338 |   | 84 |   |
| Total other  comprehensive income (loss)                     |       | $                                                         | 1,194      |   | $ | (507 | ) | $ | (132 | ) |

 

F-20

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**8.**   Prepaid Facilities ManagementRent and Other Current Assets

Prepaidfacilities management rent and other current assets consist of the following:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Prepaid  facilities managment rent |       | $                     | 3,576      |   | $ | 3,852 |   |
| Supplies                           |       | 2,997                 |       | 2,749 |   |
| Leases receivable                  |       | 1,259                 |       | 727 |   |
| Interest  receivable               |       | —                |       | 90 |   |
| Due from vendor                    |       | —                |       | 604 |   |
| Sales tax  reimbursement           |       | —                |       | 107 |   |
| Income tax  receivable             |       | 1,138                 |       | 3,406 |   |
| Prepaid insurance                  |       | 392                   |       | 641 |   |
| Other                              |       | 524                   |       | 775 |   |
|                               |       | $                     | 9,886      |   | $ | 12,951 |   |

 

**9.**   Prepaid Facilities ManagementRent and Other Assets

Prepaid facilities management rent and other assetsconsist of the following:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Prepaid  facilities managment rent |       | $                     | 8,508      |   | $ | 10,032 |   |
| Leases receivable                  |       | 1,301                 |       | 1,005 |   |
| Notes receivable                   |       | 478                   |       | 303 |   |
| Deposits                           |       | 593                   |       | 851 |   |
| Derivative  instruments            |       | 1,647                 |       | 1,335 |   |
| Other                              |       | 650                   |       | 508 |   |
|                               |       | $                     | 13,177     |   | $ | 14,034 |   |

 

F-21

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**10.**   Property, Plant and Equipment

Property, plant and equipment consist of thefollowing:

| ** **                                                  | ** ** | **Estimated**        | ** ** | **December 31** | ** ** |
|-------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                  | ** ** | **Useful Life** | ** ** | **2005**             | ** ** | **2006** | ** ** |
| Facilities management  equipment                            |       | 5-10 years           |       | $                    | 214,588    |   | $ | 211,750 |   |
| Facilities management  improvements                         |       | 7-10 years           |       | 11,078               |       | 12,110 |   |
| Buildings and  improvements                                 |       | 15-39 years          |       | 1,479                |       | 1,607 |   |
| Furniture, fixtures and  computer equipment                 |       | 2-7 years            |       | 12,321               |       | 13,362 |   |
| Trucks and autos                                            |       | 3-5 years            |       | 6,699                |       | 7,525 |   |
| Tooling costs                                               |       | 3 years              |       | 422                  |       | 422 |   |
| Land and improvements                                       |       | —               |       | 77                   |       | 77 |   |
|                                                        |       |                 |       | 246,664              |       | 246,853 |   |
| Less: accumulated  depreciation                             |       |                 |       | 131,630              |       | 131,463 |   |
|                                                        |       |                 |       | 115,034              |       | 115,390 |   |
| Facilities management  equipment, not yet placed in service |       |                 |       | 3,425                |       | 3,264 |   |
| Property, plant and  equipment, net                         |       |                 |       | $                    | 118,459    |   | $ | 118,654 |   |

 

During 2006, the Company reduced the cost andaccumulated depreciation of facilities management equipment by approximately$12,776 representing assets that were fully depreciated and no longer inservice at year end.

Depreciation of property, plant and equipment totaled$19,254, $26,409 and $29,615 for the years ended December 31, 2004, 2005and 2006, respectively.

At December 31, 2005and 2006, trucks and autos included $6,577 and $7,463, respectively, ofequipment under capital lease with an accumulated amortization balance of$3,899 and $4,395, respectively.

F-22

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**11.**   Goodwill and Intangible Assets

Goodwilland intangible assets consist of the following:

| ** **               | ** ** | **As of December 31, 2005** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Cost**                                        | ** ** | **Accumulated  Amortization** | ** ** | **Net Book Value** | ** ** |
| Goodwill:                |       |                                            |       |   |   |   |   |   |   |   |   |
| Facilities Management    |       | $                                               | 37,718     |   |   |   |   |   |   | $ | 37,718 |   |   |
| Product Sales            |       | 223                                             |       |   |   |   |   |   | 223 |   |   |
|                     |       | $                                               | 37,941     |   |   |   |   |   |   | $ | 37,941 |   |   |
| Intangible assets:       |       |                                            |       |   |   |   |   |   |   |   |   |
| Facilities  Management:  |       |                                            |       |   |   |   |   |   |   |   |   |
| Trade Name               |       | $                                               | 12,650     |   |   | $ | — |   |   |   | $ | 12,650 |   |   |
| Non-compete agreements   |       | 4,580                                           |       |   | 4,095 |   |   |   | 485 |   |   |
| Contract rights          |       | 109,755                                         |       |   | 12,344 |   |   |   | 97,411 |   |   |
| Product Sales:           |       |                                            |       |   |   |   |   |   |   |   |   |
| Customer lists           |       | 1,451                                           |       |   | 734 |   |   |   | 717 |   |   |
| Deferred financing costs |       | 5,923                                           |       |   | 393 |   |   |   | 5,530 |   |   |
|                     |       | $                                               | 134,359    |   |   | $ | 17,566 |   |   |   | $ | 116,793 |   |   |

 

| ** **               | ** ** | **As of December 31, 2006** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **Cost**                                        | ** ** | **Accumulated  Amortization** | ** ** | **Net Book Value** | ** ** |
| Goodwill:                |       |                                            |       |   |   |   |   |   |   |   |   |
| Facilities Management    |       | $                                               | 38,231     |   |   |   |   |   |   | $ | 38,231 |   |   |
| Product Sales            |       | 223                                             |       |   |   |   |   |   | 223 |   |   |
|                     |       | $                                               | 38,454     |   |   |   |   |   |   | $ | 38,454 |   |   |
| Intangible assets:       |       |                                            |       |   |   |   |   |   |   |   |   |
| Facilities  Management:  |       |                                            |       |   |   |   |   |   |   |   |   |
| Trade Name               |       | $                                               | 12,650     |   |   | $ | — |   |   |   | $ | 12,650 |   |   |
| Non-compete agreements   |       | 4,041                                           |       |   | 3,861 |   |   |   | 180 |   |   |
| Contract rights          |       | 125,437                                         |       |   | 18,290 |   |   |   | 107,147 |   |   |
| Product Sales:           |       |                                            |       |   |   |   |   |   |   |   |   |
| Customer lists           |       | 1,451                                           |       |   | 830 |   |   |   | 621 |   |   |
| Deferred financing costs |       | 5,996                                           |       |   | 1,051 |   |   |   | 4,945 |   |   |
|                     |       | $                                               | 149,575    |   |   | $ | 24,032 |   |   |   | $ | 125,543 |   |   |

 

Included in Intangible Assets is the deferred taxbenefit of the difference between the book and tax basis of the assets acquiredin the 2005 Acquisition. The Intangible Asset is amortized over 15 years as thetax benefit is realized.

F-23

----

**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**11.**   Goodwill and Intangible Assets (Continued)

Estimated futureamortization expense of intangible assets consists of the following:

| 2007       |   | $      | 7,308   |   |
|------------|--------|--------|---------|--------|
| 2008       |   | 7,263  |    |
| 2009       |   | 7,158  |    |
| 2010       |   | 6,953  |    |
| 2011       |   | 6,587  |    |
| Thereafter |   | 75,309 |    |
|       |   | $      | 110,578 |   |

 

Amortization expense ofintangible assets for the years ended December 31, 2004, 2005 and 2006 was$2,540, $6,117 and $7,130, respectively.

**12.**   Accrued Expenses

Accruedexpenses consist of the following:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Accrued interest                                   |       | $                     | 4,508      |   | $ | 4,448 |   |
| Accrued  salaries/benefits                         |       | 145                   |       | 248 |   |
| Accrued  partnership note                          |       | 1,284                 |       | — |   |
| Accrued  commission/bonuses                        |       | 2,237                 |       | 2,514 |   |
| Accrued expenses  on corporate office buildout     |       | 539                   |       | — |   |
| Accrued warranty                                   |       | 268                   |       | 216 |   |
| Deferred service  revenue                          |       | 84                    |       | 29 |   |
| Deferred smart  card revenue                       |       | 925                   |       | 456 |   |
| Accrued rent                                       |       | —                |       | 446 |   |
| Current portion  of deferred retirement obligation |       | 104                   |       | 104 |   |
| Accrued  professional fees                         |       | 261                   |       | 498 |   |
| Accrued personal  property taxes                   |       | 783                   |       | 816 |   |
| Accrued sales tax                                  |       | 470                   |       | 417 |   |
| Accrued benefit  insurance                         |       | 635                   |       | 941 |   |
| Other accrued  expenses                            |       | 229                   |       | 312 |   |
|                                               |       | $                     | 12,472     |   | $ | 11,445 |   |

 

F-24

----

**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**13.**   Deferred Retirement Obligation

The deferred retirementobligation at December 31, 2005 and 2006 relates to payments due to aformer shareholder of the Company in connection with a retirement agreement,which provides for annual payments of $104 until the death of the formershareholder. The liability has been estimated based upon the life expectancy ofthe former shareholder utilizing actuarial tables.

**14.**   Income Taxes

Theprovision for state and federal income taxes consists of the following:

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2006** | ** ** |
| Current state       |       | $                                           | 299        |   | $ | 1,074 |   | $ | (223 | ) |
| Deferred state      |       | 714                                         |       | 623 |   | 340 |   |
| Current federal     |       | 170                                         |       | 5,368 |   | (380 | ) |
| Deferred federal    |       | 2,751                                       |       | 1,498 |   | 410 |   |
| Total income  taxes |       | $                                           | 3,934      |   | $ | 8,563 |   | $ | 147 |   |

 

Thenet deferred tax liability in the accompanying balance sheets includes thefollowing amounts of deferred tax assets and liabilities at December 31:

| ** **                                      | ** ** | **2005** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Current deferred tax  assets (liabilities):     |       |     |       |     |       |
| Derivative instrument interest                  |       | $        | (430       | )        | $          | — |   |
| Accounts receivable                             |       | 183      |       | 161      |       |
| Inventory                                       |       | 139      |       | 161      |       |
| Accrued bonus                                   |       | 569      |       | 574      |       |
| Deferred compensation                           |       | 128      |       | 41       |       |
| Warranty Reserve                                |       | 139      |       | —   |       |
| Long term lease receivable reserve              |       | 48       |       | —   |       |
| Other                                           |       | 133      |       | 24       |       |
|                                            |       | 909      |       | 961      |       |
| Non-current deferred  tax liabilities (assets): |       |     |       |     |       |
| Depreciation                                    |       | 23,427   |       | 22,077   |       |
| Amortization                                    |       | 3,977    |       | 6,874    |       |
| Sales-type leases                               |       | 1,235    |       | 481      |       |
| Derivative instrument interest                  |       | —   |       | 392      |       |
| Other                                           |       | 371      |       | (204     | )          |
|                                            |       | 29,010   |       | 29,620   |       |
| Net deferred tax  liabilities                   |       | $        | 28,101     |     | $          | 28,659 |   |

 

F-25

----

**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**14.**   Income Taxes (Continued)

For the years ended December 31,2004, 2005 and 2006 the statutory income tax rate differed from the effectiverate primarily as a result of the following differences:

| ** **                                  | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Taxes computed at  federal statutory rate   |       | 34.0     | %          | 35.0     | %          | 34.0     | %          |
| State income  taxes, net of federal benefit |       | 6.7      |       | 5.3      |       | 7.8      |       |
| Tax return  reassessments and settlements   |       | —   |       | —   |       | (40.0    | )          |
| Meals &  entertainment             |       | 0.7      |       | 0.5      |       | 10.1     |       |
| Other                                       |       | 1.4      |       | 0.7      |       | 2.8      |       |
| Income tax  provision                       |       | 42.8     | %          | 41.5     | %          | 14.7     | %          |

 

A valuation allowance against the deferred tax assetsat the balance sheet date is not considered necessary because the deferred taxasset will, more likely than not, be fully realized.

During February of2007, the Company received notice that the Internal Revenue Service (IRS) willbe auditing the 2004 tax return. Any impact on the Corporation’s liability forincome taxes cannot presently be determined, but the Corporation believesadequate provision has been made for potential adjustments.

**15.**   Preferred Stock Purchase Rights

Pursuant to the terms of a Shareholder RightsAgreement (the “Rights Agreement”), the Board of Directors declared adistribution on June 15, 1999 of one Preferred Stock Purchase Right (a “Right”)for each outstanding share of Common Stock of the Company (the “Common Stock”).Under certain circumstances, each Right entitles the holder thereof to purchasefrom the Company a unit consisting of one ten thousandth of a share (a “Unit”)of Series A Junior Participating Cumulative Preferred Stock, par value$.01 per share (the “Preferred Stock”), at a cash exercise price of $80.00 perUnit, subject to adjustment. The Rights are not exercisable and are attached toand trade with all shares of Common Stock until the earlier to occur of (i) 10days following the first public announcement that a person or group ofaffiliated or associated persons has acquired beneficial ownership of 15% ormore of the outstanding shares of Common Stock (an “Acquiring Person”) ( thedate of said announcement being referred to as the “Stock Acquisition Date”), (ii) 10business days following the commencement of a tender offer or exchange offerthat could result upon its consummation in a person or group becoming thebeneficial owner of 15% or more of the outstanding shares of Common Stock or (iii) thedetermination by the Board of Directors that any person is an “Adverse Person”as defined in the Rights Agreement. The Rights will expire at the close ofbusiness on June 15, 2009 (the “Expiration Date”), unless previously redeemedor exchanged by the Company as described below. The Rights are not entitled tovote or to receive dividends.

In the event that a Stock Acquisition Date occurs orthe Board of Directors determines that a person is an Adverse Person, eachRight will be entitled to receive upon exercise that number of Units ofPreferred Stock of the Company having a market value of two times the exerciseprice of the Right. In the event that, at any time following the StockAcquisition Date, (i) the Company merges with and into any other person,and the Company is not the continuing or surviving corporation, (ii) anyperson merges with and into the Company and the Company is the continuing orsurviving corporation of such merger and, in 

F-26

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**15.**   Preferred Stock Purchase Rights (Continued)

connection with suchmerger, all or part of the shares of Common Stock are changed into or exchangedfor securities of any other person or cash or any other property, or (iii) 50%or more of the Company’s assets or earning power is sold, each Right will beentitled to receive, upon exercise, common stock of the acquiring companyhaving a market value equal to two times the exercise price of the Right.Rights that are or were beneficially owned by an Acquiring Person or an AdversePerson may (under certain circumstances specified in the Rights Agreement)become null and void.

The Rights may be redeemedin whole, but not in part, at a price of $0.01 per Right by the Board ofDirectors only until the earliest of (i) the time at which a person isdeclared to be an Adverse Person, (ii) the time at which any personbecomes an Acquiring Person, or (iii) the Expiration Date.

**16.**   Segment Information

The Company operates four business units which arebased on the Company’s different product and service categories: LaundryFacilities Management, Laundry Equipment Sales, MicroFridge® and Reprographics.These four business units constitute two reportable segments (“FacilitiesManagement” and “Product Sales”). The Facilities Management segment includestwo business units: Laundry Facilities Management and Reprographics. TheLaundry Facilities Management business unit provides card- and coin-operatedlaundry equipment to multi-unit housing facilities such as apartment buildings,colleges and universities and public housing complexes. The Reprographicsbusiness unit provides card- and coin-operated copiers to academic and publiclibraries. The Product Sales segment includes two business units: MicroFridge®and Laundry Equipment Sales. The MicroFridge® business unit revenue includessales of its own patented and proprietary line ofrefrigerator/freezer/microwave oven combinations to a customer base whichincludes hospitality and assisted living facilities, military housing andcolleges and universities. The Laundry Equipment Sales business unit operatesas a distributor of, and provides service to, commercial laundry equipment inpublic laundromats, as well as for institutional purchasers, includinghospitals, hotels and the United States military for use in their ownon-premise laundry facilities.

There are no intersegment revenues.

F-27

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**16.**   Segment Information (Continued)

The tables below presentinformation about the operations of the reportable segments of Mac-Gray for theyears ended December 31, 2004, 2005 and 2006. The information presentedrepresents the key financial metrics that are utilized by the Company’s seniormanagement in assessing the performance of each of the Company’s reportablesegments. For comparative purposes the Company has reclassified its revenuesand gross margins for the year ended December 31, 2004 into the Company’scurrent Facilities Management and Product Sales segments.

| ** **                                     | ** ** | **For the years ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2004**                                                      | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenue:                                       |       |                                                          |       |   |   |   |   |
| Facilities management                          |       | $                                                             | 140,480    |   | $ | 214,816 |   | $ | 232,181 |   |
| Product sales                                  |       | 42,214                                                        |       | 45,807 |   | 47,146 |   |
| Total                                          |       | 182,694                                                       |       | 260,623 |   | 279,327 |   |
| Gross margin:                                  |       |                                                          |       |   |   |   |   |
| Facilities management                          |       | 26,833                                                        |       | 41,818 |   | 43,533 |   |
| Product sales                                  |       | 10,781                                                        |       | 9,243 |   | 9,425 |   |
| Total                                          |       | 37,614                                                        |       | 51,061 |   | 52,958 |   |
| Selling, general  and administration expenses  |       | 25,130                                                        |       | 31,450 |   | 35,663 |   |
| Impairment of  assets                          |       | —                                                        |       | — |   | 2,502 |   |
| Loss on early  extinguishment of debt          |       | 183                                                           |       | 668 |   | 73 |   |
| Gain on sale of  assets                        |       | (1,208                                                        | )          | (10,735 | ) | (32 | ) |
| (Gain) loss  related to derivative instruments |       | —                                                        |       | (1,876 | ) | 96 |   |
| Interest and  other expenses, net              |       | 4,312                                                         |       | 10,939 |   | 13,653 |   |
| Income before provision  for income taxes      |       | $                                                             | 9,197      |   | $ | 20,615 |   | $ | 1,003 |   |

 

Certain operating expenses in 2004 and 2005 which werepreviously included in Cost of Facilities Management revenue have beenreclassified to cost of sales for the Product Sales segment to conform to 2006’spresentation. The revised classification of $947 and $1,104 for the years endedDecember 31, 2004 and 2005, respectively, consists of salaries, warehousing and other operating expenses thatsupport the Laundry Equipment Sales business unit within the Product Salessegment.

Therevised classification is as follows:

| ** **            | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------|------------|---------------------------------------------------------------|------------|
| ** **            | ** ** | **2004**                                                      | ** ** | **2005** | ** ** |
| ** **            | ** ** | **As Reported**                                          | ** ** | **Reclassified** | ** ** | **As Reported** | ** ** | **Reclassified** | ** ** |
| Revenue:              |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Facilities management |       |                                                          | $          | 140,480 |   |   |   | $ | 140,480 |   |   |   | $ | 214,816 |   |   |   | $ | 214,816 |   |   |
| Product sales         |       |                                                          | 42,214     |   |   |   | 42,214 |   |   |   | 45,807 |   |   |   | 45,807 |   |   |
| Total                 |       |                                                          | 182,694    |   |   |   | 182,694 |   |   |   | 260,623 |   |   |   | 260,623 |   |   |
| Gross margin:         |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Facilities management |       |                                                          | 25,886     |   |   |   | 26,833 |   |   |   | 40,714 |   |   |   | 41,818 |   |   |
| Product sales         |       |                                                          | 11,728     |   |   |   | 10,781 |   |   |   | 10,347 |   |   |   | 9,243 |   |   |
| Total                 |       |                                                          | $          | 37,614 |   |   |   | $ | 37,614 |   |   |   | $ | 51,061 |   |   |   | $ | 51,061 |   |   |

 

F-28

----

**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**16.**   SegmentInformation (Continued)

| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2005**              | ** ** | **2006** | ** ** |
| Assets                        |       |                  |       |   |   |
| Facilities management         |       | $                     | 282,698    |   | $ | 293,749 |   |
| Product sales                 |       | 23,757                |       | 25,973 |   |
| Total for reportable segments |       | 306,455               |       | 319,722 |   |
| Corporate(1)                  |       | 17,553                |       | 18,321 |   |
| Deferred income taxes         |       | 909                   |       | 961 |   |
| Total assets                  |       | $                     | 324,917    |   | $ | 339,004 |   |

----

(1)          Principallycash and cash equivalents, prepaid expenses and property, plant &equipment not included elsewhere.

**17.**   Commitments and Contingencies

The Company is involved in various litigationproceedings arising in the normal course of business. In the opinion ofmanagement, the Company’s ultimate liability, if any, under pending litigationwould not materially affect its financial condition or the results of itsoperations.

*Leases.*   TheCompany leases certain equipment and facilities under non-cancelable operatingleases. The Company also leases certain vehicles under capital leases.

Futureminimum lease payments under non-cancelable operating and capital leasesconsist of the following:

| ** **                                                                      | ** ** | **Capital** | ** ** | **Operating** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------|------------|---------------|------------|
| ** **                                                                      | ** ** | **Leases**  | ** ** | **Leases**    | ** ** |
| Year ended  December 31,                                                   |       |        |       |          |       |   |   |
| 2007                                                                            |       | $           | 1,421      |          |       | $ | 2,459 |   |   |
| 2008                                                                            |       | 1,026       |       |          | 2,203      |   |   |
| 2009                                                                            |       | 704         |       |          | 2,009      |   |   |
| 2010                                                                            |       | 374         |       |          | 1,959      |   |   |
| 2011                                                                            |       | —      |       |          | 1,598      |   |   |
| Thereafter                                                                      |       | —      |       |          | 5,462      |   |   |
|                                                                            |       | 3,525       |       |          | $          | 15,690 |   |   |
| Less: amount representing interest (LIBOR of 5.320%  at December 31, 2006) |       | 457         |       |          |       |   |   |
|                                                                            |       | 3,068       |       |          |       |   |   |
| Present value future minimum lease payments less  amounts due within one year   |       | 1,245       |       |          |       |   |   |
| Amounts due after one  year                                                     |       | $           | 1,823      |          |       |   |   |   |

 

Rent expense incurred by the Company undernon-cancelable operating leases totaled $1,409, $2,439 and $3,221 for the yearsended December 31, 2004, 2005 and 2006, respectively.

F-29

----

**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**17.**   Commitments and Contingencies (Continued)

*GuaranteedFacilities Management Rent Payments.*   The Companyoperates card- and coin-operated facilities management laundry rooms undervarious lease agreements in which the Company is required to make minimum guaranteedrent payments to the respective lessors. The following is a schedule by yearsof future minimum guaranteed rent payments required under these leaseagreements that have initial or remaining non-cancelable contract terms inexcess of one year as of December 31, 2006:

| 2007       |   | $     | 7,362  |   |
|------------|--------|-------|--------|--------|
| 2008       |   | 6,123 |   |
| 2009       |   | 4,851 |   |
| 2010       |   | 4,190 |   |
| 2011       |   | 2,840 |   |
| Thereafter |   | 4,353 |   |
|       |   | $     | 29,719 |   |

 

**18.**   Employee Benefit and Stock Plans

*RetirementPlans.*   The Company maintains a qualifiedprofit-sharing/401(k) plan (the “Plan”) covering substantially allemployees. The Company’s contributions to the Plan are at the discretion of theBoard of Directors. Costs under the Plan amounted to $644, $1,046 and $1,122for the years ended December 31, 2004, 2005 and 2006, respectively.

*StockOption and Incentive Plans.*   On April 7,1997, the Board of Directors adopted, and the Company’s stockholders approved,the 1997 Stock Option and Incentive Plan for the Company (the “1997 Stock Plan”).On May 26, 2005, the Board of Directors adopted, and the Company’sstockholders approved, the 2005 Stock Option and Incentive Plan for the Company(the “2005 Stock Plan”; together the “Stock Plans”). The Stock Plans aredesigned and intended as a performance incentive for officers, employees,consultants and directors to promote the financial success and progress of theCompany. All officers, employees and independent directors are eligible toparticipate in the Stock Plans. Awards, when made, may be in the form of stockoptions, restricted stock, unrestricted stock options, and dividend equivalentrights. The Stock Plans require the maximum term of options to be ten years.

Employee options generally vest such that one third ofthe options will become exercisable on each of the first through thirdanniversaries of the date of grant of the options; however, the Administratorof the Stock Plans may determine, at its discretion, the vesting schedule forany option award. In the event of termination of the optionees’ relationshipwith the Company, vested options not yet exercised terminate within 90 days.The Stock Plans also provide for the automatic annual grant to each of theindependent directors to purchase 7,500 shares of common stock. Thenon-qualified options granted to independent directors are exercisableimmediately and will terminate on the tenth anniversary of the grant. Theexercise prices are the fair market value of the shares underlying the optionson the respective dates of the grants.

F-30

----

**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**18.**   Employee Benefit and Stock Plans (Continued)

At December 31, 2006, the stock plans provide forthe issuance of up to 2,607,769 shares of common stock. At December 31,2006, approximately 1,966,720 shares of common stock were reserved for issuanceunder the Stock Plans, of which 1,210,640 shares were subject to outstandingoptions, 436,983 shares were issued pursuant to the exercise of optionagreements and 319,097 remained available for issuance.

The following is a summaryof stock option plan activity:

| ** **                      | ** ** | **2004**   | ** ** | **2005**     | ** ** | **2006**   | ** ** |
|---------------------------------|------------|------------|------------|--------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Average**  | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** | ** ** | ** ** | **Exercise** | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Shares** | ** ** | **Price** | ** ** | **Shares** | ** ** | **Price** | ** ** |
| Outstanding, beginning  of year |       | 1,055,400  |       |         | $          | 4.01       |       |   | 914,367 |   |   | $ | 4.24 |   |   | 1,123,284 |   |   | $ | 5.60 |   |   |
| Granted                         |       | 72,000     |       |         | $          | 6.43       |       |   | 363,200 |   |   | $ | 8.76 |   |   | 256,520 |   |   | $ | 11.77 |   |   |
| Exercised                       |       | (172,833   | )          |         | $          | 3.61       |       |   | (104,583 | ) |   | $ | 3.75 |   |   | (129,967 | ) |   | $ | 4.54 |   |   |
| Forfeited                       |       | (40,200    | )          |         | $          | 4.95       |       |   | (49,700 | ) |   | $ | 7.55 |   |   | (39,197 | ) |   | $ | 8.29 |   |   |
| Outstanding, end of year        |       | 914,367    |       |         | $          | 4.24       |       |   | 1,123,284 |   |   | $ | 5.60 |   |   | 1,210,640 |   |   | $ | 6.93 |   |   |
| Exercisable, end of year        |       | 719,035    |       |         | $          | 4.18       |       |   | 768,785 |   |   | $ | 4.35 |   |   | 817,860 |   |   | $ | 5.38 |   |   |

 

| ** **      | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-----------------|------------|------------------------------|------------|------------------------------|------------|
| ** **      | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **      | ** ** | **Number**                   | ** ** | **Average**                  | ** ** | **Average** | ** ** | **Number** | ** ** | **Average** | ** ** |
| ** **      | ** ** | **Outstanding**              | ** ** | **Remaining**                | ** ** | **Exercise** | ** ** | **Exercisable** | ** ** | **Exercise** | ** ** |
| ** **      | ** ** | **at 12/31/06**         | ** ** | **Contractual Life**    | ** ** | **Price** | ** ** | **at 12/31/06** | ** ** | **Price** | ** ** |
| $3.00 - $4.54   |       |                         | 511,720    |                         |       |   | 4.78 |   |   |   | $ | 3.55 |   |   |   | 511,720 |   |   |   | $ | 3.55 |   |   |
| $4.55 - $7.56   |       |                         | 97,100     |                         |       |   | 7.08 |   |   |   | $ | 5.50 |   |   |   | 90,900 |   |   |   | $ | 5.44 |   |   |
| $7.57 - $10.00  |       |                         | 339,300    |                         |       |   | 7.42 |   |   |   | $ | 8.70 |   |   |   | 159,240 |   |   |   | $ | 8.66 |   |   |
| $10.01 - $15.13 |       |                         | 262,520    |                         |       |   | 9.38 |   |   |   | $ | 11.77 |   |   |   | 56,000 |   |   |   | $ | 12.60 |   |   |
|            |       |                         | 1,210,640  |                         |       |   | 6.70 |   |   |   | $ | 6.93 |   |   |   | 817,860 |   |   |   | $ | 5.38 |   |   |

 

*Mac-GrayCorporation 2001 Employee Stock Purchase Plan.*   TheCompany established the Mac-Gray Corporation 2001 Employee Stock Purchase Plan(the “ESPP”) in May of 2001. Under the terms of the ESPP, eligibleemployees may have between 1% and 15% of eligible compensation deducted fromtheir pay to purchase common stock. The per share purchase price is 85% of thefair market value of the stock on, the lower of, the first day or the last dayof each six month interval. Up to 200,000 shares may be offered pursuant to theESPP. The plan includes certain restrictions, such as the holding period of thestock by employees. The number of shares of common stock purchased through theESPP was 31,610 and 17,534 for the years ended December 31, 2005 and 2006,respectively. There have been 124,429 shares purchased since the inception ofthe plan. At December 31, 2005 and 2006 the Company had accumulatedemployee withholdings associated with this plan of $142 and $330 foracquisition of stock in 2006 and 2007, respectively.

F-31

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**19.**   Earnings Per Share

| ** **                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                                   | ** ** | **2005** | ** ** | **2006** | ** ** |
| Net income                                                         |       | $                                          | 5,263      |   | $ | 12,052 |   | $ | 856 |   |
| Weighted average  number of common shares outstanding—basic   |       | 12,702                                     |       | 12,864 |   | 13,008 |   |
| Effect of dilutive  securites:                                     |       |                                       |       |   |   |   |   |
| Stock options                                                      |       | 326                                        |       | 419 |   | 440 |   |
| Weighted average  number of common shares outstanding—diluted |       | 13,028                                     |       | 13,283 |   | 13,448 |   |
| Net income per share—basic                                    |       | $                                          | 0.41       |   | $ | 0.94 |   | $ | 0.07 |   |
| Net income per share—diluted                                  |       | $                                          | 0.40       |   | $ | 0.91 |   | $ | 0.06 |   |

 

There were 57, 1, and 253shares under option plans that were excluded from the computation of dilutedearnings per share at December 31, 2004, 2005 and 2006, respectively, dueto their anti-dilutive effects.

**20.**   Summary of Quarterly FinancialInformation (unaudited)

| ** **                                               | ** ** | **Year Ended December 31, 2005** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                               | ** ** | **1st Qtr**                                     | ** ** | **2nd Qtr** | ** ** | **3rd Qtr** | ** ** | **4th Qtr** | ** ** | **Total** | ** ** |
| Revenue                                                  |       | $                                                    | 62,373     |   | $ | 63,383 |   | $ | 65,573 |   | $ | 69,294 |   | $ | 260,623 |   |
| Cost of revenue                                          |       | 49,252                                               |       | 51,351 |   | 53,930 |   | 55,029 |   | 209,562 |   |
| Gross margin                                             |       | 13,121                                               |       | 12,032 |   | 11,643 |   | 14,265 |   | 51,061 |   |
| Operating  expenses                                      |       | 7,890                                                |       | (3,216 | ) | 7,826 |   | 8,883 |   | 21,383 |   |
| Income from  operations                                  |       | 5,231                                                |       | 15,248 |   | 3,817 |   | 5,382 |   | 29,678 |   |
| Interest and  other expense, net                         |       | (2,272                                               | )          | (2,553 | ) | (2,899 | ) | (3,215 | ) | (10,939 | ) |
| Gain related to  derivative instruments                  |       | —                                               |       | — |   | 1,659 |   | 217 |   | 1,876 |   |
| Income before  provision for income taxes                |       | 2,959                                                |       | 12,695 |   | 2,577 |   | 2,384 |   | 20,615 |   |
| Provision for  income taxes                              |       | 1,257                                                |       | 5,395 |   | 1,141 |   | 770 |   | 8,563 |   |
| Net income                                               |       | $                                                    | 1,702      |   | $ | 7,300 |   | $ | 1,436 |   | $ | 1,614 |   | $ | 12,052 |   |
| Net income per common share—basic                   |       | $                                                    | 0.13       |   | $ | 0.57 |   | $ | 0.11 |   | $ | 0.12 |   | $ | 0.94 |   |
| Net income per  common share—diluted                |       | $                                                    | 0.13       |   | $ | 0.55 |   | $ | 0.11 |   | $ | 0.12 |   | $ | 0.91 |   |
| Weighted average  common shares outstanding—basic   |       | 12,809                                               |       | 12,848 |   | 12,879 |   | 12,917 |   | 12,864 |   |
| Weighted average common  shares outstanding—diluted |       | 13,163                                               |       | 13,204 |   | 13,351 |   | 13,522 |   | 13,283 |   |

 

F-32

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**MAC-GRAY CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (In thousands, except per share data)**

**20.**   Summary of Quarterly Financial Information (unaudited)(Continued)

| ** **                                               | ** ** | **Year Ended December 31, 2006** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                               | ** ** | **1st Qtr**                                     | ** ** | **2nd Qtr** | ** ** | **3rd Qtr** | ** ** | **4th Qtr** | ** ** | **Total** | ** ** |
| Revenue                                                  |       | $                                                    | 67,698     |   | $ | 69,019 |   | $ | 70,003 |   | $ | 72,607 |   | $ | 279,327 |   |
| Cost of revenue                                          |       | 53,447                                               |       | 56,214 |   | 58,057 |   | 58,651 |   | 226,369 |   |
| Gross margin                                             |       | 14,251                                               |       | 12,805 |   | 11,946 |   | 13,956 |   | 52,958 |   |
| Operating  expenses                                      |       | 8,674                                                |       | 9,107 |   | 8,105 |   | 12,320 |   | 38,206 |   |
| Income from  operations                                  |       | 5,577                                                |       | 3,698 |   | 3,841 |   | 1,636 |   | 14,752 |   |
| Interest and  other expense, net                         |       | (3,184                                               | )          | (3,397 | ) | (3,666 | ) | (3,406 | ) | (13,653 | ) |
| Gain related to  derivative instruments                  |       | 542                                                  |       | 383 |   | (965 | ) | (56 | ) | (96 | ) |
| Income before  provision for income taxes                |       | 2,935                                                |       | 684 |   | (790 | ) | (1,826 | ) | 1,003 |   |
| Provision for  income taxes                              |       | 1,181                                                |       | 275 |   | (523 | ) | (786 | ) | 147 |   |
| Net income                                               |       | $                                                    | 1,754      |   | $ | 409 |   | $ | (267 | ) | $ | (1,040 | ) | $ | 856 |   |
| Net income per common share—basic                   |       | $                                                    | 0.14       |   | $ | 0.03 |   | $ | (0.02 | ) | $ | (0.08 | ) | $ | 0.07 |   |
| Net income per  common share—diluted                |       | $                                                    | 0.13       |   | $ | 0.03 |   | $ | (0.02 | ) | $ | (0.08 | ) | $ | 0.06 |   |
| Weighted average  common shares outstanding—basic   |       | 12,944                                               |       | 12,984 |   | 13,034 |   | 13,070 |   | 13,008 |   |
| Weighted average common  shares outstanding—diluted |       | 13,352                                               |       | 13,444 |   | 13,034 |   | 13,070 |   | 13,448 |   |

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(1)          Thesum of the quarterly earnings per share amounts may not equal the full yearamount since the computations of the weighted average shares outstanding foreach quarter and the full year are computed independently of each other.

**21.**   SubsequentEvents

**On February 28, 2007, the Company acquiredthe laundry facilities management assets and distribution rights of a regionaloperator in the southeast for approximately $2,500 in cash. The purchase price allocationwill be completed in the first quarter of 2007.**

F-33

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**MAC-GRAYCORPORATION**

**SCHEDULE II**

**VALUATIONAND QUALIFYING ACCOUNTSYEARS ENDED DECEMBER 31, 2004, 2005, AND 2006**

| ** **                                          | ** ** | **Balance**      | ** ** | **Charged to** | ** ** | ** **     | ** ** | **Balance**      | ** ** |
|-----------------------------------------------------|------------|------------------|------------|---------------------|------------|----------------|------------|------------------|------------|
| ** **                                          | ** ** | **Beginning**    | ** ** | **Cost and**   | ** ** | ** **     | ** ** | **at End**  | ** ** |
| ** **                                          | ** ** | **of Year** | ** ** | **Expenses**        | ** ** | **Deductions** | ** ** | **of Year** | ** ** |
| Year Ended  December 31, 2004:                 |       |             |       |                |       |           |       |             |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts and lease reserves  |       |             | $          | 935                 |       |           |       | $                | 234        |   |   |   | $ | (787 | ) |   |   | $ | 382 |   |   |
| Year Ended  December 31, 2005:                 |       |             |       |                |       |           |       |             |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts and lease reserves  |       |             | $          | 382                 |       |           |       | $                | 329        |   |   |   | $ | (123 | ) |   |   | $ | 588 |   |   |
| Year Ended  December 31, 2006:                 |       |             |       |                |       |           |       |             |       |   |   |   |   |   |   |   |   |
| Allowance for  doubtful accounts and lease reserves |       |             | $          | 588                 |       |           |       | $                | 126        |   |   |   | $ | (280 | ) |   |   | $ | 434 |   |   |

 

F-34

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