**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**(MarkOne)**

| x                                                      | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|--------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| **For the fiscal year ended December 31, 2005**   |
| **OR**                                                 |
| o                                                      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| **For the transition period from _______ to  _______** |

 

**COMMISSIONFILE NUMBER 1-13495**

**MAC-GRAY CORPORATION**

(Exact name of registrant as specified inits charter)

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

 

Registrant’s telephonenumber, including area code: (781) 487-7600

Securities RegisteredPursuant to Section 12(b) of the 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

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

Indicate by check mark whether the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o  No x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of the registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer or a non-accelerated filer (asdefined in Rule 12b-2 of the Act).

Large Accelerated Filer o               Accelerated Filer o               Non-AcceleratedFiler x

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

The aggregate market value of the voting stock of theregistrant held by non-affiliates of the registrant as of June 30, 2005was $61,916,812.

As of March 27, 2006, 12,952,542 shares of commonstock of the registrant, par value $.01 per share, were outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the Registrants’ Proxy Statement for theAnnual Meeting of Stockholders to be held on May 25, 2006 are incorporatedby reference into Part III of this report.

 

 

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**PART I**

**Forward-Looking Statements**

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 7,  “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”. Investors should carefullyreview all of the factors described therein, which may not be an exhaustivelist 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 anduniversities, we believe we are the largest provider of such services tothe college and university market in the United 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 2005,81% of our consolidated revenue was derived from laundry facilities management.We operate laundry rooms under long-term leases with property owners, collegesand universities and governmental agencies. We refer to these leases as “laundryleases” and this business as “laundry facilities management.”  As of December 31, 2005, our laundryfacilities management business had revenue-generating laundry equipmentoperating in 40 states and the District of Columbia.

Our MicroFridge® business operating as Intirion, derivesrevenue through the sale and rental of a family of patented combinationrefrigerator/freezer/microwave ovens, or “Units”, and other householdappliances, to colleges and universities, military bases, the hotel and motelmarket, and assisted living facilities. The MicroFridge® business also derives revenue through thesales of commercial laundry equipment to the United States military. Our MicroFridge® business unit is a national distributor ofMaytag’s Amana®, Magic Chef® andMaytag brands of appliances using the brand name “Maytag Direct.”®

Our laundry equipment sales unit sells and servicescommercial laundry equipment manufactured by Maytag Corporation, or “Maytag,”and also sells laundry equipment manufactured by The Dexter Company, WhirlpoolCorporation, and American Dryer Corporation. This business unit sells and rentslaundry equipment to retail laundromats, restaurants, hotels, health clubs andsimilar 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’ vended(card or coin-operated) reprographic equipment, with operations concentrated inthe Northeast United States.

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In January 2005, werestructured portions of our sales organization and the corresponding internalfinancial reporting of our business segments to improve the sales and marketingefforts associated with the sales of equipment. Whereas in 2004 and prioryears, the revenue, costs, and expenses related to the laundry equipment salesand services business were reported in our Laundry and Reprographics businesssegment, beginning on January 1, 2005, the laundry equipment sales andservices business is included in a new business segment entitled “ProductSales.”  Also included in this newbusiness segment is all of the revenue that was previously included in theMicroFridge® reporting business segment. This reportingchange results in the Company having two different reporting business segments:“Facilities Management,” which includes the core business of operating laundryrooms in the multi-unit housing industry, and “Product Sales,” which includesthe sales of laundry equipment, MicroFridge® products, and other appliances, equipment and relatedservice businesses operated by the Company. Also included in the “FacilitiesManagement” segment is the reprographics revenue and related direct expenses,which are immaterial for business segment reporting purposes. These changes inour reportable business segments are reflected in the financial statements andanalysis of the Company’s financial information. For comparative purposes wehave reclassified our revenues and gross margins for the years ended December 31,2003 and 2004 into our current Facilities Management and Product Sales segments

***Segment Information***

The following is adiscussion of each of the Company’s reportable business segments: (i) FacilitiesManagement and (ii) Product Sales. Financial information with regard toeach business segment is reported under Note 14 to the Company’s consolidatedfinancial statements included in this report.

**Facilities Management Segment**

Mac-Gray’s FacilitiesManagement segment includes both our laundry facilities management business andreprographics facilities management business. For the years ended December 31,2004 and 2005, our facilities management segment accounted for approximately77% and 82% of our total revenue and 69% and 80% of our gross margin,respectively.

***Laundry Facilities Management Business***

A substantial portion of our Facilities Managementsegment’s and our total revenue is derived through our laundry facilitiesmanagement business, through which we act as a laundry facilities managementcontractor with property owners or managers. For the year ended December 31,2005 the laundry facilities management business accounted for approximately81.3% of the Company’s consolidated revenue. Under Mac-Gray’s long-term leases,the Company typically receives the exclusive right to service laundry roomswithin a multi-unit housing property in exchange for a negotiated percentage ofthe total revenue collected (this percentage is referred to herein as “facilitiesmanagement rent.” During the past five years, we have been able to retainapproximately 97% of our equipment base per year. During this same period,excluding the acquisition of the western and southern laundry facilitiesmanagement assets of Web Service Company, Inc (“Web”) in January 2005 (the“2005 Acquisition”) and the acquisition of the eastern region laundryfacilities management assets from Web in January 2004 (the “2004Acquisition”), we have been able to add an average of 4% per year to ourequipment base through internally generated growth. Mac-Gray believes that itsability to retain its existing equipment base, while growing that base throughinternally generated growth in equipment installations, is indicative of itsservice of, and attention to, property owners and managers. The Company hasalso been able to provide its customers with card and proprietary technologies,and continues to invest in research and development of such technologies. Theproperty owner or manager is usually responsible for maintaining, cleaning, andthe security of the premises and payment of utilities. Mac-Gray leases spacewithin a property, in some instances improves the leased space with flooring,ceilings and other improvements (“betterments”), and then installs and services

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the laundry equipment andcollects the payments. Mac-Gray generally has the ability to set and adjust thevending pricing for its equipment based upon local market conditions.

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

Mac-Gray also generates revenue by leasing equipmentto commercial laundry customers who choose neither to purchase equipment nor tobecome a laundry facilities management customer but wish to maintain their ownlaundry rooms. This leasing program generated revenues of $3.6 million and $2.6 millionfor the years ended December 31, 2005 and 2004, respectively, and isincluded in the laundry facilities management business unit.

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

*Revenue.**  *Mac-Gray operates as a laundryfacilities management contractor under long-term leases or arrangements withproperty owners or managers. Mac-Gray’s efforts are designed to maintain thesecustomer relationships over the long-term. Our typical lease has an originalaverage term of approximately seven years, with an option to renew if mutuallyagreed upon by us and the owner or manager. In each of the past five years, wehave been able to retain approximately 97% of our equipment base per year.

*Customers.*   Asof March 15, 2006, Mac-Gray provided laundry services to approximately53,500 laundry rooms located in 40 states in the Northeast, Southern, Midwest,and Northwest United States, as well as the District of Columbia. As of March 15,2006, no customer represented more than 1% of Mac-Gray’s equipment base. Mac-Grayserves customers in multi-unit housing facilities, including apartmentbuildings, colleges and university residence halls, condominiums and publichousing 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 17% of the laundry facilities managementrevenue for 2005. 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. The Web laundry facilities management assets acquired in January 2005did not significantly affect the degree of seasonality experienced by theCompany.

*Competition.*   Thelaundry facilities management industry is highly competitive, capital intensiveand requires the delivery of reliable and prompt service to customers. Mac-Graybelieves that customers consider different factors in selecting a laundryfacilities management contractor, including customer service, reputation,facilities management rent rates, including advance rents, and range ofproducts and services. Mac-Gray believes that different types of customersassign varied weight to each of these factors and that no one factor alonedetermines a customer’s selection of a laundry facilities management contractor.Within any given geographic area, Mac-Gray may compete with local independentoperators, regional and multi-region operators,, and one national operator. Theindustry is highly fragmented; consequently, Mac-Gray has grown byacquisitions, as well as through new equipment placement. As of March 15,2006, Mac-Gray believes that it is the second largest card or coin-operatedlaundry facilities management contractor in the United States.

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*Impactof Vacancy Rates.*   The Company’s laundryfacilities management revenue is affected by changes in the multi-unit housingvacancy rates. As the United States economy began to slow down in 2001, thevacancy rates in the multi-unit housing market increased. This increase had anegative affect on the Company’s laundry facilities management revenue. Asthese vacancy rates continued to increase throughout 2002 and 2003 the Companybelieves laundry facilities management revenue was negatively affected byapproximately 2%. Beginning in 2004 the Company experienced increases inlaundry facilities management revenue in several of its key markets, which theCompany believes was due, in part, to decreases in multi-unit housing vacancyrates in those markets. Independent data shows the vacancy rate in many of theCompany’s markets has begun to decline, but remains higher than in 2001. TheCompany’s markets that have been most affected by increased vacancy rates havebeen in the southern states, particularly Florida, Georgia and North Carolina.Vacancy rates have not increased to the same extent in the Company’s othermarkets.

*Suppliers.*   TheCompany currently purchases a large portion of the equipment that it uses inits laundry facilities management business from Maytag. In addition, theCompany derives a portion of its revenue, as well as certain competitiveadvantages, from its position as a distributor of Maytag commercial laundryproducts. The Company’s relationship with Maytag began in 1927. Although eitherparty upon written notice may terminate the purchase and distributionagreements between the Company and Maytag, the Company has never had such anagreement terminated by Maytag. A termination of, or substantial revision ofthe terms of, the contractual arrangements or business relationships withMaytag could have a material adverse effect on the Company’s business, resultsof operations, financial condition and prospects.

***Reprographics Facilities Management Business***

Our reprographics facilities management business unit,operating as Copico, is a provider of card and coin-operated 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 representedapproximately 1% of the Company’s consolidated revenue in 2005.

Copico’s revenue andcorresponding operating income have been declining since 1999 when collegelibraries, followed by public libraries, began to make reference material electronicallyavailable to patrons. Revenue in this segment has decreased since 1999 byapproximately 58%. Electronic availability, widespread conversion to laserprinters (free of charge in many school libraries) and other technicaladvancements have led to reduced use of vended copy machines resulting in reducedrevenue at several accounts. As a result, since 2002, the Company has electedeither not to renew, or to terminate contracts with several customers, whichwere either not sufficiently profitable or forecasted to be unprofitable. TheCompany expects this trend to continue.

**Product Sales**Segment

Mac-Gray’s Product Salessegment includes both MicroFridge® andLaundry Equipment Sales. For the years ended December 31, 2004 and 2005,our product sales segment accounted for approximately 23% and 18% of our totalrevenue and 31% and 20% of our gross margin, respectively.

***MicroFridge***® Sales Business

*Revenue.*   OurMicroFridgeâ businessunit consists of supplying combination refrigerator/freezer/microwave ovens, orUnits, under the brand name MicroFridgeâ to multi-unit housing facilities such asmilitary bases, hotels, motels, colleges and universities and assisted livingfacilities. The MicroFridge® business unit revenue includes sales of Unitsunder the brand name MicroFridgeâ to a customer base which includes hospitalityand assisted living facilities, military housing and colleges and 

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universities. TheMicroFridgeâ business unit is a national distributor ofMaytag’s Amana®,Magic Chef® and Maytag brands of kitchen appliances usingthe brand name “Maytag Direct.”® For the years ended December 31, 2004 and2005, our MicroFridge business unit accounted for approximately 15% and 12% ofour total revenue, respectively.

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

Mac-Gray believes that the MicroFridgeâ 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.*   TheMicroFridgeâ business unit revenue is derived from both thesale and rental of MicroFridgeâ Units and related products. In 2005, thelargest market was the hospitality lodging industry and assisted living marketthroughout the United States, 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 MicroFridgeâ Unit product line is available throughgovernment contracts with various governmental agencies. MicroFridgeâ Units have been installed at selected UnitedStates government facilities throughout the world. MicroFridgeâ Units arealso sold and leased to the academic living market. The academic living marketis composed of more than 1,800 colleges and universities across the UnitedStates that have on-campus residence halls.

*Competition.*   Inaddition to large direct sellers, the MicroFridgeâ segment also competes with the major retailstores and local and regional distributors who sell various brand-name compactrefrigerators as well as microwave ovens in the markets served by MicroFridgeâ. Although we hold apatent on combination units utilizing internal circuitry, there has beenincreased competition from “similar look” products utilizing an externalcircuitry control mechanism. There also exists local and regional competitionin the MicroFridgeâ 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.MicroFridgeâ’s principal competitorsinclude Absocold, Avanti, General Electric, Sanyo Fisher Sales, Sears, Tatung,Home Depot, Lowe’s, Wal-Mart, and several companies focused on the collegerental marketplace.

*Suppliers.*   TheMicroFridgeâ business unit maintains original equipmentmanufacturer, or “OEM” arrangements with two primary manufacturers: SanyoE&E Corporation, and Nisshin Industry Co. Ltd. The principal patentunderlying the MicroFridgeâ product is held jointly by Sanyo and us. Thepatented circuitry of the MicroFridge® Unitsis marketed under the trade name Safe PlugTM. In 1997 Sanyo signed a non-competition agreement withus whereby Sanyo is precluded from entering the MicroFridgeâ market,provided that certain minimum annual quantities of products are purchased fromSanyo. These quantity requirements were met in 2005. The OEM agreement withNisshin Industry Co. Ltd. is renewable year to year unless terminated withproper notice.

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

Through its equipmentsales and services business, Mac-Gray is a significant distributor for severalmajor laundry equipment manufacturers, primarily Maytag. Mac-Gray does notmanufacture any of the commercial laundry equipment that it sells. As anequipment distributor, Mac-Gray sells commercial laundry equipment to publiclaundromats, as well as to the multi-unit housing industry. In addition,Mac-Gray sells commercial laundry equipment directly to institutionalpurchasers, including hospitals, 

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restaurants,and hotels, for use in their own on-premises laundry facilities. Mac-Gray iscertified by the manufacturers to service the commercial laundry equipment thatit sells. All installation and repair services are provided on an occurrencebasis, not on a contractual basis. Related revenue is recognized at the timethe installation service, or other service, is provided to the customer. Forthe years ended December 31, 2004 and 2005, our laundry equipment salesbusiness unit accounted for approximately 8% and 6% of our total revenue,respectively.

**Employee Base**

As of March 15, 2006,the Company employed 743 full-time employees. No employee is covered by acollective bargaining agreement and the Company believes that its relationshipwith its employees is good.

**Operating Characteristics**

The Company maintains a corporate staff as well ascentralized finance, human resources, legal services, information technologyand marketing departments. Regionally, the Company maintains service centers andwarehouses 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 in thatbusiness. There is no significant backlog of orders in the Company’s two salesbusinesses.

**Contact Information**

The Company files its annual report on Form 10-K,quarterly reports on Form 10-Q, and current reports on Form 8-Kwith the Securities and Exchange Commission, or “SEC”. Company reports filedwith the 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 corporate offices are located at 404Wyman Street, Suite 400, Waltham, Massachusetts, 02451-1212. TheCompany’s telephone number is (781) 487-7600; its fax number is(781) 487-7606, and its email address for investor relations isir@macgray.com.

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**Item 1A.**                RiskFactors

This annual report on Form 10-Kcontains statements which are not historical facts and are consideredforward-looking within the meaning of the Private Securities Litigation ReformAct of 1995. These forward-looking statements contain projections of theCompany’s future results of operations or financial position or state otherforward-looking information. In some cases you can identify these statements byforward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,”“intend,” “may,” “should,” “will” and “would” or similar words. You should notrely on forward-looking statements, because they involve known and unknownrisks, 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, performance or achievements expressed or implied bythe forward-looking statements. Some of the factors that might cause thesedifferences are as follows:

*If we are unable toestablish new laundry leases, renew our existing laundry leases or retainrelationships with our customers who are not subject to leases, our business,results of operations, cash flows and financial condition could be adverselyaffected.*

Our laundry facilities management business unit, whichprovided 81.3% of our total revenue for the year ended December 31, 2005,is highly 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 long-termleases 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 adverseeffect on our business, results of operations, cash flows and financialcondition. Further, approximately 10% of our customers are not subject toleases, are subject to short-term leases of less than one year remainingor have the right to terminate their lease with us at their option. Failure toretain these customers could have a material adverse effect on our business,results of operations, cash flows and financial condition.

*We face strongcompetition in the outsourced laundry facilities management industry.*

The outsourced laundryfacilities management industry is highly competitive, and we compete for long-termleases, both locally and nationally, with property owners and other operatorsin the industry. We compete based on customer service, reputation, facilitiesmanagement rent rates, incentive payments, a range of products and services.Smaller local and regional operators typically have long-standingrelationships with property owners and managers in their specific geographicmarket. As such, we may have difficulty penetrating such markets, as propertyowners and managers may be resistant to terminating such long-standingrelationships. We also compete with property owners as there is no guaranteethat property owners will continue to outsource their laundry facilitiesmanagement to operators. Nationally, there is one competitor, CoinmachCorporation, in the industry with a larger installed equipment base than us.Competition in the industry may make it more difficult and more expensive toconsummate acquisitions in the future and to maintain and expand our installedequipment base. In addition, some of our competitors may have less indebtednessthan we do, and therefore, more of their cash is potentially available forbusiness purposes other than debt service. We cannot assure you that ourresults of operations, cash flows or financial condition will not be materiallyand adversely affected by competition, or that we will be able to maintain ourprofitability if the competitive environment changes.

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*Our cash flows maynot be sufficient to finance the significant capital expenditures required toreplace equipment and implement new technology or make incentive payments toproperty 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 case of equity financings,could result in dilution to stockholders.  If we cannot maintain or replace our equipmentas we require or implement our new technologies, our results of operations,cash flows and financial condition could be materially and adversely affected.

*If we are unable tocontinue our relationships with Maytag and other equipment suppliers, ourrevenues could be reduced, and our ability to meet customer requirements couldbe materially and adversely affected.*

We purchase substantially all of the equipment that weuse in our laundry facilities management business unit from Maytag. Inaddition, we derive a significant amount of our product sales revenue from ourposition as a distributor of Maytag commercial laundry products. While Maytaghas never terminated any agreement it has with us, we cannot assure you thatMaytag will continue its relationship with us. If Maytag terminates itsrelationship with us, our results of operations, cash flows and financial conditioncould be materially and adversely affected, and further, we may be unable toreplace our relationship with Maytag with a comparable company on favorableterms, or at all.

In addition, the recent sale of Maytag to WhirlpoolCorp. may adversely impact or bring uncertainty to our relationship with Maytag.We are unable to predict what effect, if any, the change of control of Maytagmay have on us or our business relationship with Maytag.

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 minimumrequirements stipulated in the agreement, Sanyo may enter the MicroFridgemarket and, as a result, our market share may decrease. In addition, as our agreementwith Sanyo has a one year term and is re-negotiated annually, there is apossibility that Sanyo may choose not to renew the agreement.

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*An increase inmulti-unit housing sector vacancy rates in the markets in which weconduct business could adversely affect our facilities management revenue.*

Our facilitiesmanagement revenue from our operation of card and coin-operated laundryequipment, particularly in the multi-unit housing sector, depends partiallyupon the level of tenant occupancy. The number of apartments occupied in anapartment building with a vended laundry facility directly affects our revenue.Extended periods of reduced occupancy in our clients’ buildings can adverselyaffect our operations. The level of occupancy can be adversely affected by manymarket and general economic conditions, 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 toaccess capital on acceptable financial terms, our ability to consummateacquisitions 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 to stockholders;

·       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 cannot assureyou that we would be able to consummate on commercially reasonable terms, or atall;

·       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 havedifficulties integrating future acquisitions into our business.*

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

Any futureacquisitions 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;

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·       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 MicroFridgeproducts may be susceptible to product liability claims for which our currentlevels of insurance coverage may not be adequate.*

Through our MicroFridgebusiness, we market and distribute combination refrigerator/freezer/microwaveoven units under the brand name MicroFridge. The sale and distribution ofMicroFridge units, as well as other products, entails a risk of productliability claims. Further, although MicroFridge units are manufactured by thirdparties under contract with us, we may still be subject to risks of productliability claims related to MicroFridge units. Potential product liabilityclaims may exceed the amount of our product liability insurance coverage or maybe excluded from that coverage. We cannot assure you that we will be able torenew our 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 which it is not indemnifiedor for damages exceeding the limits of our product liability insurancecoverage, the claim could have a material adverse effect on our business,results of operations and financial condition.

*Inability toprotect our trademarks and other proprietary rights could adversely impact ourcompetitive position.*

We rely on patents, copyrights, trademarks, tradesecrets, confidentiality provisions and employee and third-partynon-disclosure and non-solicitation agreements to establish and protect ourintellectual property and proprietary rights. We cannot be certain that stepswe have taken to protect our intellectual property and proprietary rights willbe adequate or that third parties will not infringe or misappropriate any ofour intellectual property or proprietary rights. While we have periodicallymade filings with the U.S. Patent and Trademark Office, we have traditionallyrelied upon the protections afforded by contract rights and common lawownership rights, and we cannot assure you that these contract rights and commonlaw ownership rights will adequately protect our intellectual property andproprietary rights. Any infringement or misappropriation of our intellectualproperty and proprietary rights could damage their value and could have amaterial adverse effect on our business, results of operations and financialcondition. We may have to engage in litigation to protect our rights to ourintellectual property and proprietary rights, which could result in significantlitigation expenses and require a significant amount of management’s time.

We own or license severalregistered and unregistered trademarks, including Mac-Gray, Web,MicroFridge and LaundryView, that we use in the marketing and sale of ourproducts. However, the degree of protection that these trademarks afford us isunknown 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, which could have amaterial adverse effect on our business, results of operations and financialcondition.

10

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

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 significantintangible assets and goodwill, the value of which might not be realized in theevent of a sale or liquidation of our businesses.*

At December 31, 2005,approximately $154.7 million, or 47.9%, of our total assets were intangibleassets, consisting primarily of contract rights, and goodwill. In the event ofa sale or liquidation, there can be no assurance that the value of ourintangible assets would be realized.

*We face risksassociated with environmental 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, andthird-party claims for property damage or personal injury, as a result ofviolations of, or liabilities under, environmental laws and regulations. Whilewe are not aware of any existing or potential environmental claims against usthat are likely 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 are controlledby a concentrated group of stockholders, whose interests could be in conflictwith yours.*

As of December 31,2005, our directors, executive officers, and certain of our stockholdersrelated to such persons and their affiliates beneficially owned in theaggregate approximately 47.3% of the outstanding shares of our common stock.See “Principal stockholders” and “Management.” This percentage ownership doesnot include options to purchase 405,000 shares of our common stock held by someof these persons, which are exercisable at or 60 days subsequent to December 31,2006. If all of these options had been exercised as of December 31, 2005,then these stockholders and their affiliates would have beneficially owned 50.4%of the outstanding shares of our common stock. Additionally, we have enteredinto a stockholders’ agreement, dated June 26, 1997, with some of thesestockholders that gives them rights of first offer to purchase shares of ourcommon stock offered for sale by another stockholder party thereto. See “Certainrelationships and related transactions.” As a result of this concentration inownership, these stockholders, acting together, have the ability tosignificantly influence the outcome of the election of directors and all othermatters requiring approval by a majority of stockholders. Circumstances mayarise in which the interests of this group of stockholders could be in conflictwith interests of other stockholders.

*Provisions in ourcharter and bylaws, Delaware Law, and the shareholder rights agreement couldhave the effect of discouraging takeovers.*

Specific provisionsof our charter and bylaws, as described below; sections of the corporate law ofDelaware; the shareholder 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 

11

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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;

·       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

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

**Item 1B.**               UnresolvedStaff Comments

**None.**

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**Item 2.**                        Properties

Mac-Grayrents approximately 32,000 square feet in Waltham, Massachusetts which it usesas its corporate headquarters and 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, 2005,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:

| ** **                  | ** ** | **Approximate** | ** ** | **Annual**              | ** ** | **Expiration**       | ** ** |
|-----------------------------|------------|-----------------|------------|-------------------------|------------|----------------------|------------|
| **Location**                | ** ** | ** **      | ** ** | **Square Footage** | ** ** | **Rental Rate** | ** ** | **Date** | ** ** |
| Albuquerque, New  Mexico    |       |            | 6,600      |                    |       |                 | $          | 43,800 |   |   |   | 4/2007 |   |   |
| Buda, Texas                 |       |            | 7,000      |                    |       |                 | 46,200     |   |   |   | 1/2009 |   |   |
| Buffalo, New York           |       |            | 10,000     |                    |       |                 | 52,800     |   |   |   | 9/2008 |   |   |
| Charlotte, North  Carolina  |       |            | 10,640     |                    |       |                 | 60,885     |   |   |   | 3/2008 |   |   |
| College Station,  Texas     |       |            | 1,250      |                    |       |                 | 6,540      |   |   |   | 10/2006 |   |   |
| Deerfield Beach,  Florida   |       |            | 8,300      |                    |       |                 | 68,475     |   |   |   | 5/2007 |   |   |
| Deerfield Beach,  Florida   |       |            | 2,000      |                    |       |                 | 24,868     |   |   |   | 1/2007 |   |   |
| Denver, Colorado            |       |            | 5,000      |                    |       |                 | 28,021     |   |   |   | 9/2010 |   |   |
| East Brunswick,  New Jersey |       |            | 9,600      |                    |       |                 | 81,264     |   |   |   | 7/2010 |   |   |
| East Hartford,  Connecticut |       |            | 14,900     |                    |       |                 | 76,128     |   |   |   | 5/2006 |   |   |
| Eugene, Oregon              |       |            | 2,500      |                    |       |                 | 17,580     |   |   |   | 6/2008 |   |   |
| Euliss, Texas               |       |            | 10,000     |                    |       |                 | 43,900     |   |   |   | 4/2007 |   |   |
| Gurnee, Illinois            |       |            | 22,521     |                    |       |                 | 152,812    |   |   |   | 4/2011 |   |   |
| Hendersonville,  Tennessee  |       |            | 11,000     |                    |       |                 | 51,000     |   |   |   | 4/2006 |   |   |
| Houston, Texas              |       |            | 10,687     |                    |       |                 | 59,396     |   |   |   | 10/2010 |   |   |
| Jessup, Maryland            |       |            | 10,361     |                    |       |                 | 75,402     |   |   |   | 3/2007 |   |   |
| Lake City,  Florida         |       |            | 1,125      |                    |       |                 | 7,704      |   |   |   | 4/2007 |   |   |
| Lithia Springs, Georgia     |       |            | 10,675     |                    |       |                 | 62,055     |   |   |   | 2/2011 |   |   |
| Oklahoma City,  Oklahoma    |       |            | 2,250      |                    |       |                 | 11,475     |   |   |   | 11/2007 |   |   |
| Orlando, Florida            |       |            | 2,100      |                    |       |                 | 20,849     |   |   |   | 12/2006 |   |   |
| Phoeniz, Arizona            |       |            | 25,920     |                    |       |                 | 102,000    |   |   |   | 4/2007 |   |   |
| Portland, Oregon            |       |            | 10,000     |                    |       |                 | 61,080     |   |   |   | 3/2011 |   |   |
| Salt Lake City,  Utah       |       |            | 4,750      |                    |       |                 | 28,740     |   |   |   | 6/2008 |   |   |
| Seattle,  Washington        |       |            | 9,218      |                    |       |                 | 18,750     |   |   |   | 5/2006 |   |   |
| Syracuse, New  York         |       |            | 8,400      |                    |       |                 | 44,520     |   |   |   | 10/2008 |   |   |
| Tucson, Arizona             |       |            | 4,676      |                    |       |                 | 41,600     |   |   |   | 4/2007 |   |   |
| Walpole,  Massachusetts     |       |            | 19,000     |                    |       |                 | 148,555    |   |   |   | 5/2006 |   |   |
| Waltham, Massachusetts      |       |            | 32,000     |                    |       |                 | 962,641    |   |   |   | 11/2015 |   |   |
| Westbrook, Maine            |       |            | 5,625      |                    |       |                 | 46,927     |   |   |   | 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.

Through the first quarter of 2006, Mac-Gray continuedto rent a portion of its former offices in Cambridge, Massachusetts while thebranch operation relocated to Woburn, Massachusetts.

Mac-Gray believes that itsproperties are generally well maintained and in good condition. Mac-Gray believesthat its properties are adequate for present needs and that suitable additionalor 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 2005.

**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.

| ** **     | ** ** | **Year Ended**   | ** ** | **Year Ended**   | ** ** |
|----------------|------------|-----------------------|------------|-----------------------|------------|
| ** **     | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **     | ** ** | **2004**              | ** ** | **2005**              | ** ** |
| ** **     | ** ** | **High**              | ** ** | **Low**               | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                     | 6.62       |                  | $          | 5.16 |   | $ | 8.74 |   | $ | 7.77 |   |
| Second Quarter |       | 7.05                  |       | 6.14                  |       | 9.17 |   | 8.50 |   |
| Third Quarter  |       | 7.06                  |       | 6.45                  |       | 12.95 |   | 9.30 |   |
| Fourth Quarter |       | 8.09                  |       | 7.15                  |       | 13.24 |   | 10.70 |   |
|                |            |                       |            |                       |            |  |  |  |  |  |  |  |  |

 

As of March 27, 2006 there were 147 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 2005 senior credit facility.

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**Item6.**                        SelectedFinancial Data (Dollars in thousands, except per share data)

Set forth below areselected historical financial data as of the dates and for the periodsindicated. The selected financial data set forth below should be read inconjunction with, and are qualified by reference to, “Management’s Discussionand Analysis of Financial Condition and Results of Operations” and the auditedconsolidated financial statements of Mac-Gray and the notes thereto includedelsewhere in this report.

| ** **                                                                                    | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2001**                                   | ** ** | **2002 ** | ** ** | **2003 ** | ** ** | **2004(1)** | ** ** | **2005(2)** | ** ** |
| Statement of  Income Data:                                                                    |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                                                                       |       | $                                          | 152,069    |   | $ | 150,368 |   | $ | 149,656 |   |   | $ | 182,694 |   |   |   | $ | 260,623 |   |   |
| Cost of revenue:                                                                              |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of facilities  management revenues                                                       |       | 74,300                                     |       | 73,961 |   | 73,409 |   |   | 94,459 |   |   |   | 143,156 |   |   |
| Depreciation and  amortization                                                                |       | 19,276                                     |       | 16,501 |   | 16,723 |   |   | 20,747 |   |   |   | 31,337 |   |   |
| Cost of product sales                                                                         |       | 27,551                                     |       | 27,494 |   | 28,217 |   |   | 29,874 |   |   |   | 35,069 |   |   |
| Total cost of revenue                                                                         |       | 121,127                                    |       | 117,956 |   | 118,349 |   |   | 145,080 |   |   |   | 209,562 |   |   |
| Operating  expenses:                                                                          |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| General and  administration                                                                   |       | 8,823                                      |       | 9,359 |   | 9,519 |   |   | 11,078 |   |   |   | 14,164 |   |   |
| Sales and marketing                                                                           |       | 10,994                                     |       | 11,125 |   | 11,341 |   |   | 13,005 |   |   |   | 16,097 |   |   |
| Depreciation                                                                                  |       | 1,201                                      |       | 1,197 |   | 1,100 |   |   | 1,047 |   |   |   | 1,189 |   |   |
| Gain on sale of assets                                                                        |       | (52                                        | )          | (192 | ) | (145 | ) |   | (1,208 | ) |   |   | (10,735 | ) |   |
| Loss on early  extinguishment of debt                                                         |       | —                                     |       | — |   | 381 |   |   | 183 |   |   |   | 668 |   |   |
| Total operating expenses                                                                      |       | 20,966                                     |       | 21,489 |   | 22,196 |   |   | 24,105 |   |   |   | 21,383 |   |   |
| Income from operations                                                                        |       | 9,976                                      |       | 10,923 |   | 9,111 |   |   | 13,509 |   |   |   | 29,678 |   |   |
| Interest expense, net                                                                         |       | (5,164                                     | )          | (4,578 | ) | (2,807 | ) |   | (4,312 | ) |   |   | (10,939 | ) |   |
| Gain related to  derivative instruments                                                       |       | —                                     |       | — |   | — |   |   | — |   |   |   | 1,876 |   |   |
| Gain on sale of lease  receivables                                                            |       | —                                     |       | — |   | 836 |   |   | — |   |   |   | — |   |   |
| Other expense, net                                                                            |       | (28                                        | )          | (4 | ) | — |   |   | — |   |   |   | — |   |   |
| Income before provision  for income taxes and effect of change in accounting principle        |       | 4,784                                      |       | 6,341 |   | 7,140 |   |   | 9,197 |   |   |   | 20,615 |   |   |
| Provision for income  taxes                                                                   |       | (2,299                                     | )          | (2,567 | ) | (3,036 | ) |   | (3,934 | ) |   |   | (8,563 | ) |   |
| Net income before effect  of change in accounting principle                                   |       | 2,485                                      |       | 3,774 |   | 4,104 |   |   | 5,263 |   |   |   | 12,052 |   |   |
| Effect of change in  accounting principle, net of tax(3)                                      |       | —                                     |       | (906 | ) | — |   |   | — |   |   |   | — |   |   |
| Net income available to  common stockholders                                                  |       | $                                          | 2,485      |   | $ | 2,868 |   | $ | 4,104 |   |   | $ | 5,263 |   |   |   | $ | 12,052 |   |   |
| Net income per common  share before the effect of change in accounting principle—basic   |       | $                                          | 0.20       |   | $ | 0.30 |   | $ | 0.32 |   |   | $ | 0.41 |   |   |   | $ | 0.94 |   |   |
| Net income per common  share before the effect of change in accounting principle—diluted |       | $                                          | 0.20       |   | $ | 0.30 |   | $ | 0.32 |   |   | $ | 0.40 |   |   |   | $ | 0.91 |   |   |
| Net income per common  share—basic                                                       |       | $                                          | 0.20       |   | $ | 0.23 |   | $ | 0.32 |   |   | $ | 0.41 |   |   |   | $ | 0.94 |   |   |
| Net income per common  share—diluted                                                     |       | $                                          | 0.20       |   | $ | 0.23 |   | $ | 0.32 |   |   | $ | 0.40 |   |   |   | $ | 0.91 |   |   |
| Weighted average common  shares outstanding—basic                                        |       | 12,645                                     |       | 12,661 |   | 12,635 |   |   | 12,702 |   |   |   | 12,864 |   |   |
| Weighted average common  shares outstanding—diluted                                      |       | 12,647                                     |       | 12,664 |   | 12,741 |   |   | 13,028 |   |   |   | 13,283 |   |   |

 

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| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2001**                                   | ** ** | **2002(3)** | ** ** | **2003(3)** | ** ** | **2004(1)(3)** | ** ** | **2005(2)(3)** | ** ** |
| Other Financial  Data:                                                   | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| EBITDA(4)                                                                |       | 30,425                                     |       | 27,711 |   | 27,770 |   |   | 35,303 |   |   |   | 64,080 |   |   |
| Depreciation and  amortization                                           |       | 20,477                                     |       | 17,698 |   | 17,823 |   |   | 21,794 |   |   |   | 32,526 |   |   |
| Capital expenditures(5)                                                  |       | 12,779                                     |       | 13,334 |   | 15,372 |   |   | 17,826 |   |   |   | 26,380 |   |   |
| Cash flows provided by  operating activities                             |       | 18,473                                     |       | 26,835 |   | 24,480 |   |   | 37,108 |   |   |   | 40,817 |   |   |
| Cash flows used in  investing activites                                  |       | (11,917                                    | )          | (12,436 | ) | (12,802 | ) |   | (57,101 | ) |   |   | (123,166 | ) |   |
| Cash flows (used in)  provided by financing activities                   |       | (8,046                                     | )          | (14,608 | ) | (11,398 | ) |   | 21,188 |   |   |   | 86,904 |   |   |
| Balance Sheet Data  (at end of period):                                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Working capital                                                          |       | 195                                        |       | (2,601 | ) | 5,247 |   |   | (2,737 | ) |   |   | (2,507 | ) |   |
| Long-term debt and  capital lease obligations, including current portion |       | 70,219                                     |       | 56,825 |   | 50,873 |   |   | 73,328 |   |   |   | 166,678 |   |   |
| Long-term debt and  capital lease obligations, net of current portion    |       | 62,572                                     |       | 47,975 |   | 47,254 |   |   | 67,225 |   |   |   | 165,493 |   |   |
| Total assets                                                             |       | 167,895                                    |       | 162,379 |   | 162,005 |   |   | 202,330 |   |   |   | 324,083 |   |   |
| Stockholders' equity                                                     |       | 60,574                                     |       | 63,688 |   | 68,729 |   |   | 75,936 |   |   |   | 88,601 |   |   |

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

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

3.                  The financial data for the years ended December 31,2002, 2003, 2004 and 2005 includes the adoption of FAS 142.

4.                  EBITDA is defined as net income before provision forincome taxes, depreciation and amortization expense, and interest expense. AdjustedEBITDA is EBITDA further adjusted to exclude the items described in the tablebelow. We have excluded these items because we believe they are not reflectiveof our ongoing operating performance. EBITDA and Adjusted EBIDTA are includedin this report because they are a basis upon which our management assesses ouroperating performance. EBITDA and Adjusted EBITDA are not measures of ourliquidity or financial performance under GAAP and should not be considered asalternatives to net income or any other performance measure derived inaccordance with GAAP, or as an alternative to cash flows from operatingactivities as a measure of our liquidity. The use of EBITDA and Adjusted EBITDAinstead of net income has limitations as an analytical tool, including theexclusion of interest expense and depreciation and amortization expense, whichrepresent significant and unavoidable operating costs given the level ofindebtedness and the capital expenditures needed to maintain our business. Managementcompensates for these limitations by relying primarily on our GAAP results andby using EBITDA and Adjusted EBITDA only supplementally. Our managementbelieves EBITDA and Adjusted EBITDA are useful to investors because they helpenable investors to evaluate our business in the same manner as our managementand because they are frequently used by securities analysts, investors andother interested parties in the evaluation of companies with substantialfinancial leverage. Our measures of EBITDA and Adjusted EBITDA are notnecessarily comparable to other similarly titled captions of other companiesdue to potential inconsistencies in the methods of calculation.

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

| ** **                                                 | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                 | ** ** | **2001**                                   | ** ** | **2002** | ** ** | **2003** | ** ** | **2004(1)** | ** ** | **2005(2)** | ** ** |
| Net income                                                 |       | $                                          | 2,485      |   | $ | 2,868 |   | $ | 4,104 |   |   | $ | 5,263 |   |   | $ | 12,052 |   |
| Add:                                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Provision for income taxes                                 |       | 2,299                                      |       | 2,567 |   | 3,036 |   |   | 3,934 |   |   | 8,563 |   |
| Cost of revenue, depreciation and amortization  expense    |       | 19,276                                     |       | 16,501 |   | 16,723 |   |   | 20,747 |   |   | 31,337 |   |
| Operating expenses, depreciation and amortization  expense |       | 1,201                                      |       | 1,197 |   | 1,100 |   |   | 1,047 |   |   | 1,189 |   |
| Interest expense, net                                      |       | 5,164                                      |       | 4,578 |   | 2,807 |   |   | 4,312 |   |   | 10,939 |   |
| EBITDA                                                     |       | $                                          | 30,425     |   | $ | 27,711 |   | $ | 27,770 |   |   | $ | 35,303 |   |   | $ | 64,080 |   |
| Add (Subtract):                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Gain on sale of certain assets, net                        |       | $                                          | —     |   | $ | — |   | $ | — |   |   | $ | (1,218 | )(a) |   | $ | (10,767 | )(b) |
| Gain related to derivative instruments                     |       | —                                     |       | — |   | — |   |   | — |   |   | $ | (1,876 | ) |
| Loss related to 2005 hurricanes                            |       | —                                     |       | — |   | — |   |   | — |   |   | 316 |   |
| Loss on early extinguishment of debt                       |       | —                                     |       | — |   | — |   |   | 183 |   |   | 668 |   |
| Effect of change in accounting principle                   |       | —                                     |       | (906 | ) | — |   |   | — |   |   | — |   |
| Adjusted EBITDA                                            |       | $                                          | 30,425     |   | $ | 26,805 |   | $ | 27,770 |   |   | $ | 34,268 |   |   | $ | 52,421 |   |

 

(a)           Represents a pretax gain recognized in connection withthe sale of certain of our laundry facilities management assets and relatedcontracts in western states to Web Service Company.

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

Followingis the impact on earnings of implementing FAS 142 on the years ended December 31,2005, 2004, 2003 and 2002, and what the impact on the same period in 2001 wouldhave been:

| ** **                                                                       | ** ** | **For the year ended December 31, (In thousands, except per share data)** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2001**                                                                                                                         | ** ** | **2001  per  share** | ** ** | **2002** | ** ** | **2002  per  share** | ** ** | **2003** | ** ** | **2003  per  share** | ** ** | **2004** | ** ** | **2004  per  share** | ** ** | **2005** | ** ** | **2005  per  share** | ** ** |
| Reported earnings                                                                |       | $                                                                                                                                | 2,485      |   | $ | 0.20 |   | $ | 2,868 |   | $ | 0.23 |   | $ | 4,104 |   | $ | 0.32 |   | $ | 5,263 |   | $ | 0.40 |   | $ | 12,052 |   | $ | 0.91 |   |
| Add: Impairment charge to comply with new accounting  standard—net of taxes |       | —                                                                                                                           |       | — |   | 906 |   | 0.07 |   | — |   | — |   | — |   | — |   | — |   | — |   |
|                                                                             |       | 2,485                                                                                                                            |       | 0.20 |   | 3,774 |   | 0.30 |   | 4,104 |   | 0.32 |   | 5,263 |   | 0.40 |   | 12,052 |   | 0.91 |   |
| Add: Goodwill amortization—net of taxes                                     |       | $                                                                                                                                | 1,907      |   | $ | 0.15 |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Earnings, as  adjusted                                                           |       | $                                                                                                                                | 4,392      |   | $ | 0.35 |   | $ | 3,774 |   | $ | 0.30 |   | $ | 4,104 |   | $ | 0.32 |   | $ | 5,263 |   | $ | 0.40 |   | $ | 12,052 |   | $ | 0.91 |   |

 

5.                  Excludes $566, $915, $1,380, $1,579, and $1,499 in2001, 2002, 2003, 2004, and 2005, respectively, of capital leases associatedwith vehicles acquired and used in the operation of the Company.

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

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

This report contains, in addition to historicalinformation, forward-looking statements that involve risks and uncertainties. Theseforward-looking statements reflect our current views about future events andfinancial performance. Investors should not rely on forward-looking statementsbecause they are subject to a variety of factors that could cause actualresults to differ materially from our expectations. Factors that couldcause or contribute to such differences include, without limitation, thefactors 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 in 1927 and incorporated inDelaware in 1997. We conduct our business in the following four units: (1) thelaundry facilities management business unit, through which we manage laundryfacilities in multi-unit housing; (2) the MicroFridge**®** 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. Prior to 2005, we reported ourreportable business segments as laundry and reprographics (consisting of ourlaundry facilities management, laundry equipment sales and reprographicsbusiness units) and MicroFridge**®**.We have reclassified prior year financial information to conform to currentsegment reporting.

Our business model is built on a stable demand forlaundry services, combined with long-term leases, strong customerrelationships, a broad customer base and predictable capital needs. For theyears ended December 31, 2004 and 2005 our total revenues were $182.7million and $260.6 million, respectively. Approximately 74.8% and 81.3% of ourtotal revenues for these periods, respectively, were 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, inexchange for a negotiated portion of the revenue we collect. As of December 31,2005, 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 

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capital needs arepredictable and largely within our control. For the years ended December 31,2004 and 2005, we incurred approximately $17.8 million and $26.4 million ofcapital expenditures, respectively. In addition, we make incentive payments toproperty owners and property management companies to secure our leasearrangements. For the years ended December 31, 2004 and 2005, we paidapproximately $3.4 million and $4.5 million of incentive payments,respectively.

In addition, through our product sales segment, wegenerate revenues by selling commercial laundry equipment, our line ofcombination refrigerator/freezer/microwave oven units under 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, 2004 and 2005, our product salessegment generated 23.1% and 17.6% of our total revenues and approximately 27.2%and 18.1% of our gross margins, respectively.

Our financial objective is to maintain and enhanceprofitability by retaining existing customers, adding customers in areas inwhich we currently operate and selectively expanding our geographic footprintand density through acquisitions. One of the key challenges we face ismaintaining and expanding our customer base in a competitive industry. Weexperience competition from other industry participants, including national,regional and local laundry facilities management operators and from propertyowners and property management companies who self-operate their laundryfacilities. We devote substantial resources to our sales efforts and arefocused on continued innovation in order to distinguish us from competitors.Approximately 10% to 15% of such laundry room leases are up for renewal eachyear. Over the past five calendar years, we have been able to retain, onaverage, approximately 97% of our total installed equipment base each year,while adding an average of approximately 4% per year to our installed equipmentbase through organic growth.

The MicroFridge® business unit derives revenue through the saleand rental of its MicroFridge® appliances to the hospitality industry,military bases, colleges and universities and assisted living facilities. 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 10, 2005, we acquired the laundryfacilities management assets of Web Service Company, Inc., or “Web,” in 13western and southern states for approximately $112.7 million (the “2005Acquisition”). This acquisition added approximately $70.0 million of revenue in2005, representing approximately 33% of our 2005 revenue derived from laundryfacilities management operations.

In connection with the 2005 Acquisition, on January 10,2005, we and various lenders entered into senior credit facilities consistingof an $80.0 million term loan facility and a $120.0 million revolvingloan facility, each of which matures on January 10, 2010. We used$80.0 million of the term loan facility and approximately$93.4 million of the revolving loan facility to finance the 2005Acquisition, pay related costs and expenses, and repay the outstandingobligations under and terminate our 2003 senior credit facilities. The 2005senior credit facilities are collateralized by a blanket lien on our assets andthe assets of our subsidiaries, other than one non-wholly owned subsidiary inwhich we own a controlling interest, as well as a pledge by us of all of thecapital stock of these subsidiaries. On April 29, 2005, as required by the2005 senior credit facilities and to manage the additional interest rate riskcreated by the 2005 senior credit facilities, we entered into additionalinterest rate swap agreements effective as of various dates between May 2,2005 and June 30, 2008. In connection with our August 2005 offeringof 7.625% notes, we amended the 2005 senior credit facilities to allow, amongother things, for the offering of the notes and the application of the proceedstherefrom, and used all of the net proceeds from the notes offering to repaythe term loan facility in full and reduce the amount outstanding under therevolving loan facility. Following 

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the repayment of the termloan facility, only the $120.0 million revolving loan facility remainsavailable. See “Liquidity and Capital Resources.”

On June 30, 2005, we completed the sale of ourcorporate headquarters in Cambridge, Massachusetts for $11.8 million incash. We used the net proceeds from the sale to repay the $3.8 millionbalance of the mortgage loan on the property and repay $2.0 million underthe 2005 senior credit facilities. Concurrently with the closing of the sale,we leased the property back from the purchaser until March 31, 2006 whilewe relocated our corporate, warehouse and branch operations to new facilities.In connection with this sale, in the second quarter of 2005 we recorded a gainof approximately $6.1 million, net of taxes.

On July 22, 2005, we entered into a ten-yearlease, commencing October 1, 2005, for approximately 32,000 square feet ofoffice space for the new location of our corporate headquarters. We have theoption to extend the term of the lease for two additional five-year terms.Generally we will pay $78,496 per month during the initial five years. Afteryear five, the fixed monthly rent will increase to $86,477 per month for theremaining term of the lease. In addition, we will pay our pro rata shares oftaxes, insurance and maintenance costs during the term of the lease.

On August 16, 2005, we issued $150 million ofsenior unsecured notes maturing on August 15, 2015. Interest on the seniornotes accrues at the rate of 7.625% per annum and is payable semiannually inarrears. The net proceeds of the senior notes were used to retire the term loanand reduce the revolving loan balance outstanding under the 2005 senior creditfacility. See “Liquidity and Capital Resources.”

Concurrent with the reduction of the amounts due underour 2005 senior credit facility, we terminated our hedge accounting treatmentfor eight interest rate swaps which resulted in a gain of approximately $1.6 million.

On January 20,2006 we acquired the laundry facilities management assets of a regionaloperator for approximately $11.5 million. We estimate that the operations,located primarily in the Southern New England area, will add approximately $8million of annual revenue.

On March 29, 2006,the members of the Compensation Committee of the Board of Directors approved acash bonus award to certain members of senior management including theexecutive officers of the Company. The Committee determined the amount of thecash bonuses for senior management based on several factors, including eachmanager’s success in furthering the Company’s financial and strategicobjectives. Included in the awards was $125,000 to Stewart MacDonald, Jr.,Chairman and Chief Executive Officer, $100,000 to Neil F. MacLellan III,Executive Vice President and Chief Operating Officer and $100,000 to Michael J.Shea, Executive Vice President and Chief Financial Officer.

**Resultsof Operations (Dollars in thousands, except per share data)**

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

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***Revenue***

| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **2005 to 2004** | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|----------------------------|------------|
| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **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 | % |   |

 

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

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 the 2005 Acquisition.

*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.

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 coin-operatedsystem.

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 tocontinue, as the usage of vended copiers declines and we continue our strategyof not renewing contracts that we predict will have a negative impact onincome.

*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 

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sales. We believe that thehospitality sales increase is attributable to an increase in capital spendingby the industry and the addition of several new distributors by our Company. Oursales to the government are continually affected by changes in governmentspending priorities. We believe current spending is directed away from militaryhousing improvements and toward the current military efforts in the MiddleEast.

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***

*Cost of facilitiesmanagement revenue.  *Costof facilities management revenue includes rent paid to customers as well ascosts associated with installing and servicing machines and costs ofcollecting, counting, and depositing facilities management revenue, and thecosts of purchasing, delivering and servicing rented facilities managementequipment and MicroFridge® equipment. Cost of facilities managementrevenue increased by $48,697, or 52%, to $143,156 for the year ended December 31,2005 as compared to $94,459 for the year ended December 31, 2004. Thisincrease is attributable primarily to the cost associated with the revenuegenerated by the assets acquired in the 2005 Acquisition. Included in the costfor the year ended December 31, 2005 is $316 related to losses incurred asa result of the 2005 hurricanes. As a percentage of facilities managementrevenue, cost of facilities management revenue was consistent at 67% for theyears ended December 31, 2005 and 2004. Changes in facilities managementrent as a percentage of facilities management revenue can be affected by newand renewed laundry leases and by other factors such as the amount of incentivepayments and laundry room betterments invested in new or renewed laundryleases. As we vary the amount invested in a facility, the facilities managementrent as a function of facilities management revenue can vary. Incentivepayments and betterments are amortized over the life of the laundry lease. Thepercentage of facilities management rent to facilities management revenue isalso impacted by the facilities management rent rate structure in thereprographics business unit. Because this business unit has a much lowerfacilities management rent rate structure than the laundry facilitiesmanagement business unit, the reduction in the size of the reprographicsbusiness unit through the non-renewal of leases will result in an increase inthe overall facilities management rent as a percentage of revenue.

*Depreciation andamortization.  *Depreciationand amortization increased by $10,590, or 51%, to $31,337 for the year ended December 31,2005 as compared to $20,747 for the year ended December 31, 2004. 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.

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*Cost of product sales.*   Cost of product sales consists primarily of the costof laundry equipment, MicroFridge**®** equipment and parts and supplies sold as partof the product sales segment. Cost of product sales increased by $5,195, or17%, to $35,069 for the year ended December 31, 2005 as compared to$29,874 for the year ended December 31, 2004. As a percentage of sales,cost of product sold was approximately 77% and 71% for the years ended December 31,2005 and 2004, respectively. The gross margin on product sales includes thegross margins from the laundry equipment sales and MicroFridge® businessunits. The gross margin in the laundry equipment sales business unit decreasedto 31% for the year ended December 31, 2005 as compared to 32% for thesame period in 2004. The gross margin in the MicroFridge**®** business unitdecreased to 20% for the ended December 31, 2005 as compared to 25% forthe same period in 2004. The erosion of margins is attributable to theincreased cost of product, fuel cost surcharges passed through to us and thecost of carrying more inventory than in prior years due to supplier shortages. TheCompany was unable to recover all of these expenses.

***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 14% 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.

*Loss on earlyextinguishment of debt.*   We used a portion of the proceeds from our $150,000senior note offering to repay the term loan portion of the 2005 senior creditfacility. Unamortized financing costs of $461 related to the term loan wereexpensed in the third quarter of 2005. Inconnection with the 2005 senior credit facilities we repaid in full and terminated our 2003 seniorcredit facilities. Unamortized financing costs of $207 associated with our 2003senior credit facilities were expensed in the first quarter of 2005. Inconnection with an amendment to our 2003 senior credit facilities, unamortizedfinancing costs of $183 were expensed in the first quarter of 2004.

*Gain on sale of assets  *.Gain on sale of assets represents the gain from thesale of vehicles and other non-inventory assets in the ordinary course ofbusiness. In the year ended December 31, 2005, the gain included $10,588from the sale of our corporate headquarters. In the year ended December 31,2004, the gain included $1,218 from the sale of certain laundry facilitiesmanagement 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.

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

| ** **                            | ** ** | **For the year 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 |   |

 

**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 5.4% 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.

**Gainrelated to derivative instruments**

The Company is party tointerest rate swap agreements that it had accounted for as cash flow hedges. Thefair value of these swaps has been included in other comprehensive income inthe equity section of the balance sheet. As a result of the reduction in theamount 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.

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A reconciliation of netincome, as reported to net income, as adjusted is provided below:

| ** **                                             | ** ** | **Year 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 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 |   |

 

To supplement theCompany's unaudited consolidated financial statements presented on a generallyaccepted accounting principles (GAAP) basis, management has used a non-GAAPmeasure of net income.  Managementbelieves presentation of this measure is appropriate to enhance an overallunderstanding of our historical financial performance and future prospects.  Adjusted net income, which is adjusted toexclude certain gains and losses from the comparable GAAP net income, is anindication of our baseline performance before gains, losses or other chargesthat are considered by management to be outside of our core operating results.These non-GAAP results are among the primary indicators management uses as abasis for evaluating the Company's financial performance as well as forforecasting future periods.  For thesereasons, management believes these non-GAAP measures can be useful toinvestors, potential investors and others. The presentation of this additional information is not meant to beconsidered in isolation or as a substitute for net income or other measuresprepared in accordance with GAAP.

**Fiscalyear ended December 31, 2004 compared to fiscal year ended December 31,2003**

Theinformation presented below for the years ended December 31, 2003 and 2004is derived from Mac-Gray’s consolidated financial statements and related notesthereto.

***Revenue***

| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **2004 to 2003** | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|----------------------------|------------|
| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | **Increase**               | ** ** | **%** | ** ** |
| ** **                          | ** ** | **2003**   | ** ** | **2004**   | ** ** | **(Decrease)**             | ** ** | **Change** | ** ** |
| Laundry  facilities management      |       | $          | 104,783    |       | $          | 136,725                    |       |   | $ | 31,942 |   |   |   | 30 | % |   |
| Reprographics  revenue              |       | 5,166      |       | 3,755      |       |                       | (1,411     | ) |   |   | (27 | %) |   |
| Total facilities management revenue |       | 109,949    |       | 140,480    |       |                       | 30,531     |   |   |   | 28 | % |   |
| MicroFridge® revenue      |       | 25,382     |       | 27,287     |       |                       | 1,905      |   |   |   | 8 | % |   |
| Laundry equipment  sales revenue    |       | 14,325     |       | 14,927     |       |                       | 602        |   |   |   | 4 | % |   |
| Total product sales revenue         |       | 39,707     |       | 42,214     |       |                       | 2,507      |   |   |   | 6 | % |   |
| Total revenue                       |       | $          | 149,656    |       | $          | 182,694                    |       |   | $ | 33,038 |   |   |   | 22 | % |   |

 

Total revenue increased by $33,038, or 22%, to$182,694 for the year ended December 31, 2004 compared to $149,656 for theyear ended December 31, 2003. The increase in total revenue for the yearended December 31, 2004 is primarily attributable to the revenueassociated with our acquisition of the eastern region laundry facilitiesmanagement assets from Web Service Company, Inc. on January 16, 2004for approximately $42 million (the “2004 Acquisition”).

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*Facilitiesmanagement revenue.*   Total facilities management revenue increased by$30,531, or 27.8%, to $140,480 for the year ended December 31, 2004 ascompared to $109,949 for the year ended December 31, 2003.

Revenue in our laundry facilities management businessunit increased by $31,942, or 30%, to $136,725 for the year ended December 31,2004 as compared to $104,783 for the year ended December 31, 2003. Of theincrease, $27,200, or approximately 85.2%, is attributable to the 2004Acquisition, while $4,742, or approximately 14.8% of the increase, isattributable to organic growth. Organic growth in 2004 was derived from the netaddition of equipment installed in the field, vend-price increases,increase in usage of installed equipment, and the conversion of coin-operatedto card-operated systems.

Revenue in our reprographics business unit decreasedby $1,411, or 27.3%, to $3,755 for the year ended December 31, 2004 ascompared to $5,166 for the year ended December 31, 2003. This decrease isprimarily attributable to the decrease in equipment use in libraries andsimilar facilities, as compared to 2003, and a reduction in the number oflocations operated by us. We are forecasting decreases in reprographicsbusiness unit revenue to continue as the usage of vended reprographicsequipment declines and we continue our strategy of not renewing contracts whichwe predict will have a negative impact on income.

*Product sales.*   Total productsales revenue increased by $2,507, or 6.3%, to $42,214 for the year ended December 31,2004 as compared to $39,707 for the year ended December 31, 2003.

Revenue in our MicroFridge**®** business unit increased $1,905, or 7.5%, to$27,287 for the year ended December 31, 2004 as compared to $25,382 forthe year ended December 31, 2003. The largest contributor to this increasein sales was the unit’s academic business, which experienced revenue growth of$1,256, or 29%, in 2004 as compared to 2003. Sales to hospitality and assistedliving customers increased $735, or 8%, for the year ended December 31,2004 as compared to the same period in 2003. Offsetting these increases was adecrease in sales to government customers of $700, or 6%, for the year ended December 31,2004 as compared to the same period in 2003. The increases in sales to theacademic and hospitality and assisted living customers are primarilyattributable to the improved economic conditions, our ability to attract newcustomers and the introduction of new appliance products. We believe thedecrease in the government sales business in 2004 is primarily attributable tooverall spending by the government being directed away from military housingimprovements and toward the current military efforts in the Middle East.

Revenue in our laundryequipment sales business unit increased $602, or 4%, to $14,927 for the yearended December 31, 2004 as compared to $14,325 for the year ended December 31,2003. This increase is primarily attributable to a slight increase in thenumber of units sold and a favorable impact on revenue caused by the productmix sold.

***Cost of revenue***

*Costof facilities management revenue.*   Costof facilities management revenue includes rent paid to customers, those costsassociated with installing and servicing laundry facilities managementequipment, the costs of collecting, counting and depositing the facilitiesmanagement revenue, and the costs of purchasing, delivering and servicingrented laundry facilities management equipment and MicroFridge® equipment. Costof facilities management revenue increased by $21,050, or 29%, to $94,459 forthe year ended December 31, 2004 as compared to $73,409 for the year endedDecember 31, 2003. This increase is primarily attributable to theadditional contracts added to the laundry facilities management business unitas a result of the 2004 Acquisition. As a percentage of facilities managementrevenue, cost of facilities management revenue has increased to 67.2% for theyear ended December 31, 2004 as compared to 66.8% for the year ended December 31,2003. This percentage increase is the result of the contractual laundryfacilities management rent rate for the portfolio of laundry leases acquired inthe 2004 Acquisition being slightly higher than our existing laundry leases.Facilities management rent can be affected by new and 

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renewed laundry leases andby 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. 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, any decrease inrevenue will result in an increase in the overall cost of facilities managementrevenue as a percentage of facilities management revenue.

*Depreciationand amortization.*   Depreciation andamortization includes amounts included as a component of cost of revenue, whichare primarily related to our laundry facilities management equipment in serviceand amounts included as an operating expense, which are primarily non-revenue-generatingcorporate assets. Depreciation and amortization increased by $4,024, or 24%, to$20,747 for the year ended December 31, 2004 as compared to $16,723 forthe year ended December 31, 2003. This increase is primarily attributableto the depreciation and amortization of assets and contracts comprising thelaundry facilities management assets purchased in the 2004 Acquisition. Thelaundry facilities management equipment acquired had an appraised value of$12,027 as of the acquisition date. We are depreciating this equipment overfive years. The contract rights acquired had an appraised value of $28,060 asof the acquisition date and are being amortized over twenty years. Alsocontributing to the increased depreciation expense over 2003 was the fact thatmore new laundry facilities management equipment was placed in service at newlocations and more laundry facilities management equipment was replaced aslaundry leases were renewed.

*Costof product sales.*   Cost of productsales consists primarily of the cost of laundry equipment, MicroFridgeequipment and parts and supplies sold. In 2004, laundry and MicroFridgeequipment sales decreased as a percentage of total revenue. These salestypically create higher operating costs due to delivery and installation generallybeing more costly in the laundry equipment sales business unit than in thelaundry facilities management business unit. Cost of product sales increased by$1,657, or 5.9%, to $29,874 for the year ended December 31, 2004 ascompared to $28,217 for the year ended December 31, 2003. Gross margins onproduct sales were 27.8% for the year ended December 31, 2004 and 26.7%for the year ended December 31, 2003. The gross margin on product salesincludes laundry and MicroFridge equipment sales. The gross margin in thelaundry equipment sales business unit decreased slightly in 2004 as compared to2003 from 33.1% of revenue to 32.4%, due to competitive pressure and costincreases which were not entirely passed on to our customers. The gross marginassociated with MicroFridge equipment sales increased to 25.2% of revenue in2004 from 23.1% in 2003. This increase was caused primarily by the change insales mix; specifically, an increase in higher margin sales to the academicmarkets.

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***Operating expenses***

*General,administration, sales and marketing expense.*   General,administration, sales and marketing expense increased by $3,223, or 15%, to$24,083 for the year ended December 31, 2004 as compared to $20,860 forthe year ended December 31, 2003. As a percentage of total revenue,general, administration, sales and marketing expense decreased from 14% in 2003to 14% in 2004. The increases in general, administration, sales and marketingexpense are primarily attributable to the additional sales personnel, sellingexpenses and marketing expenditures associated with the 2004 Acquisition oflaundry leases. Also contributing to the increase were increases in generalliability insurance, information technology systems related depreciation, andcosts associated with the preparation for compliance with Section 404 ofthe Sarbanes-Oxley Act of 2002.

*Loss on earlyextinguishment of debt.*   In connection with the 2004 Acquisition and thecorresponding amendment to our 2003 senior credit facilities, $183 ofunamortized financing costs associated with the 2003 senior credit facilitieswere expensed during 2004. In connection with the June 24, 2003refinancing of our 2000 senior credit facilities, $381 of unamortized financingcosts were expensed during 2003.

*Gain on sale of assets, net.*   The net gain onsale of assets was $1,208 and $145 for the years ended December 31, 2004and 2003, respectively. In January 2004, in connection with the 2004Acquisition, we realized a gain of $1,218 on the sale of certain laundryfacilities equipment and laundry leases for approximately $2,000, our bestestimate of fair value. Also included in the transaction were prepaidfacilities management rent, equipment and parts inventory. Also included ingain on sale of assets was the sale of vehicles and non-inventory assetsin the ordinary course of our business.

**Income from operations**

Income from operations increased by $4,398, or 48%, to$13,509 for the year ended December 31, 2004 as compared to $9,111 for theyear ended December 31, 2003. To supplement the consolidated financialstatements presented on a GAAP basis, we have used a non-GAAP financial measureof adjusted income from operations. Management believes presentation of thismeasure is useful to investors to enhance an overall understanding of our historicalfinancial performance and future prospects. Adjusted income from operations,which is adjusted to exclude certain gains and losses from the comparable GAAPincome from operations, is an indication of our baseline performance beforegains, losses or other charges that are considered by management to be outsideof our core operating results. Excluding the loss on early extinguishment ofdebt and the gain on sale of assets to Web Service Company, income fromoperations would have been $12,474 and $9,492 for the years ended December 31,2004 and 2003, respectively, or a 31% increase. This increase was due primarilyto the reasons discussed above.

Areconciliation of income from operations, as reported, to adjusted income fromoperations is provided below:

| ** **                            | ** ** | **For the year  ended December 31,** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                            | ** ** | **2003**                                                 | ** ** | **2004** | ** ** |
| Income from  operations               |       | $                                                        | 9,111      |   | $ | 13,509 |   |
| Loss on early  extinguishment of debt |       | 381                                                      |       | 183 |   |
| Gain on sale of  certain fixed assets |       | —                                                   |       | (1,218 | ) |
| Income from operations,  as adjusted  |       | $                                                        | 9,492      |   | $ | 12,474 |   |

 

**Interest expense, net**

Interest expense, net,increased by $1,505, or 54%, to $4,312 for the year ended December 31,2004 as compared to $2,807 for the year ended December 31, 2003. Thisincrease is primarily attributable to the increased borrowings in January 2004to finance the approximately $39,900 cash component of the 2004 

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Acquisition.Non-cash interest expense associated with the accounting treatment of ourinterest rate swap agreements resulted in interest expense of $1,368 and $648for the years ended December 31, 2004 and 2003, respectively.

**Gain on sale of lease receivables**

During 2003, we soldcertain lease receivables associated with the MicroFridge business unit. The$836 gain associated with this sale is primarily attributable to the interestincome that would have been recognized throughout the life of the lease had itnot been sold.

**Provision for income taxes**

The provision for incometaxes increased by $898, or 30%, to $3,934 for the year ended December 31,2004 as compared to $3,036 for the year ended December 31, 2003. Theincrease is primarily attributable to the changes in taxable income. Theeffective tax rate has remained relatively constant at 42.8% and 42.5%, for theyears ended December 31, 2004 and 2003, respectively.

**Net income**

As a result of the foregoing, net income increased$1,159, or 28%, to $5,263 for the year ended December 31, 2004 as comparedto $4,104 for the year ended December 31, 2003.

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

| ** **                                             | ** ** | **Year ended  December 31,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                             | ** ** | **2003**                               | ** ** | **2004** | ** ** |
| Net income, as  reported                               |       | $                                      | 4,104      |   | $ | 5,263 |   |
| Income before provision for income taxes, as  reported |       | $                                      | 7,140      |   | $ | 9,197 |   |
| Gain on non-recurring sale of assets                   |       | —                                 |       | (1,218 | ) |
| Loss on early  extinguishment of debt                  |       | 381                                    |       | 183 |   |
| Income before  provision for income taxes, as adjusted |       | 7,521                                  |       | 8,162 |   |
| Provision for  income taxes, as adjusted               |       | 3,198                                  |       | 3,491 |   |
| Net income, as adjusted                                |       | $                                      | 4,323      |   | $ | 4,671 |   |
| Diluted earnings  per share, as adjusted               |       | $                                      | 0.33       |   | $ | 0.36 |   |

 

To supplement theCompany’s unaudited consolidated financial statements presented on a generallyaccepted accounting principles (GAAP) basis, management has used a non-GAAP measureof net income. Management believes presentation of this measure is appropriateto enhance 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. The presentation ofthis additional information is not meant to be considered in isolation or as asubstitute for net income or other measures prepared in accordance with GAAP.

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**Liquidityand Capital 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 described below.Included in the capital requirements that we expect to be able to fund during2006 is approximately $35,000 of anticipated capital expenditures andincentive payments. The anticipated capital expenditures for 2006 are primarilycomposed of laundry equipment installed and the cost of laundry roombetterments incurred in connection with new customer leases and the renewal ofexisting leases.

During 2005 and 2004, we required substantial amountsof new debt financing to fund our 2005 Acquisition and 2004 Acquisition. Absentextraordinary transactions such as these, we historically have not neededsources of financing other than our internally generated cash flow and ourrevolving credit facility to fund our working capital, capital expenditures andinvestment requirements. As a result, we anticipate that our cash flow fromoperations and revolving credit facility will be sufficient to meet ouranticipated cash requirements for at least 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 2005senior credit 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 or amendments,if necessary, would be available on reasonable terms, if at all.

**Operating Activities**

For the years ended December 31,2003, 2004, and 2005, cash flows provided by operating activities were $24,480,$37,108 and $37,902, 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 increase for the year ended December 31, 2005as compared to the year ended December 31, 2004 is primarily attributableto ordinary changes in working capital and the addition of the laundryfacilities management business acquired in January 2005. The mostsignificant increases in cash flows provided by operating activities were netincome and depreciation and amortization expense as well as increases inaccounts payable and accrued expenses. The increase in depreciation andamortization expense is primarily attributable to the additional laundryfacilities management equipment and contract rights acquired in January 2005.The increase in accounts payable is primarily attributable to an increase inaccrued facilities management rent as a result of the January 2005acquisition as well as the timing of trade accounts payable. The mostsignificant decreases in cash flows provided by operating activities werecaused by increases in accounts receivable and prepaid expenses. The increasein accounts receivable was primarily attributable to the timing of sales oflaundry equipment and MicroFridge® equipment. The increase in prepaid expenses isprimarily attributable to an increase in prepaid facilities management rent asa result of the 2005 Acquisition.

**Investing Activities**

For the years ended December 31,2003, 2004, and 2005, cash flows used in investing activities were $12,802,$57,101 and $120,251, respectively. The increase for the year ended December 31,2005 as 

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comparedto the year ended December 31, 2004 is primarily attributable to thepayment for certain acquisitions of laundry facilities management assets during2005 of $112,680. Other capital expenditures for the years ended December 31,2005 and 2004 were $26,380 and $17,826, respectively. The increase of $8,554,or 50%, in other capital expenditures was the result of more laundry equipmentbeing placed in service, and more laundry facilities management contracts beingrenegotiated in the year ended December 31, 2005 than in the same periodin 2004, due in part to the additional laundry facilities management contractsacquired in January 2005 and January 2004.

**Financing Activities**

For the years ended December 31, 2003, 2004, and2005, cash flows (used in) provided by financing activities were ($11,398),$21,188 and $86,904, respectively. Cash flows (used in) provided by financingactivities consist primarily of proceeds from and repayments of bankborrowings, and other long-term debt, which increased due to borrowings to fundthe 2005 Acquisition and the 2004 Acquisition. Also included in the years endedDecember 31, 2005 and 2004 are the financing costs related to the 2005senior note offering, 2005 senior credit facilities and an amendment to our2003 senior credit facilities obtained in January 2004, in connectionwith the 2005 Acquisition and the 2004 Acquisition.

In connection with the 2005 Acquisition, on January 10,2005, we and various lenders entered into senior credit facilities consistingof an $80.0 million term loan facility and a $120.0 million revolvingloan facility, each of which matures on January 10, 2010. We used$80.0 million of the term loan facility (which was subsequently retired inAugust 2005 as discussed below) and approximately $93.4 million ofthe revolving loan facility to finance the 2005 Acquisition, pay related costsand expenses, and repay the outstanding obligations under and terminate our2003 senior credit facilities. The 2005 senior credit facilities arecollateralized by a blanket lien on our assets and the assets of oursubsidiaries, other than one non-wholly owned subsidiary in which we own acontrolling interest, as well as a pledge by us of all the capital stock ofthese subsidiaries.

Borrowings outstanding under the 2005 senior creditfacilities bear interest at a fluctuating rate equal to (i) in the case ofEurodollar rate loans, the LIBOR rate (adjusted for statutory reserves) plus anapplicable percentage, ranging from 1.75% to 2.50% (2.25% as of December 31,2005), determined quarterly by reference to the funded debt ratio or (ii) inthe case 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 0.75% to 1.50% (1.25% as of December 31,2005), determined quarterly by reference to the funded debt ratio. The averageinterest rates of our borrowings under the 2005 and 2003 senior creditfacilities at December 31, 2004 and December 31, 2005 were 4.5% and5.4%, respectively.

Under the 2005 senior credit facilities, we pay acommitment fee equal to a percentage, either 0.375% or 0.50%, determinedquarterly by reference to the funded debt ratio, of the average daily-unusedportion of the 2005 senior credit facilities. This commitment fee percentagewas 0.375% as of December 31, 2005.

The credit agreement for the 2005 senior creditfacilities includes customary covenants, including, but not limited to,restrictions pertaining to: (i) the incurrence of additional indebtedness,(ii) limitations on liens, (iii) making distributions, dividends andother payments, (iv) the making of certain investments and loans, (v) mergers,consolidations and acquisitions, (vi) dispositions of assets, (vii) themaintenance of minimum consolidated net worth, maximum funded debt ratios,minimum consolidated cash flow coverage ratios, and maximum senior securedleverage ratios, (viii) transactions with affiliates, (ix) sale andleaseback transactions, (x) entering into swap agreements and(xi) changes to governing documents, in each case subject to numerousbaskets, exceptions and thresholds. The funded debt ratio, consolidated cashflow coverage ratio and senior secured leverage ratio that we were required tomeet as of 

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December 31, 2005were 4.25 to 1.00, 1.10 to 1.00, and 2.00 to 1.00, respectively. We were incompliance with these and all other financial covenants at December 31,2005.

The credit agreement for the 2005 senior creditfacilities provides for customary events of default, including, but not limitedto:(i) failure to pay any principal or interest when due, (ii) failureto comply with covenants, (iii) any material representation or warrantymade by us proving to be incorrect in any material respect, (iv) defaultsrelating to or acceleration of other material indebtedness, (v) certaininsolvency or receivership events affecting us or any of our subsidiaries, (vi) achange in control, (vii) material judgments, claims or liabilities againstus or (viii) a material defect in the lenders’ lien against the collateralsecuring the obligations under the credit agreement. There were no events ofdefault under the 2005 senior credit facilities at December 31, 2005.

As of December 31, 2005, there was $14,000outstanding under the revolving line of credit and $400 in outstanding lettersof credit. The available balance under the revolving line of credit was$105,600 at December 31, 2005.   Theactual amount that could be borrowed against the line of credit is governed bythe funded debt ratio covenant. At December 31, 2005, the total amountthat could be borrowed was $55 million. The average interest rate on theborrowings outstanding at December 31, 2005 was approximately 5.4%,including the applicable 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 setforth below:

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

 

Subject to certain conditions, we will be entitled atour option on one or more occasions prior to August 15, 2008 to redeemnotes in an aggregate principal amount not to exceed 35% of the aggregateprincipal 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.

Under the terms of the notes, we were required tocomplete a publicly registered exchange offer for the senior notes forsubstantially identical senior notes. The exchange offer was completed on October 25,2005.

The terms of senior notes include customary covenants,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 (vii) merger,consolidation or sale of substantially all of our assets, in each case subjectto numerous baskets, exceptions and thresholds. We were in compliance with allcovenants at December 31, 2005.

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The terms of senior notes provide for customary eventsof default, including, but not limited to: (i) failure to pay any principalor 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, 2005.

The net proceeds of the senior notes were used toretire the term loan and reduce the revolving loan balance outstanding underthe 2005 senior credit facility.

On March 4, 2004, we obtained a $4,000 mortgageloan on our corporate headquarters in Cambridge, Massachusetts. The loan boreinterest at a rate of LIBOR plus 1.50%, had a twenty-five year amortizationschedule, which included quarterly payments of $40 plus interest from September 2004,and had a balloon payment of $3,280 due upon its maturity on December 31,2008. This loan was repaid with part of the proceeds of the sale of ourcorporate headquarters and the mortgage released on June 30, 2005.

We have entered into standard International Swaps andDerivatives Association, or ISDA, interest rate swap agreements to manage theinterest rate risk associated with our 2005 senior credit facilities. For adescription of our interest rate swap agreements, see “Item 3. Quantitative andQualitative Disclosures About Market Risk.”

On June 24, 2003, theCompany terminated its two $20,000 interest rate swap agreements, which hadbeen in effect since February 2000 and January 2002, respectively. TheJanuary 2002 interest rate swap agreement was due to expire in February 2004while the February 2000 interest rate swap agreement was due to expire in February 2005.The Company paid $3,037 to terminate both the February 2000 and January 2002swap agreements. As the timing of the forecasted future interest payments didnot significantly change as a result of the replacement of our prior creditfacility with the 2005 senior credit facilities, the accumulated othercomprehensive losses related to the terminated interest rate swap agreementsare reclassified against current period earnings in the same period theforecasted interest payments occur. Upon termination, there was $1,419, net oftaxes of $946, included in accumulated other comprehensive loss. The $88associated with the January 2002 interest rate swap agreement wasreclassified as an earnings charge through February 2004 and the $1,331associated with the February 2000 interest rate swap agreement wasreclassified as an earnings charge through February 2005.

**Contractual Obligations**

A summary of theCompany’s contractual obligations and commitments related to its outstandinglong-term debt and future minimum lease payments related to the Company’svehicle fleet, corporate headquarters and warehouse rent and minimum facilitiesmanagement rent as of December 31, 2005 is as follows:

| **Fiscal**     | ** ** | **Long Term** | ** **         | **Facilities Rent** | ** ** | **Capital Lease** | ** ** | **Operating Lease** | ** ** | ** ** | ** ** |
|----------------|------------|--------------------|--------------------|--------------------------|------------|------------------------|------------|--------------------------|------------|------------|------------|
| **Year ** | ** ** | **Debt**           | ** **         | **Commitments**          | ** ** | **Commitments**        | ** ** | **Commitments**          | ** ** | **Total**  | ** ** |
| 2006           |       |               | $                  | —                   |       |                   |       | $                        | 6,473      |       |       |   | $ | 1,227 |   |   |   | $ | 2,045 |   |   | $ | 9,745 |   |
| 2007           |       |               | —             |                     |       |                   | 5,658      |                     |       |       | 835        |   |   |   | 2,044 |   |   | 8,537 |   |
| 2008           |       |               | —             |                     |       |                   | 4,456      |                     |       |       | 452        |   |   |   | 1,739 |   |   | 6,647 |   |
| 2009           |       |               | —   |                     |       |                   | 3,364      |                     |       |       | 163        |   |   |   | 1,582 |   |   | 5,109 |   |
| 2010           |       |               | 14,000             |                     |       |                   | 2,683      |                     |       |       | —     |   |   |   | 1,247 |   |   | 17,930 |   |
| Thereafter     |       |               | 150,000            |                     |       |                   | 2,571      |                     |       |       | —     |   |   |   | 5,334 |   |   | 157,905 |   |
| Total          |       |               | $                  | 164,000                  |       |                   |       | $                        | 25,205     |       |       |   | $ | 2,677 |   |   |   | $ | 13,991 |   |   | $ | 205,873 |   |

 

We anticipate thatavailable funds from current operations, existing cash and other sources ofliquidity will be sufficient to meet current operating requirements and anticipatedcapital expenditures. However, we may require external sources of financing forany significant future acquisitions. Further, the 2005 senior credit facilitymatures in January 2010. The repayment of this facility may require externalfinancing.

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**Off Balance Sheet Arrangements**

**At theyear ended December 31, 2003, 2004 and 2005, the Company had norelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off balancesheet arrangements, or other contractually narrow or limited purposes. TheCompany is, therefore, not materially exposed to any financing, liquidity,market or credit risk that could arise if it had engaged in such relationships.**

**Seasonality**

We experience moderateseasonality as a result of our operations in the college and university market.Revenues derived from the college and university market represented approximately17% of our total facilities management revenue in 2005. Academic facilitiesmanagement and rental revenues are derived substantially during the school yearin the first, second and fourth calendar quarters. Conversely, our operatingand capital expenditures have historically been higher during the thirdcalendar quarter when we install a large amount of equipment while colleges anduniversities are generally on summer break. Product sales, principally ofMicroFridge products, to this market are typically higher during the thirdcalendar quarter as compared to the rest of the calendar year, somewhatoffsetting the seasonality effect of the laundry facilities management businessunit. The laundry facilities management assets acquired in the 2005 Acquisitionare not expected to affect the degree of seasonality experienced by us.

**Inflation**

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

**CriticalAccounting Policies and Estimates**

The preparation of our consolidated financialstatements in accordance with GAAP requires management to make judgments,assumptions and estimates that effect the amounts reported. A criticalaccounting estimate is an assumption about highly uncertain matters and couldhave a material effect on the consolidated financial statements if another,also reasonable, amount were used or a change in the estimate is reasonablylikely from period to period. We base our assumptions on historical experienceand on other estimates that we believe are reasonable under the circumstances.Actual results could differ significantly from these estimates.

Our critical accounting policies, as described in Note2 to the Mac-Gray audited consolidated financial statements includedelsewhere in this report, “Significant Accounting Policies,” state our policiesas they relate to significant matters: cash and cash equivalents, revenuerecognition, provision for doubtful accounts, inventories, provision forinventory reserves, intangible assets, impairment of long-lived assets,financial instruments and fair value of financial instruments.

*Cashand 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, 2005 and 2004, this totaled $8,388 and$4,549, 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 period willbe reasonably stated.

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*Revenuerecognition.**  *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 into long-term lease transactions thatmeet the qualifications of a sales-type lease for certain equipment. For thesetransactions, the amount of revenue recognized upon product shipment is thepresent value of the minimum lease payments, excluding executory costs andexcluding profits on executory costs, discounted at the interest rate implicitin the lease. Interest revenue is recognized over the life of the rentalagreement. At December 31, 2005 and 2004, we had $2,677 and $4,276, respectively,in receivables related to sales-type leases. These receivables have beenrecorded net of unearned interest income of $300 and $359 at December 31,2005 and 2004. These receivables are primarily due ratably over the next fiveyears and have been classified as other current assets and other long-termassets, as appropriate, on the balance sheet. The related reserve foruncollectible lease receivables at December 31, 2005 and 2004 was $120 and$152, respectively. We have not entered into significant sales-type leasessince 2001.

All installation and repair services are provided onan occurrence basis, not on a contractual basis. Related revenue is recognizedat the time the installation service, or other service, is provided to thecustomer.

We believe our accounting for facilities managementrevenue, rental revenue, service fees and long-term lease transactions areappropriate for us, properly matching the earnings process with the properreporting period.

*Provisionfor doubtful accounts.**  *Ona regular basis, we review the adequacy of our provision for doubtful accountsfor trade accounts receivable and lease receivables based on historicalcollection results and current economic conditions using factors based on theaging of our trade accounts receivable and lease receivables. In addition, weestimate specific additional allowances based on indications that a specificcustomer may be experiencing financial difficulties.

*Inventories.**  *Inventories are stated at the lowerof cost (as determined using the first-in, first-out method) or market andprimarily consist of finished goods. Based on the nature of our inventory,being laundry and MicroFridge equipment, and our inventory handling practices,we believe the lower of cost or market is the most appropriate valuation methodfor us.

*Provisionfor inventory reserves.**  *On a regular basis, we review the adequacy of ourreserve for inventory obsolescence based on historical experience, productknowledge and frequency of shipments.

*Goodwilland intangible assets.**  *Intangibleassets primarily consist of various non-compete agreements, customer lists,goodwill and contract rights recorded in connection with acquisitions. Thenon-compete agreements are amortized using the straight-line method over thelife of the agreements, which range from two to five years. Customer lists areamortized using the straight-line method over fifteen years. Contract rightsare amortized using the straight-line method over fifteen or twenty 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 our ability to maintain or exceed the level ofcustomer satisfaction maintained by the seller prior to the acquisition by us.We are accounting for acquired contract rights on a pool-basis based on the 

35

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fact that, in general, nosingle contract accounts for more than 1.5% of the revenue of any acquiredportfolio and the fact that few of the contracts are predicted to beterminated, either prior to or at the end of the contract term. Based on ourexperience, we believe that these costs associated with various acquisitionsare properly recognized and amortized over a reasonable length of time. Inaccordance with FAS 142, we stopped amortizing goodwill on January 1,2002.

*Impairmentof long-lived assets.**  *Wereview long-lived assets, including fixed assets, acquired contract rights andintangible assets with definitive lives, for impairment whenever events orchanges in business circumstances indicate that the carrying amount of theassets may not be fully recoverable or that the useful lives of these assetsare no longer appropriate. Our annual impairment test for contract rightsassigned a 15-year amortization period consists of comparing the currentnumber of machines under contract and the current cash flow of all ourcontracts in the market where the portfolios were acquired to the originalnumber of machines acquired and the cash flow as predicted by us at the time ofthe acquisition. For those contract rights assigned a 20-yearamortization period, our annual impairment test consists primarily ofidentifying the accumulated retention rate of the specific contract portfolioin order to assess the appropriateness of the net book value of the relatedcontract rights. If impairment is indicated, the asset is written down to itsestimated fair value on a discounted cash flow basis.

In accordance with FAS 142, we test our goodwillannually for impairment and whenever events or changes in businesscircumstances indicate that the carrying amount of the assets may not be fullyrecoverable. The goodwill impairment review consists of a two-step process offirst determining the fair value of the reporting unit and comparing it to thecarrying value of the net assets allocated to the reporting unit. Fair valuesof the reporting units were determined based on estimates of comparable marketprice or discounted future cash flows. If this fair value exceeds the carryingvalue, no further analysis or goodwill impairment charge is required. If thefair value of the reporting unit is less than the carrying value of the netassets, the fair value of the reporting unit is allocated to all the underlyingassets and liabilities, including both recognized and unrecognized tangible andintangible assets, based on their fair value. If necessary, goodwill is thenwritten-down to its fair value. On January 1, 2002, in connection with theinitial application of FAS 142, we recognized an impairment charge of$906.

*Financialinstruments.**  *Weaccount for derivative instruments in accordance with Statement of FinancialAccounting Standard No. 133, “Accounting for Derivative Instruments andHedging Activities” (“SFAS 133”), and Statement of Financial AccountingStandard No. 138, “Accounting for Certain Derivative Instruments andCertain Hedging Activities-an amendment of FASB No. 133” (“FAS 138”).These statements require us to recognize derivatives on our balance sheet atfair value. Derivatives that are not hedges must be adjusted to fair valuethrough earnings. If the derivative is a hedge, changes in the fair value ofderivatives will either be offset against the change in fair value of thehedged assets, liabilities or firm commitments through earnings or recognizedin other comprehensive income until the hedged item is recognized in earnings,depending on the intended use of the derivative. The ineffective portion of aderivative’s change in fair value will be immediately recognized in earnings.We have designated some of our interest rate swap agreements as cash flowhedges. Accordingly, the change in fair value of the agreements is recognizedin other comprehensive income and the ineffective portion of the change isrecognized in earnings immediately.

*Fair value of financialinstruments.**  *Forpurposes of financial reporting, we have determined that the fair value offinancial instruments approximates book value at December 31, 2005 and2004, based upon terms currently available to us in financial markets. The fairvalue of the interest rate swaps is the estimated amount that we would receiveor pay to terminate the agreement at the reporting date, taking into accountcurrent interest rates and the credit worthiness of the counter party.

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**New Accounting Pronouncements**

In November 2004, the Financial AccountingStandards Board (“FASB”) issued FAS Statement No. 151, “Inventory Costs,an Amendment of ARB No. 43 Chapter 4” (“SFAS 151”). SFAS 151 isapplicable for inventory costs incurred during fiscal years beginning after June 15,2005. SFAS 151 requires that items such as idle facility expense,excessive spoilage, double freight and rehandling be recognized ascurrent-period charges rather than being included in inventory regardless ofwhether the costs meet the criterion of abnormal as defined in ARB 43. TheCompany is currently completing its evaluation of the adoption of SFAS 151and does not believe that this statement will have an impact on its results ofoperations.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share BasedPayment” (“SFAS 123R”). SFAS 123R is a revision of FASB Statement No. 123,“Accounting for Stock-Based Compensation,” supersedes Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”),and amends SFAS No. 95 “Statement of Cash Flows.” SFAS 123R requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues. SFAS 123R is effective for fiscal years beginning after June 15,2005, or for the Company, January 1, 2006. In March 2005, the U.S.Securities and Exchange Commission (the “SEC”) issued Staff Accounting BulletinNo. 107, “Share-Based Payments” (“SAB 107”). SAB107 expresses views of theSEC regarding the interaction between SFAS and certain SEC rules andregulations and provides the SEC’s views regarding the valuation of share-basedcompensation for public companies. The Company is currently completing itsevaluation of the adoption of SFAS 123R and the impact that this statementwill have on its results of operations. The Company will apply the principlesof SAB 107 in conjunction with its adoption of SFAS 123R.

In March 2005, the FASB issued FASB Interpretation No.47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations.” FIN47 clarifies that the term “conditional asset retirement obligation” as used inSFAS No. 143, “Accounting for Assets Retirements Obligations,” refers to alegal obligation to perform an asset retirement activity in which the timingand or method of settlement are conditional on a future event that may or may notbe within the control of the entity. Furthermore, the uncertainty about thetiming and or method of settlement of a conditional asset retirement obligationshould be factored into the measurement of the liability when sufficientinformation exists. FIN 47 clarifies that an entity is required to recognizethe liability for the fair value of a conditional assets obligation whenincurred if the liability’s fair value can be reasonably estimated. Adoption ofFIN 47 did not have any material effect on the Company’s results of operations,financial condition or cash flows.

In August 2005, theFASB issued Statement No. 154, Accounting Changes and Error Corrections (“SFASNo. 154”). This statement applies to all voluntary changes in accountingprinciple and to changes required by an accounting pronouncement if thepronouncement does not include specific transition provisions, and it changesthe requirements for accounting for and reporting them. Unless it isimpractical, the statement requires retrospective application of the changes toprior periods’ financial statements. This statement is effective for accountingchanges and correction of errors made in fiscal years beginning after December 15,2005, or for the Company beginning January 1, 2006.

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

The Company is exposed toa variety of risks, including changes in interest rates on its borrowings. Inthe normal course of its business, the Company manages its exposure to theserisks as described below. The Company does not engage in trading market-risksensitive instruments for speculative purposes.

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*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, 2005.

| ** **            | ** ** | **December 31, 2005**                               | ** ** |
|-----------------------|------------|---------------------------------------------------------------|------------|
| ** **            | ** ** | **Expected Maturity Date (In Thousands)** | ** ** |
| ** **            | ** ** | **2006**                                                      | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Long-term Debt:       |       |                                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Fixed Rate            |       | $—                                                       |       | $— |   | $— |   | $— |   | $— |   | $ | 150,000 |   | $ | 150,000 |   |
| Average interest rate |       |                                                          |       |   |   |   |   |   |   |   |   | 7.625 | % |   |   |
| Variable rate         |       | $—                                                       |       | $— |   | $— |   | $— |   | $ | 14,000 |   | $ | — |   | $ | 14,000 |   |
| Average interest rate |       |                                                          |       |   |   |   |   |   |   | 5.43 | % |   |   |   |   |
|                       |            |                                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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. Concurrentwith the reduction of the amounts due under the 2005 credit facilities, eightswap agreements previously designated as cash flow hedges ceased to qualify ascash flow hedges, of which four were terminated by the Company. Of theremaining four contracts, one continues to be designated as a cash flow hedge. Thechange in the fair value of the remaining three swap agreements which do notqualify for hedge accounting is recognized in the income statement in the periodin which the change occurs. The change in the fair value of these threecontracts together with the gain on termination of the four contracts, resultedin a gain of $1,876 for the year ended December 31, 2005.

Thetable below outlines the details of each remaining swap agreement:

| ** **       | ** ** | ** **   | ** ** | ** **     | ** ** | **Notional**          | ** ** | ** **     | ** ** | ** ** | ** ** |
|------------------|------------|--------------|------------|----------------|------------|-----------------------|------------|----------------|------------|------------|------------|
| ** **       | ** ** | **Original** | ** ** | ** **     | ** ** | **Amount**            | ** ** | ** **     | ** ** | ** ** | ** ** |
| **Date of** | ** ** | **Notional** | ** ** | **Fixed/**     | ** ** | **December 31,** | ** ** | **Expiration** | ** ** | **Fixed**  | ** ** |
| **Origin**       | ** ** | **Amount**   | ** ** | **Amortizing** | ** ** | **2005**              | ** ** | **Date**       | ** ** | **Rate**   | ** ** |
| Jun 24, 2003     |       | $            | 20,000     |           | Fixed      |                  |       | $              | 20,000     |       |       | Jun 30, 2008 |   |   | 2.69 | % |   |
| Jun 24, 2003     |       | $            | 20,000     |           | Amortizing | (1)                   |       | $              | 12,857     |       |       | Jun 30, 2008 |   |   | 2.34 | % |   |
| May 2, 2005 |       | $            | 17,000     |           | Fixed      | (2)                   |       | $              | —     |       |       | Dec 31, 2011 |   |   | 4.69 | % |   |
| May 2, 2005 |       | $            | 12,000     |           | Fixed      | (3)                   |       | $              | —     |       |       | Sep 30, 2009 |   |   | 4.66 | % |   |
| May 2, 2005 |       | $            | 10,000     |           | Fixed      | (3)                   |       | $              | —     |       |       | Dec 31, 2011 |   |   | 4.77 | % |   |

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(1)          Cash flow hedge

(2)          Effective Date isMarch 31, 2007

(3)          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 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 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, 2004 and 2005, the fairvalue of the Swap 

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Agreements were $940 and$1,647, respectively. These amounts have been included in other assets on theconsolidated balance sheet.

On June 24, 2003, the Company terminated its two$20,000 interest rate swap agreements, which had been in effect since February 2000and January 2002, respectively. The January 2002 interest rate swapagreement was due to expire in February 2004 while the February 2000interest rate swap agreement was due to expire in February 2005. TheCompany paid $3,037 to terminate both the February 2000 and January 2002swap agreements. As the timing of the forecasted future interest payments didnot significantly change as a result of the replacement of our prior creditfacilities with the 2005 credit facility, the accumulated other comprehensivelosses related to the terminated interest rate swap agreements are reclassifiedagainst current period earnings in the same period the forecasted interestpayments occur. Upon termination, there was $1,419, net of taxes of $946,included in accumulated other comprehensive loss. The $88 associated with the January 2002interest rate swap agreement was reclassified as an earnings charge through February 2004and the $1,331 associated with the February 2000 interest rate swapagreement was reclassified as an earnings charge through February 2005.

As of December 31,2005, there was $14,000 outstanding under the revolving line of credit and $400in outstanding letters of credit. The available balance under the revolvingline of credit was $105,600 at December 30, 2005. The average interestrate on the borrowings outstanding at December 31, 2005 was approximately5.4%, 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-31hereto.

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

None.

**Item 9A.**                Controlsand Procedures

As of the end of the period covered by this report,and pursuant to Rule 13a-15(b) under the Securities ExchangeAct of 1934, the Company carried out an evaluation under the supervision andwith the participation of management, including the Company’s Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of the Company’s disclosure controls and procedures. Based on thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat, as of the end of the period covered by this report, the Company’sdisclosure controls and procedures were effective in that they provide reasonableassurance that information required to be disclosed by us in the reports wesubmit or file under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms. There was no change in the Company’s internal controlover financial reporting that occurred during the fiscal quarter covered bythis report that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

While the Company believesthat the present design of its disclosure controls and procedures is effectiveto make known to its senior management in a timely fashion all materialinformation concerning its business, the Company will continue to improve thedesign and effectiveness of its disclosure controls and procedures to theextent necessary in the future to provide senior management with timely accessto such material information, and to correct any deficiencies that the Companymay discover in the future.

**Item 9B.**               OtherInformation

None.

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant

The information appearingunder the caption “Information Regarding Directors/Nominees” and “InformationRegarding Executive Officers” in the Company’s definitive proxy statement forits 2006 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 StockholderMatters

The information appearingunder the caption “Principal and Management Stockholders” in the Company’sdefinitive proxy statement for its 2005 annual meeting of stockholders isincorporated herein by reference.

**Stock Option Plan Information and Employee StockPurchase Plan Information**

Thefollowing tables provide information as of December 31, 2005 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.

| **Plan category**                                      | ** ** | ** ** | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plan  (excluding securities  referenced in column (a))** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                              | ** ** | **(c)**                                                                                                          | ** ** |
| Equity  compensation plans approved by security holders(1)  |       |       | 1,123,284  |                                                                                                                                                 |       |                                                                                                             | $          | 5.60                                                                                                                                                                                                             |       |   |   | 1,261,738 | (2) |   |
| Equity  compensation plans not approved by security holders |       |       | -0-        |                                                                                                                                                 |       |                                                                                                             | -0-        |                                                                                                                                                                                                             |       |   | -0- |   |   |
| Total                                                       |       |       | 1,123,284  |                                                                                                                                                 |       |                                                                                                             | $          | 5.60                                                                                                                                                                                                             |       |   |   | 1,261,738 | (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)          Includes87,533 shares available for future issuance under the 1997 Plan, 1,081,100shares available for future issuance under the 2005 Plan, and 93,105 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. As of March 27,2006, 90,353 shares remained available for future issuance under the 1997 Planand 1,081,100 shares remained available for future issuance under the 2005Plan.

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**Item 13.**                 CertainRelationships and Related Transactions

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

**Item 14.**                 PrincipalAccountant Fees and Services

The information concerning our principal accountantfees and services required by Item 14 will be included in our definitive proxystatement for our 2006 annual meeting of stockholders and is incorporatedherein by reference.

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**PART IV**

**Item15.**                 Exhibits,Financial Statements, Schedules

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

(b)   3. Exhibits:

Exhibitsrequired by 601 of Regulation S-K and Additional Exhibits. Unless otherwiseindicated, all exhibits are part of Commission File Number 1-13495. Certainexhibits indicated below are incorporated by reference to documents of Mac-Grayon file with 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.

·       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.

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·       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.

The following is acomplete list of exhibits filed or incorporated by reference as part of thisAnnual Report on Form 10-K.

| 3.1   | ** ** | Amended and Restated Certificate of Incorporation  (3.1) +                                                                                                                                                          | ** ** | ** ** |
|-------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| 3.2   | ** ** | By-laws, as amended (3.2) v                                                                                                                                                                                         | ** ** | ** ** |
| 4.1   |       | Specimen certificate for shares of Common Stock,  $.01 par value, of the Registrant (4.1) #                                                                                                                         |       |       |
| 4.2   |       | Shareholder Rights Agreement, dated as of  June 15, 1999, by and between the Registrant and State Street Bank and  Trust Company (4.1) x                                                                       |       |       |
| 4.3   |       | Indenture, dated August 16, 2005, among  Mac-Gray Corporation, Mac-Gray Services, Inc., Intirion Corporation and  Wachovia Bank, National Association (4.1) n                                             |       |       |
| 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 ***                                                                                                           |       |       |

43

----

 

| 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                                                                                  |       |       |
| 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                                                                                                                                            | ** ** | ** ** |
| 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

----

**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 29th  DAY OF MARCH, 2006.

|                            |     | MAC-GRAY CORPORATION                             |
|----------------------------|----------|--------------------------------------------------|
|                       | By:      | /s/ STEWART GRAY MACDONALD, JR.             |
|                       |     | Stewart Gray MacDonald, Jr.                 |
| * *                   | * * | *Chairman, Chief Executive Officer and Director* |
|                       |     | *(Principal Executive Officer)*                  |
| Date: March 29,  2006 |     |                                             |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                         | **Signature** | ** **                         | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|---------------|------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| */s/ DAVID W. BRYAN*    |          | Director                           |       | March 29,  2006 |
| David  W. Bryan         |          |                               |       |                 |
| /s/ THOMAS E.  BULLOCK  |          | Director                           |       | March 29,  2006 |
| Thomas  E. Bullock      |          |                               |       |                 |
| /s/ CHRISTOPHER  JENNY  |          | Director                           |       | March 29,  2006 |
| Christopher  Jenny      |          |                               |       |                 |
| /s/ EDWARD F.  MCCAULEY |          | Director                           |       | March 29,  2006 |
| Edward  F. McCauley     |          |                               |       |                 |
| /s/ LARRY L.  MIHALCHIK |          | Director                           |       | March 29,  2006 |
| Larry  L. Mihalchik     |          |                               |       |                 |
| /s/ JERRY A.  SCHILLER  |          | Director                           |       | March 29,  2006 |
| Jerry  A. Schiller      |          |                               |       |                 |
| /s/ MICHAEL J.  SHEA    |          | Executive Vice  President, Chief   |       | March 29,  2006 |
| Michael  J. Shea        |          | Financial Officer, Treasurer and   |       |                 |
|                    |          | Secretary (Principal Financial and |       |                 |
|                    |          | Accounting Officer)                |       |                 |

 

45

----

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

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS ANDSCHEDULE**

The following consolidatedfinancial statements of the registrant and its subsidiaries required to beincluded in Item 8 are listed below.

| MAC-GRAY CORPORATION                                                                                                 |   |   |
|----------------------------------------------------------------------------------------------------------------------|--------|--------|
| Report of Independent Registered Public Accounting  Firm                                                             |   | F-2    |
| Consolidated Balance Sheets at December 31, 2004  and 2005                                                      |   | F-3    |
| Consolidated Income Statements for the Years Ended  December 31, 2003, 2004 and 2005                            |   | F-4    |
| Consolidated Statements of Stockholders’ Equity for  the Years Ended December 31, 2003, 2004 and 2005 |   | F-5    |
| Consolidated Statements of Cash Flows for the Years  Ended December 31, 2003, 2004, and 2005          |   | F-6    |
| Notes to Consolidated Financial Statements                                                                           |   | F-7    |

 

Thefollowing consolidated financial statement schedule of Mac-Gray Corporation isincluded in Item 15 (a)(2) and should be read in conjunction with thefinancial statements included herein.

| Schedule II Valuation and  Qualifying Accounts |   | F-30 |
|------------------------------------------------|--------|------|

 

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 of Directors and Stockholders of Mac-Gray Corporation:

In our opinion, theconsolidated financial statements listed in the index appearing under Item15(a)(1) present fairly, in all material respects, the financial positionof Mac-Gray Corporation and its subsidiaries at December 31, 2004 and2005, and the results of their operations and their cash flows for each of thethree years in the period ended December 31, 2005 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  requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

/s/ PricewaterhouseCoopersLLP

Boston, MassachusettsMarch 2, 2006

F-2

----

**MAC-GRAY CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

**(Inthousands, except share data)**

| ** **                                                                                                                                                                                                                                 | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                 | ** ** | **2004**              | ** ** | **2005**              | ** ** |
| ASSETS                                                                                                                                                                                                                                     |       |                  |       |                  |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                            |       |                  |       |                  |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                  |       |                  | $          | 6,491                 |       |   |   | $ | 11,046 |   |   |
| Trade receivables, net of  allowance for doubtful accounts                                                                                                                                                                                 |       |                  | 8,437      |                  |       |   | 10,308 |   |   |
| Inventory                                                                                                                                                                                                                                  |       |                  | 5,099      |                  |       |   | 6,398 |   |   |
| Deferred income taxes                                                                                                                                                                                                                      |       |                  | 2,785      |                  |       |   | 909 |   |   |
| Prepaid expenses,  facilities management rent and other current assets                                                                                                                                                                     |       |                  | 7,457      |                  |       |   | 9,052 |   |   |
| Total current assets                                                                                                                                                                                                                       |       |                  | 30,269     |                  |       |   | 37,713 |   |   |
| Property, plant and  equipment, net                                                                                                                                                                                                        |       |                  | 89,776     |                  |       |   | 118,459 |   |   |
| Goodwill                                                                                                                                                                                                                                   |       |                  | 37,941     |                  |       |   | 37,941 |   |   |
| Intangible assets, net                                                                                                                                                                                                                     |       |                  | 33,950     |                  |       |   | 116,793 |   |   |
| Prepaid expenses,  facilities management rent and other assets                                                                                                                                                                             |       |                  | 10,394     |                  |       |   | 13,177 |   |   |
| Total assets                                                                                                                                                                                                                               |       |                  | $          | 202,330               |       |   |   | $ | 324,083 |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                                                  |       |                  |       |                  |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                       |       |                  |       |                  |       |   |   |   |   |
| Current portion of  long-term debt                                                                                                                                                                                                         |       |                  | $          | 5,161                 |       |   |   | $ | — |   |   |
| Current portion of  capital lease obligations                                                                                                                                                                                              |       |                  | 942        |                  |       |   | 1,185 |   |   |
| Trade accounts payable                                                                                                                                                                                                                     |       |                  | 10,078     |                  |       |   | 10,252 |   |   |
| Accrued facilities  management rent                                                                                                                                                                                                        |       |                  | 10,685     |                  |       |   | 15,629 |   |   |
| Accrued expenses                                                                                                                                                                                                                           |       |                  | 5,337      |                  |       |   | 12,472 |   |   |
| Deferred revenues and  deposits                                                                                                                                                                                                            |       |                  | 803        |                  |       |   | 682 |   |   |
| Total current liabilities                                                                                                                                                                                                                  |       |                  | 33,006     |                  |       |   | 40,220 |   |   |
| Long-term debt                                                                                                                                                                                                                             |       |                  | 65,702     |                  |       |   | 164,000 |   |   |
| Long-term capital lease  obligations                                                                                                                                                                                                       |       |                  | 1,523      |                  |       |   | 1,493 |   |   |
| Deferred income taxes                                                                                                                                                                                                                      |       |                  | 25,464     |                  |       |   | 29,010 |   |   |
| Deferred retirement  obligation                                                                                                                                                                                                            |       |                  | 333        |                  |       |   | 229 |   |   |
| Other liabilities                                                                                                                                                                                                                          |       |                  | 366        |                  |       |   | 530 |   |   |
| Commitments and contingencies (Note 15)                                                                                                                                                                                                    |       |                  |       |                  |       |   |   |   |   |
| 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 12,782,089 outstanding at December 31, 2004, and 13,443,754 issued  and 12,924,340 outstanding at December 31, 2005) |       |                  | 134        |                  |       |   | 134 |   |   |
| Additional paid in  capital                                                                                                                                                                                                                |       |                  | 68,568     |                  |       |   | 69,032 |   |   |
| Accumulated other  comprehensive income                                                                                                                                                                                                    |       |                  | 822        |                  |       |   | 315 |   |   |
| Retained earnings                                                                                                                                                                                                                          |       |                  | 13,283     |                  |       |   | 24,513 |   |   |
|                                                                                                                                                                                                                                       |       |                  | 82,807     |                  |       |   | 93,994 |   |   |
| Less common stock in  treasury, at cost (661,665 at December 31, 2004 and 519,414 shares at  December 31, 2005)                                                                                                                  |       |                  | (6,871     | )                     |       |   | (5,393 | ) |   |
| Total stockholders’  equity                                                                                                                                                                                                           |       |                  | 75,936     |                  |       |   | 88,601 |   |   |
| Total liabilities and stockholders’ equity                                                                                                                                                                                            |       |                  | $          | 202,330               |       |   |   | $ | 324,083 |   |   |

 

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

F-3

----

**MAC-GRAY CORPORATION**

**CONSOLIDATED INCOMESTATEMENTS**

**(Inthousands, except share data)**

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenue:                                                 |       |                                        |       |   |   |   |   |
| Facilities management revenue                            |       | $                                           | 109,949    |   | $ | 140,480 |   | $ | 214,816 |   |
| Product sales                                            |       | 39,707                                      |       | 42,214 |   | 45,807 |   |
| Total revenue                                            |       | 149,656                                     |       | 182,694 |   | 260,623 |   |
| Cost of revenue:                                         |       |                                        |       |   |   |   |   |
| Cost of facilities management revenue                    |       | 73,409                                      |       | 94,459 |   | 143,156 |   |
| Depreciation and amortization                            |       | 16,723                                      |       | 20,747 |   | 31,337 |   |
| Cost of product sales                                    |       | 28,217                                      |       | 29,874 |   | 35,069 |   |
| Total cost of revenue                                    |       | 118,349                                     |       | 145,080 |   | 209,562 |   |
| Gross margin                                             |       | 31,307                                      |       | 37,614 |   | 51,061 |   |
| Operating  expenses:                                     |       |                                        |       |   |   |   |   |
| General and administration                               |       | 9,519                                       |       | 11,078 |   | 14,164 |   |
| Sales and marketing                                      |       | 11,341                                      |       | 13,005 |   | 16,097 |   |
| Depreciation and amortization                            |       | 1,100                                       |       | 1,047 |   | 1,189 |   |
| Gain on sale of assets, net                              |       | (145                                        | )          | (1,208 | ) | (10,735 | ) |
| Loss on early extinguishment of debt                     |       | 381                                         |       | 183 |   | 668 |   |
| Total operating expenses                                 |       | 22,196                                      |       | 24,105 |   | 21,383 |   |
| Income from operations                                   |       | 9,111                                       |       | 13,509 |   | 29,678 |   |
| Interest expense, net                                    |       | (2,807                                      | )          | (4,312 | ) | (10,939 | ) |
| Gain related to derivative instruments                   |       | —                                      |       | — |   | 1,876 |   |
| Gain on sale of lease receivables                        |       | 836                                         |       | — |   | — |   |
| Income before  provision for income taxes                |       | 7,140                                       |       | 9,197 |   | 20,615 |   |
| Provision for  income taxes                              |       | (3,036                                      | )          | (3,934 | ) | (8,563 | ) |
| Net income                                               |       | $                                           | 4,104      |   | $ | 5,263 |   | $ | 12,052 |   |
| Net income per common share—basic                   |       | $                                           | 0.32       |   | $ | 0.41 |   | $ | 0.94 |   |
| Net income per common share—diluted                 |       | $                                           | 0.32       |   | $ | 0.40 |   | $ | 0.91 |   |
| Weighted average common shares outstanding—basic    |       | 12,635                                      |       | 12,702 |   | 12,864 |   |
| Weighted average  common shares outstanding—diluted |       | 12,741                                      |       | 13,028 |   | 13,283 |   |

 

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

F-4

----

**MAC-GRAY CORPORATIONCONSOLIDATED 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**      | ** ** | **Captial**      | ** ** | **Loss**          | ** ** | **Income**        | ** ** | **Earnings**            | ** ** | **of Shares** | ** ** | **Cost**   | ** ** | **Total**  | ** ** |
| Balance,  December 31, 2002                                                                                |       | 13,443,754                  |       |           | $          | 134              |       |              |       | $                 | 68,540     |                    |       |               | $          | (1,723     | )          |       |       |   |   |   |   | $ | 5,805 |   |   |   | 773,534 |   |   | $ | (9,068 | ) | $ | 63,688 |   |
| Net income                                                                                                      |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | —     |               |       |       | $          | 4,104      |       |   |   | 4,104 |   |   |   | — |   |   | — |   | 4,104 |   |
| Other comprehensive income:                                                                                     |       |                        |       |           |       |             |       |              |       |              |       |                    |       |               |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized gain on  derivative instruments and reclassification adjustment, net of tax of $901 (Note  6)        |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | 1,351      |               |       |       | 1,351      |       |       |   | — |   |   |   | — |   |   | — |   | 1,351 |   |
| Comprehensive  income                                                                                           |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | —     |               |       |       | $          | 5,455      |       |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Stock issuance - Employee  Stock Purchase Plan                                                                  |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | —     |               |       |       |       |       |       |   | (212 | ) |   |   | (24,079 | ) |   | 278 |   | 66 |   |
| Repurchase of common  stock                                                                                     |       |                        |       |           |       |             |       |              |       |              |       |                    |       |               |       |       |       |       |       |   | — |   |   |   | 155,500 |   |   | (622 | ) | (622 | ) |
| Options exercised                                                                                               |       | 5,600                       |       |           | —     |             |       |              | 21         |              |       |                    | —     |               |       |       |       |       |       |   | (154 | ) |   |   | (22,000 | ) |   | 230 |   | 97 |   |
| Stock granted                                                                                                   |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | —     |               |       |       |       |       |       |   | (104 |   |   |   | (13,095 | ) |   | 149 |   | 45 |   |
| 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  6)        |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | 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 gain on  derivative instruments and reclassificationadjustment, net of tax benefit of  $338 (Note 6) |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | (507       | )                  |       |       | (507       | )          |       |   | — |   |   |   | — |   |   | — |   | (507 | ) |
| Comprehensive income                                                                                            |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | —     |               |       |       | $          | 11,545     |       |   |   | — |   |   |   | — |   |   | — |   | — |   |
| Options exercised                                                                                               |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | —     |               |       |       |       |       |       |   | (693 | ) |   |   | (104,583 | ) |   | 1,086 |   | 393 |   |
| Tax benefit on options  exercised                                                                               |       | —                      |       |           | —     |             |       |              | 464        |              |       |                    | —     |               |       |       |       |       |       |   | — |   |   |   | — |   |   | — |   | 464 |   |
| Stock issuance—Employee                                                                                    |       |                        |       |           |       |             |       |              |       |              |       |                    |       |               |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Stock Purchase Plan                                                                                             |       | —                      |       |           | —     |             |       |              | —     |              |       |                    | —     |               |       |       |       |       |       |   | (127 | ) |   |   | (31,610 | ) |   | 328 |   | 201 |   |
| 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 |   |

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

F-5

 

----

**MAC-GRAY CORPORATION**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inthousands)**

| ** **                                                                                                 | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| Cash flows from operating activities:                                                                      |       |                                        |       |   |   |   |   |
| Net income                                                                                                 |       | $                                           | 4,104      |   | $ | 5,263 |   | $ | 12,052 |   |
| Adjustments to reconcile  net income to net cash flows provided by operating  activities:                  |       |                                        |       |   |   |   |   |
| Depreciation and  amortization                                                                             |       | 17,823                                      |       | 21,794 |   | 32,526 |   |
| Loss on early  extinguishment of debt                                                                      |       | 381                                         |       | 183 |   | 668 |   |
| (Decrease)  increase in allowance for doubtful accounts and lease reserves                                 |       | 85                                          |       | (553 | ) | 206 |   |
| Gain on sale of  assets                                                                                    |       | (485                                        | )          | (1,208 | ) | (10,735 | ) |
| Deferred income  taxes                                                                                     |       | 1,098                                       |       | 4,219 |   | 2,188 |   |
| Tax benefit from  exercise of stock options                                                                |       | -                                           |       | — |   | 464 |   |
| Director stock  grant                                                                                      |       | 45                                          |       | 37 |   | 62 |   |
| Non-cash interest  (income) expense                                                                        |       | 648                                         |       | 1,368 |   | (1,680 | ) |
| Decrease  (increase)in accounts receivable                                                                 |       | (1,482                                      | )          | 821 |   | (2,077 | ) |
| Decrease  (increase) in inventory                                                                          |       | 1,328                                       |       | 563 |   | (300 | ) |
| Decrease  (increase) in prepaid expenses, facilities management rent and other assets                      |       | 974                                         |       | (913 | ) | (5,888 | ) |
| Increase in  accounts payable, accrued facilities management rent, accrued expenses and  other liabilities |       | 234                                         |       | 5,736 |   | 10,537 |   |
| Decrease in  deferred revenues and customer deposits                                                       |       | (273                                        | )          | (202 | ) | (121 | ) |
| Net cash flows  provided by operating activities                                                           |       | 24,480                                      |       | 37,108 |   | 37,902 |   |
| Cash flows from investing activities:                                                                      |       |                                        |       |   |   |   |   |
| Capital  expenditures                                                                                      |       | (15,372                                     | )          | (17,826 | ) | (26,380 | ) |
| Payments for  acquisitions, net of cash received                                                           |       | (1,030                                      | )          | (41,454 | ) | (106,244 | ) |
| Proceeds from sale  of lease receivables                                                                   |       | 3,284                                       |       | — |   | — |   |
| Proceeds from sale  of property and equipment                                                              |       | 316                                         |       | 2,179 |   | 12,373 |   |
| Net cash flows  used in investing activities                                                               |       | (12,802                                     | )          | (57,101 | ) | (120,251 | ) |
| Cash flows from financing activities:                                                                      |       |                                        |       |   |   |   |   |
| Payments on  long-term debt and capital lease obligations                                                  |       | (1,630                                      | )          | (1,396 | ) | (1,390 | ) |
| 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 term  credit facility and mortgage note payable                                              |       | 20,000                                      |       | 22,071 |   | — |   |
| Payments on term  credit facility and mortgage note payable                                                |       | (3,071                                      | )          | (5,120 | ) | (33,880 | ) |
| Payments on 2000  Senior Secured Credit Facility, net                                                      |       | (54,500                                     | )          | — |   | — |   |
| (Payments)  borrowings on revolving credit facility, net                                                   |       | 31,765                                      |       | 5,217 |   | (22,984 | ) |
| Payments for  repurchase of common stock                                                                   |       | (622                                        | )          | — |   | — |   |
| Financing costs                                                                                            |       | (466                                        | )          | (297 | ) | (6,218 | ) |
| (Payments for)  proceeds from termination of derivative instruments                                        |       | (3,037                                      | )          | — |   | 782 |   |
| Proceeds from  issuance of common stock                                                                    |       | 66                                          |       | 95 |   | 201 |   |
| Proceeds from  exercise of stock options                                                                   |       | 97                                          |       | 618 |   | 393 |   |
| Net cash flows  (used in) provided by financing activities                                                 |       | (11,398                                     | )          | 21,188 |   | 86,904 |   |
| Increase in cash  and cash equivalents                                                                     |       | 280                                         |       | 1,195 |   | 4,555 |   |
| Cash and cash  equivalents, beginning of period                                                            |       | 5,016                                       |       | 5,296 |   | 6,491 |   |
| Cash and cash  equivalents, end of period                                                                  |       | $                                           | 5,296      |   | $ | 6,491 |   | $ | 11,046 |   |
| Supplemental cash flow information:                                                                        |       |                                        |       |   |   |   |   |
| Interest paid                                                                                              |       | $                                           | 3,132      |   | $ | 3,641 |   | $ | 6,553 |   |
| Income taxes paid                                                                                          |       | $                                           | 319        |   | $ | 646 |   | $ | 6,622 |   |

 

Supplemental disclosure of non-cash investingactivities: During the years ended December 31, 2003, 2004 and 2005, theCompany acquired various vehicles under capital lease agreements totaling$1,380, $1,579, and $1,499, respectively.

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

F-6

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

**1.   Description of the Businessand Basis of Presentation**

*Descriptionof the Business.*   Mac-Gray Corporation (“Mac-Gray”or the “Company”) generates the majority of its revenue from card/coin-operatedlaundry rooms located in the Northeastern, Southeastern and Midwestern UnitedStates. A portion of its revenue is also derived from the sale and lease of theCompany’s MicroFridge® 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 Company alsogenerates revenue from card/coin-operated reprographics equipment located inuniversity and municipal libraries, and other buildings. The majority of theCompany’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**

*Cashand Cash Equivalents.*   The Company considers allhighly liquid investments with original maturities of three months or less tobe cash equivalents. On occasion the Company has excess cash available for ashort period of time; when this occurs, the Company invests such excess cash inrepurchase agreements and other highly liquid short-term investments. Accordingly,the investments are subject to minimal credit and market risk. The Company hascash investments with financial institutions in excess of the $100 insuredlimit of the Federal Deposit Insurance Corporation. Included in cash and cashequivalents is an estimate of cash not yet collected which remains at laundryand reprographics customer locations. At December 31, 2004 and 2005, thisestimate was $4,549 and $8,388, respectively.

*RevenueRecognition.*   The Company recognizes facilitiesmanagement revenue on the accrual basis. Rental revenue is recognized ratablyover the related contractual period, which is generally less than one year. TheCompany recognizes revenue from product sales upon shipment of the products,unless otherwise 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 entered into long-term leasetransactions that meet the qualifications of a sales-type lease for certainequipment. For these transactions, the amount of revenue recognized uponproduct shipment is the present value of the minimum lease payments, excludingexecutory costs and excluding profits on executory costs, discounted at theinterest rate implicit in the lease. Interest revenue is recognized over thelife of the rental agreement. At December 31, 2004 and 2005 the Companyhad $4,276 and $2,680, respectively, in receivables related to sales-typeleases. These receivables have been recorded net of unearned interest income of$359 and $300 at December 31, 2004 and 2005. These receivables areprimarily due ratably over the next five years and have been classified asother current assets and other long-term assets, as appropriate, in theconsolidated balance sheet. The related reserve for lease receivables was $152at December 31, 2004 and 2005.  TheCompany has not entered into any significant sales-type leases since 2001. In September of2003, the Company received $3,284 for the sale of certain lease receivablesresulting in a gain of $836.

F-7

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

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

*Allowancefor Doubtful Accounts.*   On a regular basis, theCompany reviews the adequacy of its provision for doubtful accounts for tradeaccounts receivable and lease receivables based on historical 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 $230 and $436 at December 31, 2004and 2005, respectively.

*Concentrationof Credit Risk.*   Financial instruments whichpotentially expose the Company to concentration of credit risk include tradeand lease receivables generated by the Company as a result of the selling andleasing of laundry 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 customer accounted for more than 10% of revenues or accountsreceivable for any period presented.

*FairValue of Financial Instruments.*   For purposes offinancial reporting, the Company has determined that the fair value offinancial instruments approximates book value at December 31, 2004 and2005, based upon terms currently available to the Company in financial markets.The fair value of the interest rate swaps is the estimated amount that theCompany would receive or pay to terminate the agreement at the reporting date,taking into account current interest rates and the credit worthiness of thecounter party.

*Inventories.*   Inventoriesare stated at the lower of cost (as determined using the first-in, first-outmethod) or market, and consist primarily of finished goods.

*Provisionfor Inventory Reserves.**  *On a regular basis, the Company reviews the adequacyof its reserve for inventory obsolescence based on historical experience,product knowledge and frequency of shipments.

*PrepaidFacilities Management Rent.*   Prepaid facilitiesmanagement rent consists of cash advances paid to property owners and managersunder laundry service contracts. The prepaid amount is amortized ratably overthe life of the contract.

*Property,Plant and Equipment.*   Property, plant andequipment are stated at cost and depreciated using the straight-line methodover the estimated useful lives of the respective assets. Expenditures formaintenance and repairs are charged to operations as incurred; acquisitions,major renewals, and betterments are capitalized. Upon retirement or sale, thecost of assets disposed of and their related accumulated depreciation oramortization are removed from the accounts, with the resulting gain or lossreflected in income.

*FacilitiesManagement Equipment—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.

F-8

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

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

*AdvertisingCosts.*   Advertising costs are expensed asincurred. These costs were $1,101, $1,251 and $1,347 for the years ended December 31,2003, 2004 and 2005, respectively.

*Goodwilland Intangible Assets.*   Intangible assetsprimarily consist of various non-compete agreements, customer lists, goodwill,trademark and contract rights recorded in connection with acquisitions. Thenon-compete agreements are amortized using the straight-line method over thelife of the agreements, which range from two to five 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 contractaccounts for more than 1.5% of the revenue of any acquired portfolio and thefact that few of the contracts are predicted to be terminated, either prior toor at the end of the contract term. In accordance with the adoption of theprovisions of Statement of Financial Accounting Standards No. 142, “Goodwilland Other Intangible Assets” (“FAS 142”) (see note 6), the Company stoppedamortizing goodwill on January 1, 2002.

*Impairmentof Long-Lived Assets.*   The Company reviewslong-lived assets, including fixed assets 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. The Company’sannual impairment test for contract rights assigned a 15-yearamortization period consists of comparing the current number of machines undercontract and the current cash flow of all the Company’s contracts in the marketwhere the portfolios were acquired to the original number of machines acquiredand the cash flow as predicted by the Company at the time of the acquisition. Forthose contract rights assigned a 20-year amortization period, the Company’sannual impairment test consists primarily of identifying the accumulatedretention rate of the specific acquired contract portfolio in order to assessthe appropriateness of the net book value of the related contract rights. If animpairment is indicated, the asset is written down to its estimated fair valueon a discounted cash flow basis.

The Company tests its goodwill annually for impairment.The goodwill impairment review consists of a two-step process of firstdetermining the fair value of the reporting unit and comparing it to thecarrying value of the net assets allocated to the reporting unit. Fair valuesof the reporting units were determined based on estimates of comparable marketprice or discounted future cash flows. If this fair value exceeds the carryingvalue, no further analysis or goodwill impairment charge is required. If thefair value of the reporting unit is less than the carrying value of the netassets, the implied fair value of the reporting unit is allocated to all theunderlying assets and liabilities, including both recognized and unrecognizedtangible and intangible assets, based on their fair value. If necessary,goodwill is then written-down to its fair value.

The Company evaluates its trademark annually forimpairment. If the trademark is still actively used by the Company andcontinues to be a recognized brand in the industry, there is deemed to be noimpairment.

F-9

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

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

*IncomeTaxes.*   The Company accounts for income taxesutilizing the asset and liability method as prescribed by Statement ofFinancial Accounting Standards No. 109, “Accounting for Income Taxes” (“FAS 109”).Under the provisions of FAS 109, the current or deferred tax consequences of atransaction are measured by applying the provisions of enacted tax laws todetermine the amount of taxes payable currently or in future years. Theclassification of net current and non-current deferred tax assets orliabilities depend upon the nature of the related asset or liability. Deferredincome taxes are provided for temporary differences between the income taxbasis of assets and liabilities and their carrying amounts for financialreporting purposes.

*StockCompensation.*   The Company’s stock option plansare accounted for in accordance with Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees” (“APB No. 25”). The Companyuses the disclosure requirements of Statement of Financial Accounting Standard No. 123,“Accounting for Stock-Based Compensation” (“FAS 123”). Under APB No. 25,the Company does not recognize compensation expense on stock options granted toemployees, because the exercise price of each option is equal to the marketprice of the underlying stock on the date of the grant.

If thecompany had elected to recognize compensation cost based on the fair value ofthe options granted at grant date as prescribed by FAS 123, the Company’s net incomeand earnings per share would have been reduced to the following pro formaamounts:

| ** **                                                                                                | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income, as  reported                                                                                  |       | $                                          | 4,104      |   | $ | 5,263 |   | $ | 12,052 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value related  tax effects |       | (377                                       | )          | (241 | ) | (337 | ) |
| Pro forma net  income                                                                                     |       | $                                          | 3,727      |   | $ | 5,022 |   | $ | 11,715 |   |
| Earnings per  share:                                                                                      |       |                                       |       |   |   |   |   |
| Basic, as reported                                                                                        |       | $                                          | 0.32       |   | $ | 0.41 |   | $ | 0.94 |   |
| Basic, pro forma                                                                                          |       | $                                          | 0.29       |   | $ | 0.40 |   | $ | 0.91 |   |
| Diluted, as reported                                                                                      |       | $                                          | 0.32       |   | $ | 0.40 |   | $ | 0.91 |   |
| Diluted, pro  forma                                                                                       |       | $                                          | 0.29       |   | $ | 0.39 |   | $ | 0.88 |   |

 

Thefair value of the Company’s options was estimated as of the date of grant usinga Black-Scholes option pricing model with the following components:

| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2003**              | ** ** | **2004** | ** ** | **2005** | ** ** |
| Fair value of  options granted at grant date     |       | $                     | 2.42       |   | $ | 2.48 |   | $ | 3.80 |   |
| Risk free  interest rate                         |       | 3.74                  | %          | 3.03 | % | 3.84 | % |
| Expected option  term—employees             |       | 7 years               |       | 7 years |   | 7 years |   |
| Expected option  term—independent directors |       | 3 years               |       | 3 years |   | 3 years |   |
| Expected volatility                              |       | 41                    | %          | 36 | % | 37 | % |
|                                                  |            |                       |            |  |  |  |  |  |  |  |

 

F-10

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

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

Because the determination of the fair value of alloptions granted includes vesting periods over several years and additionaloption grants are expected to be made each year, the above pro formadisclosures are not representative of pro forma effects of reported net incomefor future periods.

*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. Actualresults could differ from those estimates.

*EarningsPer Share.*   The Company accounts for earnings pershare in accordance with Statement of Financial Accounting Standards No. 128,“Earnings Per Share” (“FAS 128”). FAS 128 requires the presentation of basicearnings per share (“EPS”) and diluted earnings per share. Basic EPS includesno dilution and is computed by dividing net income available to commonstockholders by the weighted-average number of common shares outstanding forthe period. Diluted EPS reflects the potential dilution of securities thatcould share in the earnings of an entity. Diluted earnings per share has beencalculated using the treasury stock method.

*OtherComprehensive Income.*   The Company accounts forcomprehensive income in accordance with Statement of Financial AccountingStandards No. 130, “Reporting Comprehensive Income” (“FAS 130”). Thisstatement requires disclosure of comprehensive income and its components ininterim and annual reports. Comprehensive income includes all changes instockholders’ equity during a period except those resulting from investments bystockholders and distributions to stockholders.

*FinancialInstruments.*   The Company accounts for derivativeinstruments in accordance with the provisions of 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 FAS No. 133” (“FAS 138”). Thesestatements require the Company to recognize derivatives on its balance sheet atfair value. 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 thehedged assets, liabilities or firm commitments through earnings or recognizedin other comprehensive income until the hedged item is recognized in earnings,depending on the intended use of the derivative. The ineffective portion of aderivative’s change in fair value will be immediately recognized in earnings.

*ProductWarranties.**  *TheCompany offers limited-duration warranties on MicroFridge® products and, at the time of sale, providesreserves for all estimated warranty costs based upon historical experience. Actualcosts have not exceeded the Company’s estimates.

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 activity for the yearended December 31, 2005 is as follows:

| ** **                             | ** ** | **Accrued**  | ** ** |
|----------------------------------------|------------|--------------|------------|
| ** **                             | ** ** | **Warranty** | ** ** |
| Balance,  December 31, 2003       |       |         | $          | 250 |   |   |
| Accruals for warranties  issued        |       |         | 383        |   |   |
| Settlements made (in  cash or in kind) |       |         | (365       | ) |   |
| Balance,  December 31, 2004       |       |         | 268        |   |   |
| Accruals for warranties  issued        |       |         | 366        |   |   |
| Settlements made (in  cash or in kind) |       |         | (344       | ) |   |
| Balance, December 31, 2005        |       |         | $          | 290 |   |   |

 

*NewAccounting Pronouncements.*   In November 2004,the Financial Accounting Standards Board (“FASB”) issued FAS Statement No. 151,“Inventory Costs, an Amendment of ARB No. 43 Chapter 4” (“SFAS 151”).SFAS 151 is applicable for inventory costs incurred during fiscal yearsbeginning after June 15, 2005. SFAS 151 requires that items such asidle facility expense, excessive spoilage, double freight and rehandling berecognized as current-period charges rather than being included in inventoryregardless of whether the costs meet the criterion of abnormal as defined inARB 43. The Company is currently completing its evaluation of the adoption ofSFAS 151 and does not believe that this statement will have an impact onits results of operations.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123 (revised 2004), “Share BasedPayment” (“SFAS 123R”). SFAS 123R is a revision of FAS Statement No. 123,“Accounting for Stock-Based Compensation,” supersedes Accounting PrinciplesBoard Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”),and amends SFAS No. 95 “Statement of Cash Flows.” SFAS 123R requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues. SFAS 123R is effective for fiscal years beginning after June 15,2005, or for the Company, January 1, 2006. In March 2005, the U.S.Securities and Exchange Commission (the “SEC”) issued Staff Accounting BulletinNo. 107, “Share-Based Payments” (“SAB 107”). SAB107 expresses views of theSEC regarding the interaction between SFAS and certain SEC rules andregulations and provides the SEC’s views regarding the valuation of share-basedcompensation for public companies. The Company is currently completing itsevaluation of the adoption of SFAS 123R and the impact that this statementwill have on its results of operations. The Company will apply the principlesof SAB 107 in conjunction with its adoption of SFAS 123R.

In March 2005, the FASB issued FASB Interpretation No.47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations.” FIN47 clarifies that the term “conditional asset retirement obligation” as used inSFAS No. 143, “Accounting for Assets Retirements Obligations,” refers to alegal obligation to perform an asset retirement activity in which the timingand or method of settlement are conditional on a future event that may or maynot be within the control of the entity. Furthermore, the uncertainty about thetiming and or method of settlement of a conditional asset retirement obligationshould be factored into the measurement of the liability when sufficientinformation exists. FIN 47 clarifies that an entity is required to recognizethe liability for the fair value of a conditional assets obligation whenincurred if the liability’s fair value can be reasonably estimated. Adoption ofFIN 47 did not have any material effect on the Company’s results of operations,financial condition or cash flows. The Company will implement FIN 47 effectiveJanuary 1, 2006.

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)

In August 2005, the FASB issued Statement No. 154,Accounting Changes and Error Corrections (“SFAS No. 154”). This statementapplies to all voluntary changes in accounting principle and to changesrequired by an accounting pronouncement if the pronouncement does not includespecific transition provisions, and it changes the requirements for accountingfor and reporting them. Unless it is impractical, the statement requiresretrospective application of the changes to prior periods’ financialstatements. This statement is effective for accounting changes and correctionof errors made in fiscal years beginning after December 15, 2005, or forthe Company beginning January 1, 2006.

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

**3.   Acquisitions**

On January 10, 2005, the Company acquired thelaundry facilities management assets of Web Service Company, Inc., or “Web”,in several western and southern states (the “2005 Acquisition”). On January 16,2004, the Company acquired Web’s laundry facilities management assets in 13eastern and southeastern states and the District of Columbia (the “2004Acquisition”). As part of the purchase price for the assets acquired in the2004 Acquisition, the Company transferred certain of its laundry facilitiesmanagement assets valued at $2,000 to Web. In accordance with SFAS No. 141,“Business Combinations”, the disposal of assets and related contracts wasrecognized at fair value, the difference between the fair value and the Company’scost recognized as a gain and the fair value of the assets transferred to theseller is included in the acquisition costs. This sale resulted in a gain ofapproximately $1,218. The acquisitions have been reflected in the accompanyingcondensed consolidated financial statements from the date of the acquisitions,and have been accounted for as purchase business combinations in accordancewith SFAS No. 141. The total purchase price of these acquisitions havebeen allocated to the acquired assets and liabilities based on estimates oftheir related fair value. The Company engaged an independent business appraisalfirm to estimate the fair value of the assets acquired in each acquisition andto advise the Company on the proper allocation of the purchase price. For eachacquisition a twenty-year amortization period has been assigned to the acquiredcontract rights and a five-year depreciation period has been assigned to theacquired used laundry equipment. The amount allocated to the trade name willnot be amortized, as the Company believes it will use the name indefinitely.

F-13

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

**3.**   Acquisitions (Continued)

The total purchase priceof each of these acquisitions, including assumed liabilities of accruedfacilities management rent and accrued notes payable was allocated as follows:

| ** **                     | ** ** | **Acquisition Date**  | ** ** |
|--------------------------------|------------|----------------------------|------------|
| ** **                     | ** ** | **January 16,  2004** | ** ** | **January 10,  2005** | ** ** |
| Contract Rights                |       |                       | $          | 28,060 |   |   |   | $ | 71,858 |   |   |
| Equipment                      |       |                       | 12,027     |   |   |   | 25,099 |   |   |
| Trade Name                     |       |                       | —     |   |   |   | 12,650 |   |   |
| Inventory                      |       |                       | 804        |   |   |   | 999 |   |   |
| Accrued  Uncollected Cash      |       |                       | 941        |   |   |   | 3,900 |   |   |
| Furniture &  Fixtures |       |                       | 30         |   |   |   | 1,452 |   |   |
| Non-Compete  Agreement         |       |                       | 49         |   |   |   | — |   |   |
| Total Purchase  Price          |       |                       | $          | 41,911 |   |   |   | $ | 115,958 |   |   |

 

The following unauditedpro forma operating results of the Company assume the 2005 acquisition tookplace on January 1, 2004. Such information includes adjustments to reflectadditional depreciation, amortization and interest expense, and is notnecessarily indicative of what the results of operations would have been or theresults of operations in future periods.

| ** **             | ** ** | **Year Ended**   | ** ** |
|------------------------|------------|-----------------------|------------|
| ** **             | ** ** | **December 31,** | ** ** |
| ** **             | ** ** | **2004**              | ** ** |
| Net revenue            |       |                  | $          | 252,031 |   |   |
| Net income             |       |                  | 1,174      |   |   |
| Net income per  share: |       |                  |       |   |   |
| Basic                  |       |                  | $          | 0.09 |   |   |
| Diluted                |       |                  | $          | 0.09 |   |   |

 

**4.**   Saleof Corporate Headquarters

On June 30, 2005, wecompleted the sale of our corporate headquarters in Cambridge, Massachusettsfor $11.8 million in cash. We used the net proceeds from the sale to repaythe $3.8 million balance of the mortgage loan on the property and repay$2.0 million under the 2005 senior credit facilities. Concurrently withthe closing of the sale, we leased the property back from the purchaser untilMarch 31, 2006 while we relocated our corporate, warehouse and branchoperations to new facilities. In connection with this sale, in the secondquarter of 2005 we recorded a gain of approximately $6.1 million, net oftaxes.

**5.   Long-Term Debt**

Concurrent with the January 10, 2005 acquisition,the Company entered into new Senior Secured Credit Facilities (“2005 CreditFacilities”). This transaction retired both the June 2003 Revolving Lineof Credit and the June 2003 Senior Secured Term Loan Facility, which hadbeen amended in January 2004 (the “January 2004 amendment”). The 2005Credit Facilities provide for borrowings up to $200,000, consisting of a$120,000 Revolving Line of Credit (“2005 Revolver”) and an $80,000 SeniorSecured Term Loan Facility (“2005 Term Loan”).

F-14

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

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

On August 16, 2005,the Company restructured its debt by issuing senior unsecured notes in theamount of $150,000. These notes bear interest at 7.625% payable semi-annuallyeach February and August. The maturity date of the notes is August 15,2015. The 2005 Credit Facilities were amended to permit the offering of thenotes and modify certain of the covenants applicable to the 2005 CreditFacilities. The proceeds from the senior notes, less financing costs, were usedto retire the 2005 Term Loan and pay down the 2005 Revolver. 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 of theyears 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.

Under the terms of the notes, we were required tocomplete a publicly registered exchange offer for the senior notes forsubstantially identical senior notes. The exchange offer was completed on October 25,2005.

The terms of senior notes include customary covenants,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 (vii) merger,consolidation or sale of substantially all of our assets, in each case subjectto numerous baskets, exceptions and thresholds. There were no events of defaultunder the senior notes at December 31, 2005.

The terms of senior notes provide for customary eventsof 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, 2005.

The 2005 Revolver matures on January 10, 2010 andcontinues to be collateralized by a blanket lien on the assets of the Companyand its two main subsidiaries, Mac-Gray Services, Inc. and IntirionCorporation, as well as a pledge by the Company of all the capital stock ofthese two subsidiaries.

F-15

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

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

Borrowings outstanding under the 2005 Revolver 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 1.75% to 2.50% (as of December 31, 2005, 2.25%)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 0.75% to 1.50% (as of December 31,2005, 1.25%), determined quarterly by reference to the funded debt ratio.

As of December 31, 2005, there was $14,000outstanding under the revolving line of credit and $400 in outstanding lettersof credit. The available balance under the revolving line of credit was$105,600 at December 31, 2005. The actual amount that could be borrowedagainst the line of credit is governed by the funded debt ratio covenant. At December 31,2005, the total amount that could be borrowed was $55 million.

The 2005 Revolver includes customary covenants,including, but not limited to, restrictions pertaining to: (i) theincurrence of additional indebtedness, (ii) limitations on liens, (iii) makingdistributions, dividends and other payments, (iv) the making of certaininvestments and loans, (v) mergers, consolidations and acquisitions, (vi) dispositionsof assets, (vii) the maintenance of minimum consolidated net worth,maximum funded debt ratios, minimum consolidated cash flow coverage ratios, andmaximum senior secured leverage ratios, (viii) transactions withaffiliates, (ix) sale and leaseback transactions, (x) entering intoswap 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 thatthe Company was required to meet as of December 31, 2005 were 4.25 to1.00, 1.10 to 1.00, and 2.00 to 1.00, respectively. The Company was incompliance with these and all other financial covenants at December 31,2005.

The 2005 Revolver provides for customary events ofdefault, including, but not limited to: (i) failure to pay any principalor interest when due, (ii) failure to comply with covenants, (iii) anymaterial representation or warranty made by the Company proving to be incorrectin any material respect, (iv) defaults relating to or acceleration ofother material indebtedness, (v) certain insolvency or receivership eventsaffecting the Company or any of its subsidiaries, (vi) a change incontrol, (vii) material judgments, claims or liabilities against theCompany or (viii) a material defect in the lenders’ lien against thecollateral securing the obligations under the Credit Agreement. There were noevents of default under the 2005 Revolver at December 31, 2005.

As a result of the January 2004 amendment,entering into the 2005 Credit Facilities in January 2005, and the August 2005amendment of the 2005 Credit Facilities, the Company expensed approximately$183 and $668 in deferred financing costs in the periods ended December 31,2004 and 2005, respectively.

The weighted average interest rates of the Company’sborrowings under the 2003 and 2005 Credit Facilities at December 31, 2004and 2005 were 4.5% and 5.4%, respectively.

On March 4, 2004, the Company obtained a $4,000mortgage loan on its corporate headquarters in Cambridge, Massachusetts. Theterms of the loan included interest at a rate of LIBOR plus 1.50%, atwenty-five year amortization with quarterly payments of $40 plus interest, anda balloon payment of 

F-16

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

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

$3,280 due upon maturityon December 31, 2008. On June 30, 2005, the outstanding mortgage loanwas paid in full as a result of the sale of the real estate.

Long-term debt also includes capital lease obligationson the company’s vehicles totaling $2,465 and $2,678 at December 31, 2004and 2005, respectively.

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

| ** ** | ** ** | **Amount** | ** ** |
|------------|------------|------------|------------|
| 2006       |       | 1,227      |       |
| 2007       |       | 835        |       |
| 2008       |       | 452        |       |
| 2009       |       | 164        |       |
| 2010       |       | 14,000     |       |
| Thereafter |       | 150,000    |       |
|       |       | $          | 166,678    |   |
|            |            |            |            |  |

 

**6.   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 2005 creditfacilities, eight swap agreements previously designated as cash flow hedges ceasedto qualify as cash flow hedges, of which four were terminated by the Company. Ofthe remaining four contracts, one continues to be designated as a cash flowhedge. The change in the fair value of the remaining three swap agreementswhich do not qualify for hedge accounting is recognized in the income statementin the period in which the change occurs. The change in the fair value of thesethree contracts together with the gain on termination of the four contracts,resulted in a gain of $1,876 for the year ended December 31, 2005.

Thetable below outlines the details of each remaining swap agreement:

| ** **              | ** ** | ** **   | ** ** | ** **     | ** ** | **Notional**          | ** ** | ** **     | ** ** | ** ** | ** **    |
|-------------------------|------------|--------------|------------|----------------|------------|-----------------------|------------|----------------|------------|------------|---------------|
| ** **              | ** ** | **Original** | ** ** | ** **     | ** ** | **Amount**            | ** ** | ** **     | ** ** | ** ** | ** **    |
| ** **              | ** ** | **Notional** | ** ** | **Fixed/**     | ** ** | **December 31,** | ** ** | **Expiration** | ** ** | **Fixed**  | ** **    |
| **Date of Origin** | ** ** | **Amount**   | ** ** | **Amortizing** | ** ** | **2005**              | ** ** | **Date**       | ** ** | **Rate**   | ** **    |
| Jun 24, 2003            |       | $20,000      |       | Fixed          |       |                  | $          | 20,000         |       |       | Jun  30, 2008 |   | 2.69% |   |
| Jun 24, 2003            |       | $20,000      |       | Amortizing     | (1)        |                  | $          | 12,857         |       |       | Jun  30, 2008 |   | 2.34% |   |
| May 2, 2005        |       | $17,000      |       | Fixed          | (2)        |                  | $          | —         |       |       | Dec  31, 2011 |   | 4.69% |   |
| May 2, 2005        |       | $12,000      |       | Fixed          | (3)        |                  | $          | —         |       |       | Sep  30, 2009 |   | 4.66% |   |
| May 2, 2005        |       | $10,000      |       | Fixed          | (3)        |                  | $          | —         |       |       | Dec  31, 2011 |   | 4.77% |   |

----

(1)          Cash flow hedge

(2)          Effective Date isMarch 31, 2007

(3)          EffectiveDate is June 30, 2008

F-17

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

**6.**   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 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, 2004 and 2005, the fairvalue of the Swap Agreements were $940 and $1,647, respectively. These amountshave been included in other assets on the consolidated balance sheet.

On June 24, 2003, the Company terminated its two$20,000 interest rate swap agreements, which had been in effect since February 2000and January 2002, respectively. The January 2002 interest rate swapagreement was due to expire in February 2004 while the February 2000interest rate swap agreement was due to expire in February 2005. TheCompany paid $3,037 to terminate both the February 2000 and January 2002swap agreements. As the timing of the forecasted future interest payments didnot significantly change as a result of the replacement of our prior creditfacility with the 2005 Credit Facilities, the accumulated other comprehensivelosses related to the terminated interest rate swap agreements are reclassifiedagainst current period earnings in the same period the forecasted interestpayments occur. Upon termination, there was $1,419, net of taxes of $946,included in accumulated other comprehensive loss. The $88 associated with the January 2002interest rate swap agreement was reclassified as an earnings charge through February 2004and the $1,331 associated with the February 2000 interest rate swapagreement was reclassified as an earnings charge through February 2005.

Thechanges in accumulated other comprehensive (loss) income relate entirely to theCompany’s interest rate swap agreement. If the Company were to change itshedging strategy, it would recognize a gain of approximately $552 based on thefair value of the Swap Agreements at December 31, 2005. The components ofother comprehensive income are as follows:

| ** **                                                   | ** ** | **For the years ended  December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2003**                                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Unrealized gain  on derivative instruments                   |       | $                                                         | 1,247      |   | $ | 622 |   | $ | 835 |   |
| Reclassification  adjustment                                 |       | 1,005                                                     |       | 1,368 |   | (1,680 | ) |
| Total other  comprehensive income (loss) before income taxes |       | 2,252                                                     |       | 1,990 |   | (845 | ) |
| Income tax  (expense) benefit                                |       | (901                                                      | )          | (796 | ) | 338 |   |
| Total other  comprehensive income (loss)                     |       | $                                                         | 1,351      |   | $ | 1,194 |   | $ | (507 | ) |

 

The reclassification adjustment above represents gains(losses) upon termination of swap agreements.

F-18

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

**7.   Prepaid Expenses,Facilities Management Rent and Other Current Assets**

Prepaidexpenses, facilities management rent and other current assets consist of thefollowing:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Prepaid  facilities managment rent |       | $                     | 2,305      |   | $ | 3,576 |   |
| Prepaid supplies                   |       | 1,892                 |       | 2,997 |   |
| Leases receivable                  |       | 1,884                 |       | 1,259 |   |
| Prepaid income  taxes              |       | —                |       | 304 |   |
| Prepaid insurance                  |       | 972                   |       | 392 |   |
| Other                              |       | 404                   |       | 524 |   |
|                               |       | $                     | 7,457      |   | $ | 9,052 |   |

 

**8.   Prepaid Expenses,Facilities Management Rent and Other Assets**

Prepaid expenses, facilities management rent and otherassets consist of the following:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Prepaid  facilities managment rent |       | $                     | 6,514      |   | $ | 8,508 |   |
| Leases receivable                  |       | 2,048                 |       | 1,301 |   |
| Notes receivable                   |       | 635                   |       | 478 |   |
| Deposits                           |       | —                |       | 593 |   |
| Derivative  instruments            |       | 940                   |       | 1,647 |   |
| Other                              |       | 257                   |       | 650 |   |
|                               |       | $                     | 10,394     |   | $ | 13,177 |   |

 

F-19

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

**9.   Property, Plantand Equipment**

Property,plant and equipment consist of the following:

| ** **                                                  | ** ** | **Estimated**        | ** ** | **December 31** | ** ** |
|-------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                                  | ** ** | **Useful Life** | ** ** | **2004**             | ** ** | **2005** | ** ** |
| Facilities  management equipment                            |       | 5-10 years           |       | $                    | 165,456    |   | $ | 211,809 |   |
| Rental equipment                                            |       | 7 years              |       | 2,243                |       | 2,779 |   |
| Facilities  management improvements                         |       | 7-10 years           |       | 9,938                |       | 11,078 |   |
| Buildings and  improvements                                 |       | 10-39 years          |       | 2,658                |       | 1,479 |   |
| Furniture,  fixtures and computer equipment                 |       | 2-7 years            |       | 9,466                |       | 12,321 |   |
| Trucks and autos                                            |       | 3-5 years            |       | 5,917                |       | 6,699 |   |
| Tooling costs                                               |       | 3 years              |       | 394                  |       | 422 |   |
| Land and  improvements                                      |       | —               |       | 221                  |       | 77 |   |
|                                                        |       |                 |       | 196,293              |       | 246,664 |   |
| Less: accumulated  depreciation                             |       |                 |       | 108,603              |       | 131,630 |   |
|                                                        |       |                 |       | 87,690               |       | 115,034 |   |
| Facilities  management equipment, not yet placed in service |       |                 |       | 2,086                |       | 3,425 |   |
| Property, plant and equipment,  net                         |       |                 |       | $                    | 89,776     |   | $ | 118,459 |   |

 

Depreciation of property, plant and equipment totaled$16,466, $19,254 and $26,409 for the years ended December 31, 2003, 2004and 2005, respectively.

At December 31, 2004and 2005, trucks and autos included $5,794 and $6,577, respectively, ofequipment under capital lease with an accumulated amortization balance of$3,328 and $3,899, respectively.

**10.   Goodwill andIntangible Assets**

Included in Intangible Assets is the deferred tax benefitof the difference between the book and tax basis of the assets acquired in the2005 Acquisition. The Intangible Asset is amortized over 15 years as the taxbenefit is realized.

Goodwill, which will not be further amortized, andintangible assets to be amortized consist of the following:

F-20

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

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

| ** **               | ** ** | **As of December 31, 2004** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|
| ** **               | ** ** | **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:   |       |                                            |       |   |   |   |   |   |   |   |   |
| Non-compete agreements   |       | $                                               | 4,580      |   |   | $ | 4,018 |   |   |   | $ | 562 |   |   |
| Contract rights          |       | 38,807                                          |       |   | 6,661 |   |   |   | 32,146 |   |   |
| Product Sales:           |       |                                            |       |   |   |   |   |   |   |   |   |
| Customer lists           |       | 1,451                                           |       |   | 637 |   |   |   | 814 |   |   |
| Deferred financing costs |       | 1,029                                           |       |   | 601 |   |   |   | 428 |   |   |
|                     |       | $                                               | 45,867     |   |   | $ | 11,917 |   |   |   | $ | 33,950 |   |   |

 

| ** **               | ** ** | **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          |       | 109,450                                         |       |   | 12,039 |   |   |   | 97,411 |   |   |
| Product Sales:           |       |                                            |       |   |   |   |   |   |   |   |   |
| Customer lists           |       | 1,451                                           |       |   | 734 |   |   |   | 717 |   |   |
| Deferred financing costs |       | 5,923                                           |       |   | 393 |   |   |   | 5,530 |   |   |
|                     |       | $                                               | 134,054    |   |   | $ | 17,261 |   |   |   | $ | 116,793 |   |   |

 

Estimated futureamortization expense of intangible assets consists of the following:

| 2006       |   | $      | 6,294   |   |
|------------|--------|--------|---------|--------|
| 2007       |   | 6,294  |    |
| 2008       |   | 6,288  |    |
| 2009       |   | 6,283  |    |
| 2010       |   | 6,045  |    |
| Thereafter |   | 70,024 |    |
|       |   | $      | 101,228 |   |

 

F-21

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

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

Amortization expenseassociated with the above intangible assets amounted to $1,357, $2,540 and$6,117 for the years ended December 31, 2003, 2004 and 2005, respectively.

**11.**   AccruedExpenses

Accruedexpenses consist of the following:

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2004**              | ** ** | **2005** | ** ** |
| Accrued interest                                   |       | $                     | 135        |   | $ | 4,508 |   |
| Accrued  salaries/benefits                         |       | 80                    |       | 145 |   |
| Accrued note payable                               |       | —                |       | 1,284 |   |
| Accrued  commission/bonuses                        |       | 1,605                 |       | 2,237 |   |
| Accrued expenses  on corporate office buildout     |       | —                |       | 539 |   |
| Accrued warranty                                   |       | 268                   |       | 268 |   |
| Deferred service  revenue                          |       | 203                   |       | 84 |   |
| Deferred smart  card revenue                       |       | 813                   |       | 925 |   |
| Current portion  of deferred retirement obligation |       | 104                   |       | 104 |   |
| Accrued  professional fees                         |       | 257                   |       | 261 |   |
| Accrued personal  property taxes                   |       | 515                   |       | 783 |   |
| Accrued income  taxes                              |       | 416                   |       | — |   |
| Accrued sales tax                                  |       | 289                   |       | 470 |   |
| Accrued insurance                                  |       | 503                   |       | 554 |   |
| Other accrued  expenses                            |       | 149                   |       | 310 |   |
|                                               |       | $                     | 5,337      |   | $ | 12,472 |   |

 

**12.**   DeferredRetirement Obligation

The deferred retirementobligation at December 31, 2004 and 2005 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.

**13.**   IncomeTaxes

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

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
| Current state       |       | $                                           | 384        |   | $ | 299 |   | $ | 1,074 |   |
| Deferred state      |       | 454                                         |       | 714 |   | 623 |   |
| Current federal     |       | 79                                          |       | 170 |   | 5,368 |   |
| Deferred federal    |       | 2,119                                       |       | 2,751 |   | 1,498 |   |
| Total income  taxes |       | $                                           | 3,036      |   | $ | 3,934 |   | $ | 8,563 |   |

 

F-22

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

**13.**   Income Taxes (Continued)

The net deferred taxliability in the accompanying balance sheets includes the following amounts ofdeferred tax assets and liabilities at December 31:

| ** **                                    | ** ** | **2004** | ** ** | **2005** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                          |       |     |       |     |       |
| Net operating loss  carryforwards             |       | $        | 130        |     | $          | — |   |
| Alternative minimum tax  credit carryforwards |       | 1,404    |       | —   |       |
| Derivative instrument  interest               |       | 77       |       | (430     | )          |
| Accounts receivable                           |       | 107      |       | 183      |       |
| Inventory                                     |       | —   |       | 139      |       |
| Accrued bonus                                 |       | 336      |       | 569      |       |
| Deferred compensation                         |       | 168      |       | 128      |       |
| Warranty Reserve                              |       | 185      |       | 139      |       |
| Deferred revenue                              |       | 332      |       | —   |       |
| Long term lease  receivable reserve           |       | 43       |       | 48       |       |
| Other                                         |       | 3        |       | 133      |       |
|                                          |       | 2,785    |       | 909      |       |
| Deferred tax liabilities:                     |       |     |       |     |       |
| Depreciation                                  |       | 21,375   |       | 23,427   |       |
| Amortization                                  |       | 2,380    |       | 3,977    |       |
| Sales-type leases                             |       | 1,606    |       | 1,235    |       |
| Other                                         |       | 103      |       | 371      |       |
|                                          |       | 25,464   |       | 29,010   |       |
| Net deferred tax liabilities                  |       | $        | 22,679     |     | $          | 28,101 |   |

 

For the years ended December 31,2003, 2004 and 2005 the statutory income tax rate differed from the effectiverate primarily as a result of the following differences:

| ** **                                  | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Taxes computed at  federal statutory rate   |       | 34.0     | %          | 34.0     | %          | 35.0     | %          |
| State income taxes, net  of federal benefit |       | 6.5      |       | 6.7      |       | 5.3      |       |
| Other                                       |       | 2.0      |       | 2.1      |       | 1.2      |       |
| Income tax provision                        |       | 42.5     | %          | 42.8     | %          | 41.5     | %          |

 

**14.   Preferred StockPurchase Rights**

Pursuant to theterms of a Shareholder Rights Agreement (the “Rights Agreement”), the Board ofDirectors declared a distribution on June 15, 1999 of one Preferred StockPurchase Right (a “Right”) for each outstanding share of Common Stock of theCompany (the “Common Stock”). Under certain circumstances, each Right entitlesthe holder thereof to purchase from the Company a unit consisting of one ten-thousandthof a share (a “Unit”) of Series A Junior Participating Cumulative PreferredStock, par value $.01 per share (the “Preferred Stock”), at a cash exerciseprice of $80.00 per Unit, subject to adjustment. The Rights are not exercisableand are attached to and trade with all shares of Common Stock until the earlierto occur of (i) 10 days following the first public announcement that a personor group of affiliated or associated persons has acquired beneficial ownershipof 15% or more of the outstanding shares of Common Stock (an “Acquiring Person”)( the date of said announcement being referred to as 

F-23

----

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

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

the “Stock AcquisitionDate”), (ii) 10 business days following the commencement of a tender offer orexchange offer that could result upon its consummation in a person or groupbecoming the beneficial owner of 15% or more of the outstanding shares ofCommon Stock or (iii) the determination by the Board of Directors that anyperson is an “Adverse Person” as defined in the Rights Agreement. The Rightswill expire at the close of business on June 15, 2009 (the “ExpirationDate”), unless previously redeemed or exchanged by the Company as describedbelow. The Rights are not entitled to vote or to receive dividends.

**In the event that a Stock AcquisitionDate occurs or the Board of Directors determines that a person is an AdversePerson, each Right will be entitled to receive upon exercise that number ofUnits of Preferred Stock of the Comany having a market value of two times theexercise price of the Right. In the event that, at any time following the StockAcquisition Date, (i) the Company merges with and into any other person, andthe Company is not the continuing or surviving corporation, (ii) any personmerges with and into the Company and the Company is the continuing or survivingcorporation of such merger and, in connection with such merger, all or part ofthe shares of Common Stock are changed into or exchanged for securities of anyother person or cash or any other property, or (iii) 50% or more of the Company’sassets or earning power is sold, each Right will be entitled to receive, uponexercise, common stock of the acquiring company having a market value equal totwo times the exercise price of the Right. Rights that are or were beneficiallyowned by an Acquiring Person or an Adverse Person may (under certain circumstancesspecified in the Rights Agreement) become null and void.**

The Rights may be redeemed in whole, but not in part,at a price of $0.01 per Right by the Board of Directors only until the earliestof (i) the time at which a person is declared to be an Adverse Person, (ii) thetime at which any person becomes an Acquiring Person, or (iii) the ExpirationDate.

**15.**   SegmentInformation

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 unitshave been aggregated into two reportable segments (“Facilities Management” and “ProductSales”). The Facilities Management segment includes two business units: LaundryFacilities Management and Reprographics. The Laundry Facilities Managementbusiness unit provides coin and debit card-operated laundry equipment tomulti-unit housing facilities such as apartment buildings, colleges anduniversities and public housing complexes. The Reprographics business unitprovides coin and debit-card-operated copiers to academic and public libraries.The Product Sales segment includes two business units: MicroFridge® andLaundry Equipment Sales. The MicroFridge® business unitrevenue includes sales 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.

Prior to January 2005, the Company operated thesame four business units, but they were aggregated into different reportablesegments (“Laundry and Reprographics” and “MicroFridge®”). The Laundry andReprographics segment included the Laundry Facilities Management, LaundryEquipment Sales and 

F-24

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

**15.**   Segment Information (Continued)

Reprographics businessunits while the MicroFridge® segment includedonly MicroFridge® sales, which included laundry equipment salesto the United States military.

In January 2005, the Company restructuredportions of its sales organization and the corresponding internal financialreporting of its business segments to improve the sales and marketing effortsassociated with the sales of equipment and appliances.

There are no intersegment revenues.

The tables below presentinformation about the operations of the reportable segments of Mac-Gray for theyears ended December 31, 2003, 2004 and 2005. 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 years ended December 31, 2003 and 2004 into theCompany’s current Facilities Management and Product Sales segments.

| ** **                                    | ** ** | **For the years ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2003**                                                      | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenue:                                      |       |                                                          |       |   |   |   |   |
| Facilities management                         |       | $                                                             | 109,949    |   | $ | 140,480 |   | $ | 214,816 |   |
| Product sales                                 |       | 39,707                                                        |       | 42,214 |   | 45,807 |   |
| Total                                         |       | 149,656                                                       |       | 182,694 |   | 260,623 |   |
| Gross margin:                                 |       |                                                          |       |   |   |   |   |
| Facilities management                         |       | 20,698                                                        |       | 25,886 |   | 40,714 |   |
| Product sales                                 |       | 10,609                                                        |       | 11,728 |   | 10,347 |   |
| Total                                         |       | 31,307                                                        |       | 37,614 |   | 51,061 |   |
| Selling, general  and administration expenses |       | 21,960                                                        |       | 25,130 |   | 31,450 |   |
| Loss on early  extinguishment of debt         |       | 381                                                           |       | 183 |   | 668 |   |
| Gain on sale of  assets                       |       | (145                                                          | )          | (1,208 | ) | (10,735 | ) |
| Gain related to  derivative instruments       |       | —                                                        |       | — |   | (1,876 | ) |
| Interest and  other expenses, net             |       | 2,807                                                         |       | 4,312 |   | 10,939 |   |
| Gain on sale of  lease receivables            |       | (836                                                          | )          | — |   | — |   |
| Income before provision  for income taxes     |       | $                                                             | 7,140      |   | $ | 9,197 |   | $ | 20,615 |   |

 

| ** **                    | ** ** | **December 31, 2004** | ** ** | **December 31,2005** | ** ** |
|-------------------------------|------------|---------------------------------|------------|---------------------------|------------|
| Assets                        |       |                            |       |                      |       |   |   |   |   |
| Facilities management         |       |                            | $          | 165,481                   |       |   |   | $ | 281,864 |   |   |
| Product sales                 |       |                            | 26,045     |                      |       |   | 23,757 |   |   |
| Total for reportable segments |       |                            | 191,526    |                      |       |   | 305,621 |   |   |
| Corporate(1)                  |       |                            | 8,019      |                      |       |   | 17,553 |   |   |
| Deferred income taxes         |       |                            | 2,785      |                      |       |   | 909 |   |   |
| Total assets                  |       |                            | $          | 202,330                   |       |   |   | $ | 324,083 |   |   |

----

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

F-25

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

**16.**   Commitmentsand 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  Leases** | ** ** | **Operating  Leases** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------|------------|-----------------------|------------|
| Year ended December 31,                                                   |       |                |       |                  |       |   |   |
| 2006                                                                           |       | $                   | 1,315      |                  |       | $ | 2,045 |   |   |
| 2007                                                                           |       | 914                 |       |                  | 2,044      |   |   |
| 2008                                                                           |       | 507                 |       |                  | 1,739      |   |   |
| 2009                                                                           |       | 186                 |       |                  | 1,582      |   |   |
| 2010 and thereafter                                                            |       | —              |       |                  | 6,581      |   |   |
|                                                                           |       | 2,922               |       |                  | $          | 13,991 |   |   |
| Less: amount  representing interest (LIBOR of 4.19% at December 31, 2005) |       | 244                 |       |                  |       |   |   |
|                                                                           |       | 2,678               |       |                  |       |   |   |
| Present value future  minimum lease payments less amounts due within one year  |       | 1,185               |       |                  |       |   |   |
| Amounts due after one year                                                     |       | $                   | 1,493      |                  |       |   |   |   |

 

Rent expense incurred by the Company undernon-cancelable operating leases totaled $1,187, $1,409 and $2,439 for the years ended December 31, 2003,2004 and 2005, respectively.

*GuaranteedFacilities Management Rent Payments.*   The Companyoperates debit-card and coin operated facilities management laundry rooms undervarious lease agreements in which the Company is required to make minimumguaranteed rent payments to the respective lessors. The following is a scheduleby years of 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, 2005:

| 2006       |   | $     | 6,473  |   |
|------------|--------|-------|--------|--------|
| 2007       |   | 5,658 |   |
| 2008       |   | 4,456 |   |
| 2009       |   | 3,364 |   |
| 2010       |   | 2,683 |   |
| Thereafter |   | 2,571 |   |
|       |   | $     | 25,205 |   |

 

F-26

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

**17.**   Employee Benefitand 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 $606, $644 and $1,046 forthe years ended December 31, 2003, 2004 and 2005, 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 thirty-threepercent (33%) of the options will become exercisable on each of the firstthrough third anniversaries of the date of grant of the options; however, theAdministrator of the Stock Plans may determine, at its discretion, the vestingschedule for any option award. In the event of termination of the optionees’relationship with the Company, vested options not yet exercised terminatewithin 90 days. The Stock Plans also provide for the automatic annual grant toeach of the independent 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. Other than the stock option grants,there were no other grants of equity-based compensation awards.

At December 31, 2005, the stock plans provide forthe issuance of up to 2,592,434 shares of common stock. At December 31,2005, approximately 1,693,700 shares of common stock were reserved for issuanceunder the Stock Plans, of which 1,1,123,284 shares were subject to outstandingoptions, 300,516 shares were issued pursuant to the exercise of optionagreements and 269,900 remained available for issuance.

Thefollowing is a summary of stock option plan activity:

| ** **                      | ** ** | **2003**   | ** ** | **2004**                               | ** ** | **2005**   | ** ** |
|---------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| ** **                      | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding,  beginning of year |       | 1,012,080  |       |                                   | $          | 3.85       |       |   | 1,055,400 |   |   | $ | 4.01 |   |   | 914,367 |   |   | $ | 4.24 |   |   |
| Granted                         |       | 131,000    |       |                                   | $          | 4.95       |       |   | 72,000 |   |   | $ | 6.43 |   |   | 363,200 |   |   | $ | 8.76 |   |   |
| Exercised                       |       | (27,600    | )          |                                   | $          | 3.49       |       |   | (172,833 | ) |   | $ | 3.61 |   |   | (104,583 | ) |   | $ | 3.75 |   |   |
| Forfeited                       |       | (60,080    | )          |                                   | $          | 3.65       |       |   | (40,200 | ) |   | $ | 4.95 |   |   | (49,700 | ) |   | $ | 7.55 |   |   |
| Outstanding, end  of year       |       | 1,055,400  |       |                                   | $          | 4.01       |       |   | 914,367 |   |   | $ | 4.24 |   |   | 1,123,284 |   |   | $ | 5.60 |   |   |
| Exercisable, end of year        |       | 574,302    |       |                                   | $          | 4.13       |       |   | 719,035 |   |   | $ | 4.18 |   |   | 768,785 |   |   | $ | 4.35 |   |   |

** **

F-27

----

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

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

| ** **      | ** ** | **Options Outstanding**              | ** ** | **Options Exercisable**                            | ** ** |
|-----------------|------------|-------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **      | ** ** | **Number  Outstanding  at 12/31/05** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  at 12/31/05** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $3.00 - $3.85   |       |                                      | 589,384    |                                                    |       |   | 5.80 |   |   |   | $ | 3.55 |   |   |   | 589,384 |   |   |   | $ | 3.55 |   |   |
| $5.00 - $6.54   |       |                                      | 143,000    |                                                    |       |   | 8.06 |   |   |   | $ | 5.45 |   |   |   | 97,401 |   |   |   | $ | 5.43 |   |   |
| $8.50 - $9.30   |       |                                      | 51,000     |                                                    |       |   | 3.17 |   |   |   | $ | 8.50 |   |   |   | 51,000 |   |   |   | $ | 8.50 |   |   |
| $11.25 - $15.13 |       |                                      | 339,900    |                                                    |       |   | 9.40 |   |   |   | $ | 8.79 |   |   |   | 31,000 |   |   |   | $ | 9.34 |   |   |
|            |       |                                      | 1,123,284  |                                                    |       |   | 7.06 |   |   |   | $ | 5.60 |   |   |   | 768,785 |   |   |   | $ | 4.35 |   |   |

 

*Mac-Gray Corporation 2001Employee Stock Purchase Plan.*   The Company established the Mac- Gray Corporation 2001 EmployeeStock Purchase Plan (the “ESPP”) in May of 2001. Under the terms of theESPP, eligible employees may have between 1% and 15% of eligible compensationdeducted from their pay to purchase common stock. The per share purchase priceis 85% of the fair market value of the stock on, the lower of, the first day orthe last day of each six month interval. Up to 200,000 shares may be offeredpursuant to the ESPP. The plan includes certain restrictions, such as theholding period of the stock by employees. The number of shares of common stockpurchased through the ESPP was 25,427 and 31,610 for the years ended December 31,2004 and 2005, respectively. There have been 106,895 shares purchased since theinception of the plan. At December 31, 2004 and 2005 the Company hadaccumulated employee withholdings associated with this plan of $79 and $142 foracquisition of stock in 2004 and 2005, respectively.

**18.**   EarningsPer Share

| ** **                      | ** ** | **For the Year Ended December 31, 2003** | ** ** |
|---------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **Income**                                                             | ** ** | **Shares** | ** ** | **Per-Share** | ** ** |
| ** **                      | ** ** | **(Numerator)**                                                        | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Net income—basic           |       |                                                                   | $          | 4,104 |   |   |   | 12,635 |   |   |   | $ | 0.32 |   |   |
| Effect of  dilutive securities: |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Stock options                   |       |                                                                   |       |   |   |   | 106 |   |   |   |   |   |   |
| Net income—diluted         |       |                                                                   | $          | 4,104 |   |   |   | 12,741 |   |   |   | $ | 0.32 |   |   |

 

| ** **                      | ** ** | **For the Year Ended December 31, 2004** | ** ** |
|---------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **Income**                                                             | ** ** | **Shares** | ** ** | **Per-Share** | ** ** |
| ** **                      | ** ** | **(Numerator)**                                                        | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Net income—basic           |       |                                                                   | $          | 5,263 |   |   |   | 12,702 |   |   |   | $ | 0.41 |   |   |
| Effect of dilutive  securities: |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Stock options                   |       |                                                                   |       |   |   |   | 326 |   |   |   |   |   |   |
| Net income—diluted         |       |                                                                   | $          | 5,263 |   |   |   | 13,028 |   |   |   | $ | 0.40 |   |   |

** **

F-28

----

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

**18.**   Earnings Per Share (Continued)

| ** **                      | ** ** | **For the Year Ended December 31, 2005** | ** ** |
|---------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                      | ** ** | **Income**                                                             | ** ** | **Shares** | ** ** | **Per-Share** | ** ** |
| ** **                      | ** ** | **(Numerator)**                                                        | ** ** | **(Denominator)** | ** ** | **Amount** | ** ** |
| Net income—basic           |       |                                                                   | $          | 12,052 |   |   |   | 12,864 |   |   |   | $ | 0.94 |   |   |
| Effect of  dilutive securities: |       |                                                                   |       |   |   |   |   |   |   |   |   |   |   |
| Stock options                   |       |                                                                   |       |   |   |   | 419 |   |   |   |   |   |   |
| Net income—diluted         |       |                                                                   | $          | 12,052 |   |   |   | 13,283 |   |   |   | $ | 0.91 |   |   |

 

There were 57, 57 and 1shares under option plans that were excluded from the computation of dilutedearnings per share at December 31, 2003, 2004 and 2005, respectively, dueto their anti-dilutive effects.

**19.**   Summaryof Quarterly Financial Information (unaudited)

| ** **                                               | ** ** | **Year Ended December 31, 2004** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                               | ** ** | **1st Qtr**                                     | ** ** | **2nd Qtr** | ** ** | **3rd Qtr** | ** ** | **4th Qtr** | ** ** | **Total** | ** ** |
| Revenue                                                  |       | $                                                    | 43,560     |   | $ | 45,211 |   | $ | 44,247 |   | $ | 49,676 |   | $ | 182,694 |   |
| Cost of revenue                                          |       | 34,448                                               |       | 36,069 |   | 35,527 |   | 39,036 |   | 145,080 |   |
| Gross margin                                             |       | 9,112                                                |       | 9,142 |   | 8,720 |   | 10,640 |   | 37,614 |   |
| Operating  expenses                                      |       | 4,819                                                |       | 6,544 |   | 6,354 |   | 6,388 |   | 24,105 |   |
| Income from  operations                                  |       | 4,293                                                |       | 2,598 |   | 2,366 |   | 4,252 |   | 13,509 |   |
| Interest and  other expense, net                         |       | (1,067                                               | )          | (1,056 | ) | (1,060 | ) | (1,129 | ) | (4,312 | ) |
| Income before  provision for income taxes                |       | 3,226                                                |       | 1,542 |   | 1,306 |   | 3,123 |   | 9,197 |   |
| Provision for  income taxes                              |       | 1,387                                                |       | 665 |   | 554 |   | 1,328 |   | 3,934 |   |
| Net income                                               |       | $                                                    | 1,839      |   | $ | 877 |   | $ | 752 |   | $ | 1,795 |   | $ | 5,263 |   |
| Net income per  common share—basic                  |       | $                                                    | 0.15       |   | $ | 0.07 |   | $ | 0.06 |   | $ | 0.14 |   | $ | 0.41 |   |
| Net income per  common share—diluted                |       | $                                                    | 0.14       |   | $ | 0.07 |   | $ | 0.06 |   | $ | 0.14 |   | $ | 0.40 |   |
| Weighted average  common shares outstanding—basic   |       | 12,607                                               |       | 12,673 |   | 12,747 |   | 12,781 |   | 12,702 |   |
| Weighted average common  shares outstanding—diluted |       | 13,017                                               |       | 13,069 |   | 13,114 |   | 13,197 |   | 13,028 |   |

 

F-29

----

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

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

| ** **                                               | ** ** | **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 |   |

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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.

**20.**   Subsequent Events

On January 20, 2006, the Company acquired thelaundry facilities management assets of a regional operator for approximately$11.5 million. The acquisition was funded by borrowing against the 2005 creditfacility. The purchase price allocation will be completed in the first quarterof 2006.

F-30

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**MAC-GRAYCORPORATION**

**SCHEDULE II**

**VALUATIONAND QUALIFYING ACCOUNTSYEARS ENDED DECEMBER 31, 2003, 2004, AND 2005**

| ** **                                          | ** ** | **Balance**      | ** ** | **Charged to** | ** ** | ** **     | ** ** | **Balance**      | ** ** |
|-----------------------------------------------------|------------|------------------|------------|---------------------|------------|----------------|------------|------------------|------------|
| ** **                                          | ** ** | **Beginning**    | ** ** | **Cost and**   | ** ** | ** **     | ** ** | **at End**  | ** ** |
| ** **                                          | ** ** | **of Year** | ** ** | **Expenses**        | ** ** | **Deductions** | ** ** | **of Year** | ** ** |
| Year Ended  December 31, 2003:                 |       |             |       |                |       |           |       |             |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts and lease reserves  |       |             | $          | 850                 |       |           |       | $                | 322        |   |   |   | $ | (237 | ) |   |   | $ | 935 |   |   |
| 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 |   |   |

 

F-31

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