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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
/X/ Quarterly report pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2002, or
/ / Transition report pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the transition period from to
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COMMISSION FILE NUMBER 0-21639
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NCO GROUP, INC.
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(Exact name of registrant as specified in its charter)
PENNSYLVANIA
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(State or other jurisdiction of incorporation or organization)
507 Prudential Road, Horsham, Pennsylvania
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(Address of principal executive offices)
23-2858652
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(IRS Employer Identification Number)
19044
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(Zip Code)
215-441-3000
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(Registrant's telephone number including area code)
Not Applicable
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(Former name, former address and former fiscal year, if changed
since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days.
Yes X No
----- -----
The number of shares outstanding of each of the issuer's classes of
common stock was 25,908,000 shares common stock, no par value, outstanding as of
November 14, 2002.
NCO GROUP, INC.
INDEX
PAGE
PART I - FINANCIAL INFORMATION
Item 1 CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Consolidated Balance Sheets -
December 31, 2001 and September 30, 2002 1
Consolidated Statements of Income -
Three and nine months ended September 30, 2001 and 2002 2
Consolidated Statements of Cash Flows -
Nine months ended September 30, 2001 and 2002 3
Notes to Consolidated Financial Statements 4
Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 18
Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK 26
Item 4 CONTROLS AND PROCEDURES 26
PART II - OTHER INFORMATION 27
Item 1. Legal Proceedings
Item 2. Changes in Securities
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Shareholders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
Signature 29
Certifications 30
Part 1 - Financial Information
Item 1 - Financial Statements
NCO GROUP, INC.
Consolidated Balance Sheets
(Amounts in thousands)
September 30,
December 31, 2002
ASSETS 2001 (Unaudited)
-------- --------
Current assets:
Cash and cash equivalents $ 32,161 $ 31,352
Restricted cash 1,125 900
Accounts receivable, trade, net of allowance for
doubtful accounts of $5,311 and $9,040, respectively 99,055 95,236
Purchased accounts receivable, current portion 47,341 60,780
Deferred income taxes 8,336 8,578
Other current assets 14,784 7,583
--------- ---------
Total current assets 202,802 204,429
Funds held on behalf of clients
Property and equipment, net 71,457 82,122
Other assets:
Goodwill 514,161 516,884
Other intangible assets, net of accumulated amortization 7,929 12,039
Purchased accounts receivable, net of current portion 92,660 88,569
Other assets 42,016 50,119
--------- ---------
Total other assets 656,766 667,611
--------- ---------
Total assets $ 931,025 $ 954,162
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Long-term debt, current portion $ 21,922 $ 31,906
Income taxes payable 176 -
Accounts payable 12,164 11,003
Accrued expenses 39,382 37,018
Accrued compensation and related expenses 16,785 15,364
--------- ---------
Total current liabilities 90,429 95,291
Funds held on behalf of clients
Long-term liabilities:
Long-term debt, net of current portion 357,868 331,450
Deferred income taxes 42,855 51,985
Other long-term liabilities 4,565 3,903
Minority interest 21,213 23,705
Shareholders' equity:
Preferred stock, no par value, 5,000 shares authorized,
no shares issued and outstanding - -
Common stock, no par value, 50,000 shares authorized,
25,816 and 25,908 shares issued and outstanding, respectively 320,993 321,833
Other comprehensive loss (4,346) (4,267)
Retained earnings 97,448 130,262
--------- ---------
Total shareholders' equity 414,095 447,828
--------- ---------
Total liabilities and shareholders' equity $ 931,025 $ 954,162
========= =========
See accompanying notes.
-1-
NCO GROUP, INC.
Consolidated Statements of Income
(Unaudited)
(Amounts in thousands, except per share data)
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
----------------------------- -----------------------------
2001 2002 2001 2002
--------- --------- --------- ---------
Revenue $ 174,347 $ 170,542 $ 528,651 $ 527,127
Operating costs and expenses:
Payroll and related expenses 85,305 81,869 267,692 251,469
Selling, general and administrative expenses 69,027 63,211 178,314 185,627
Depreciation and amortization expense 9,774 7,031 28,351 19,778
--------- --------- --------- ---------
Total operating costs and expenses 164,106 152,111 474,357 456,874
--------- --------- --------- ---------
Income from operations 10,241 18,431 54,294 70,253
Other income (expense):
Interest and investment income 763 690 2,567 2,144
Interest expense (6,627) (5,296) (21,343) (15,245)
Other income (expense) - - - (290)
--------- --------- --------- ---------
Total other income (expense) (5,864) (4,606) (18,776) (13,391)
--------- --------- --------- ---------
Income before income tax expense 4,377 13,825 35,518 56,862
Income tax expense 2,435 5,237 14,820 21,556
--------- --------- --------- ---------
Income from operations before minority interest 1,942 8,588 20,698 35,306
Minority interest (990) (887) (3,020) (2,492)
--------- --------- --------- ---------
Net income $ 952 $ 7,701 $ 17,678 $ 32,814
========= ========= ========= =========
Net income per share:
Basic $ 0.04 $ 0.30 $ 0.69 $ 1.27
Diluted $ 0.04 $ 0.29 $ 0.67 $ 1.19
Weighted average shares outstanding:
Basic 25,811 25,908 25,760 25,884
Diluted 25,957 29,721 28,651 29,867
See accompanying notes.
-2-
NCO GROUP, INC
Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)
For the Nine Months
Ended September 30,
----------------------------
2001 2002
-------- --------
Cash flows from operating activities:
Net income $ 17,678 $ 32,814
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 14,882 17,561
Amortization of intangibles 13,469 2,217
Net loss on property and equipment disposed of in connection
with the flood/corporate headquarters relocation 827 -
Provision for doubtful accounts 2,585 6,943
Impairment of purchased accounts receivable 1,785 1,629
Gain on insurance proceeds from property and equipment - (847)
Minority interest 3,020 2,493
Changes in operating assets and liabilities, net of acquisitions:
Restricted cash 2,555 225
Accounts receivable, trade (12,374) (3,043)
Deferred income taxes 4,408 9,201
Other assets (6,935) (1,863)
Accounts payable and accrued expenses 17,854 (9,183)
Income taxes payable 369 (482)
Other long-term liabilities 1,162 (1,556)
-------- --------
Net cash provided by operating activities 61,285 56,109
Cash flows from investing activities:
Purchases of accounts receivable (39,533) (50,175)
Collections applied to principal of purchased accounts receivable 26,775 38,161
Purchase price adjustment applied to principal of purchased accounts receivable - 3,197
Purchases of property and equipment (20,513) (23,841)
Proceeds from notes receivable - 1,000
Insurance proceeds from involuntary conversion of
property and equipment 560 2,633
Investment in consolidated subsidiary by minority interest 2,320 -
Net cash paid for acquisitions and acquisition related costs (11,077) (10,862)
-------- --------
Net cash used in investing activities (41,468) (39,887)
Cash flows from financing activities:
Borrowings under notes payable - 20,610
Repayment of notes payable (16,782) (11,566)
Repayment of acquired notes payable (20,084) -
Borrowings under revolving credit agreement 65,230 10,870
Repayment of borrowings under revolving credit agreement (157,350) (37,620)
Payment of fees to acquire debt (5,127) (338)
Proceeds from the issuance of convertible debt 125,000 -
Issuance of common stock, net 3,652 756
-------- --------
Net cash used in financing activities (5,461) (17,288)
Effect of exchange rate on cash (153) 257
-------- --------
Net increase (decrease) in cash and cash equivalents 14,203 (809)
Cash and cash equivalents at beginning of the period 13,490 32,161
-------- --------
Cash and cash equivalents at end of the period $ 27,693 $ 31,352
======== ========
See accompanying notes.
-3-
NCO GROUP, INC.
Notes to Consolidated Financial Statements
(Unaudited)
1. Nature of Operations:
NCO Group, Inc. (the "Company" or "NCO") is a leading provider of accounts
receivable management and collection services. The Company also owns
approximately 63 percent of NCO Portfolio Management, Inc., a separate public
company that purchases and manages defaulted consumer accounts receivable from
consumer creditors such as banks, finance companies, retail merchants, and other
consumer oriented companies. The Company's client base includes companies in the
financial services, healthcare, retail and commercial, utilities, education,
telecommunications, and government sectors. These clients are primarily located
throughout the United States of America, Canada, the United Kingdom, and Puerto
Rico.
2. Accounting Policies:
Interim Financial Information:
The accompanying unaudited consolidated financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information and with the instructions for Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of only normal recurring accruals) considered necessary for a fair presentation
have been included. Because of the seasonal nature of the Company's business,
operating results for the three-month and nine-month periods ended September 30,
2002, are not necessarily indicative of the results that may be expected for the
year ending December 31, 2002, or for any other interim period. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Company's Annual Report on Form 10-K filed with the
Securities and Exchange Commission on March 19, 2002.
Principles of Consolidation:
The consolidated financial statements include the accounts of the Company and
all affiliated subsidiaries and entities controlled by the Company. All
significant intercompany accounts and transactions have been eliminated. The
Company does not control InoVision-MEDCLR NCOP Ventures, LLC and Creditrust
SPV98-2, LLC (see note 15) and, accordingly, their financial condition and
results of operations are not consolidated with the Company's financial
statements.
Contingency Fees and Fees for Contractual Services:
The Company generates revenue from contingency fees and fees for contractual
services.
Contingency fee revenue is recognized upon collection of funds on behalf of
clients. Contingency fee revenue on long-term contracts with variable rates is
recognized based upon the percentage of completion method that requires revenue
to be recorded upon collection of funds on behalf of clients at the anticipated
average fee over the life of the contract. For certain government clients, the
Company records revenue for services upon completion, less an allowance for
transactions that may not meet clients' guidelines at the time of funding.
Fees for contractual services are recognized as services are performed and
accepted by the client.
-4-
2. Accounting Policies (continued):
Purchased Accounts Receivable:
The Company accounts for its investment in purchased accounts receivable on an
accrual basis under the guidance of the American Institute of Certified Public
Accountants' Practice Bulletin No. 6, "Amortization of Discounts on Certain
Acquired Loans," using unique and exclusive portfolios. Portfolios are
established with accounts having similar attributes. Typically, each portfolio
consists of an individual acquisition of accounts. Once a portfolio is acquired,
the accounts in the portfolio are not changed. Proceeds from the sale of
accounts within a portfolio are accounted for as collections in that portfolio.
Collections on replacement accounts received from the originator of the loans
are included as collections in the corresponding portfolios. The discount
between the cost of each portfolio and the face value of the portfolio is not
recorded because the Company expects to collect a relatively small percentage of
each portfolio's face value.
Each portfolio is initially recorded at cost, which includes the external costs
of acquiring portfolios. Collections on the portfolios are allocated to revenue
and principal reduction based on the estimated internal rate of return ("IRR")
for each pool. The IRR for each portfolio is estimated based on the expected
monthly collections over the estimated economic life of each pool (generally
five years, based on the Company's collection experience), compared to the
original purchase price. Revenue on purchased accounts receivable is recorded
monthly based on each portfolio's effective IRR for the quarter applied to each
portfolio's monthly opening carrying value. To the extent collections exceed the
revenue, the carrying value is reduced and the reduction is recorded as
collections are applied to principal. Because the IRR reflects collections for
the entire economic life of the portfolio and those collections are not
constant, lower collection rates, typically in the early months of ownership,
can result in a situation where the actual collections are less than the revenue
accrual. In this situation, the carrying value of the pool may be accreted for
the difference between the revenue accrual and collections.
To the extent the estimated future cash flow increases or decreases from the
expected level of collections, the Company prospectively adjusts the IRR
accordingly. If the carrying value of a particular portfolio exceeds its
expected future cash flows, a charge to income would be recognized in the amount
of such impairment. Additional impairments on each quarter's previously impaired
portfolios may occur if the current estimated future cash flow projections,
after being adjusted prospectively for actual collection results, is less than
the carrying values recorded. After the impairment of a portfolio, no revenue is
recorded on that portfolio and collections are recorded as a return of capital
until the full carrying value of the portfolio has been recovered. Once the full
cost of the carrying value has been recovered, all collections will be recorded
as revenue. The estimated IRR for each portfolio is based on estimates of future
cash flows from collections, and actual cash flows may vary from current
estimates. The difference could be material.
Credit Policy:
The Company has two types of arrangements under which it collects its
contingency fee revenue. For certain clients, the Company remits funds collected
on behalf of the client net of the related contingency fees while, for other
clients, the Company remits gross funds collected on behalf of clients and bills
the client separately for its contingency fees. Management carefully monitors
its client relationships in order to minimize its credit risk and generally does
not require collateral. In many cases, in the event of collection delays from
clients, management may, at its discretion, change from the gross remittance
method to the net remittance method.
Intangibles:
Goodwill represents the excess of purchase price over the fair market value of
the net assets of the acquired businesses based on their respective fair values
at the date of acquisition. Effective January 1, 2002, the Company adopted
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangibles" ("SFAS 142") (see note 3).
Other intangible assets consist primarily of deferred financing costs, which
relate to debt issuance costs incurred, and a customer list, which was acquired
as part of the Great Lakes Collection Bureau, Inc. asset acquisition. Deferred
financing costs are amortized over the term of the debt and the customer list is
amortized over five years (see note 3).
-5-
2. Accounting Policies (continued):
Interest Rate Hedges:
The Company accounts for its interest rate swap agreements as either assets or
liabilities on the balance sheet measured at fair value. Changes in the fair
value of the interest rate swap agreements are recorded in other comprehensive
income because the interest rate swap agreements were designated and qualified
as cash flow hedges. If the interest rate swap agreements no longer qualify as
cash flow hedges, the change in the fair value will be recorded in current
earnings.
Income Taxes:
The Company accounts for income taxes using an asset and liability approach. The
asset and liability approach requires the recognition of deferred tax assets and
liabilities for the expected future tax consequences of temporary differences
between the financial reporting basis and the tax basis of assets and
liabilities.
Prior to the adoption of SFAS 142 on January 1, 2002, income taxes were computed
after giving effect to the nondeductible portion of goodwill expenses
attributable to certain acquisitions.
The portfolios of purchased accounts receivable are composed of distressed debt.
Collection results are not guaranteed until received; accordingly, for tax
purposes, any gain on a particular portfolio is deferred until the full cost of
its acquisition is recovered. Revenue for financial reporting purposes is
recognized ratably over the life of the portfolio. Deferred tax liabilities
arise from income tax deferrals created during the early stages of the
portfolio. These deferrals reverse after the cost basis of the portfolio is
recovered. The creation of new tax deferrals from future purchases of portfolios
are expected to offset the reversal of the deferrals from portfolios where the
collections have become fully taxable.
Use of Estimates:
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported in the financial statements and
the accompanying notes. Actual results could differ from those estimates.
In the ordinary course of accounting for contingency fee revenue on long-term
contracts with variable rates, estimates are made by management as to the amount
of total collections and contingency fee revenue to be earned over the life of
the contract. Actual results could differ from those estimates and a material
change could occur within one reporting period.
In the ordinary course of accounting for purchased accounts receivable,
estimates have been made by management as to the amount and timing of future
cash flows expected from each portfolio. The estimated future cash flow of each
portfolio is used to compute the IRR for the portfolio. The IRR is used to
allocate cash flow between revenue and principal reduction of the carrying value
of purchased accounts receivable.
On an ongoing basis, we compare the historical trends of each portfolio to
projected collections. The future projections are then increased or decreased,
within parameters, in accordance with the historical trend. The results are
further reviewed by management with a view towards specifically addressing any
particular portfolio's performance. Actual results will differ from these
estimates and a material change in these estimates could occur within one
reporting period.
Reclassifications:
Certain amounts for December 31, 2001, have been reclassified for comparative
purposes.
-6-
3. Intangible Assets:
Goodwill:
Effective January 1, 2002, the Company adopted Statement of Financial Accounting
Standard No. 142, "Goodwill and Other Intangibles" ("SFAS 142"). As a result of
adopting SFAS 142, the Company no longer amortizes goodwill. Goodwill must be
tested at least annually for impairment, including an initial test that was
completed in connection with the adoption of SFAS 142. The test for impairment
uses a fair-value based approach, whereby if the implied fair value of a
reporting unit's goodwill is less than its carrying amount, goodwill would be
considered impaired. The Company did not incur any impairment charges in
connection with the adoption of SFAS 142.
SFAS 142 requires goodwill to be allocated and tested at the reporting unit
level. The Company's reporting units under SFAS 142 are U.S. Operations,
Portfolio Management and International Operations. Portfolio Management does not
have any goodwill. The U.S. Operations and International Operations had the
following goodwill (amounts in thousands):
December 31, September 30,
2001 2002
--------------- ----------------
U.S. Operations $ 484,182 $ 486,785
International Operations 29,979 30,099
--------- ---------
Total $ 514,161 $ 516,884
========= =========
The change in U.S. Operations' goodwill balance from December 31, 2001 to
September 30, 2002 was due to the acquisition of Great Lakes Collection Bureau,
Inc. on August 19, 2002 (see note 4). The change in International Operations'
goodwill balance from December 31, 2001 to September 30, 2002 was due to changes
in the exchange rates used for the foreign currency translation.
The following presents the results of operations as if SFAS 142 had been adopted
on January 1, 2001 (dollars in thousands):
For the Three Months Ended For the Nine Months Ended
September 30, 2001 September 30, 2001
------------------------------ -----------------------------
Diluted Diluted
Earnings Earnings
Amount Per Share Amount Per Share
--------------- -------------- ------------ ----------------
Net income, as reported $ 952 $ 0.04 $ 17,678 $ 0.67
Add back of goodwill amortization,
net of tax 3,071 0.11 8,895 0.31
------ ------ -------- ------
Adjusted net income $ 4,023 $ 0.15 $ 26,573 $ 0.98
======= ====== ======== ======
-7-
3. Intangible Assets (continued):
Other Intangible Assets:
The Company's adoption of SFAS 142 had no effect on its other intangible assets.
Other intangible assets consist primarily of deferred financing costs and a
customer list. The following represents the other intangible assets (amounts in
thousands):
December 31, 2001 September 30, 2002
--------------------------------- ---------------------------------
Gross Carrying Accumulated Gross Carrying Accumulated
Amount Amortization Amount Amortization
---------------- --------------- ---------------- ---------------
Deferred financing costs $ 11,881 $ 4,320 $ 12,208 $ 6,278
Customer list - - 6,000 142
Other intangible assets 900 532 900 649
-------- ------- -------- -------
Total $ 12,781 $ 4,852 $ 19,108 $ 7,069
======== ======= ======== =======
The Company recorded amortization expense for all other intangible assets of
$679,000 and $853,000 during the three months ended September 30, 2001 and 2002,
respectively, and $1.7 million and $2.2 million during the nine months ended
September 30, 2001 and 2002, respectively. The following represents the
Company's expected amortization expense from these other intangible assets over
the next five years (amounts in thousands):
For the Years Ended Estimated
December 31, Amortization Expense
----------------------- -----------------------
2002 $ 3,123
2003 4,004
2004 2,779
2005 1,986
2006 1,429
4. Acquisitions:
On February 20, 2001, the Company merged NCO Portfolio Management, Inc. ("NCO
Portfolio"), its wholly owned subsidiary, with Creditrust Corporation
("Creditrust") to form a new public entity focused on the purchase of accounts
receivable. After the Creditrust merger, the Company owned approximately 63
percent of the outstanding stock of NCO Portfolio. The Company's contribution to
the NCO Portfolio merger consisted of $25.0 million of purchased accounts
receivable. As part of the Creditrust merger, NCO Portfolio signed a ten-year
service agreement that appointed the Company as the sole provider of collection
services to NCO Portfolio. The Company has agreed to offer all of its future
U.S. accounts receivable purchase opportunities to NCO Portfolio. In connection
with the Creditrust merger, the Company amended its revolving credit facility to
provide NCO Portfolio with a $50.0 million revolving line of credit in the form
of a sub-facility under its existing credit facility. Initially, NCO Portfolio
borrowed $36.3 million to fund the Creditrust merger.
-8-
4. Acquisitions (continued):
On August 19, 2002, NCO acquired certain assets and related operations,
excluding the purchased accounts receivable portfolio, and assumed certain
liabilities of Great Lakes Collection Bureau, Inc. ("Great Lakes"), a subsidiary
of GE Capital Corporation ("GE Capital"), for $10.6 million in cash. NCO funded
the purchase with borrowings under its revolving credit agreement and existing
cash. NCO Portfolio acquired the purchased accounts receivable portfolio of
Great Lakes for $22.9 million. NCO Portfolio funded the purchase with $2.3
million of existing cash and $20.6 million of non-recourse financing provided by
CFSC Capital Corp. XXXIV (see note 8). This non-recourse financing is
collateralized by the Great Lakes purchased accounts receivable portfolio. As
part of the acquisition, NCO and GE Capital signed a multi-year agreement under
which NCO will provide services to GE Capital. The Company recognized goodwill
of $2.6 million and allocated $6.0 million of the purchase price to the customer
list. Because the closing balance sheet has not been finalized, the allocation
of the fair market value to the acquired assets and liabilities of Great Lakes
was based on preliminary estimates and may be subject to change. As a result of
the acquisition, the Company expects to expand its current customer base,
strengthen its relationship with certain existing customers and reduce the cost
of providing services to the acquired customers through economies of scale;
therefore, the Company believes the allocation of a portion of the purchase
price to goodwill is appropriate.
The following summarizes the unaudited pro forma results of operations, assuming
the Creditrust merger and the Great Lakes acquisition occurred on January 1,
2001. The pro forma information is provided for informational purposes only. It
is based on historical information, and does not necessarily reflect the actual
results that would have occurred, nor is it indicative of future results of
operations of the consolidated entities (amounts in thousands, except per share
data):
For the Three Months For the Nine Months
Ended September 30, Ended September 30,
----------------------- -----------------------
2001 2002 2001 2002
---------- --------- --------- ---------
Revenue $ 187,410 $ 176,547 $ 571,419 $ 555,312
Net (loss) income $ (1,702) $ 6,739 $ 2,911 $ 28,300
(Loss) earnings per share - basic $ (0.07) $ 0.26 $ 0.11 $ 1.09
(Loss) earnings per share - diluted $ (0.07) $ 0.26 $ 0.11 $ 1.04
5. Comprehensive Income:
Comprehensive income consists of net income from operations, plus certain
changes in assets and liabilities that are not included in net income but are
reported as a separate component of shareholders' equity. The Company's
comprehensive income was as follows (amounts in thousands):
For the Three Months For the Nine Months Ended
Ended September 30, September 30,
---------------------- ----------------------
2001 2002 2001 2002
------ ------- -------- --------
Net income $ 952 $ 7,701 $ 17,678 $ 32,814
Other comprehensive income:
Foreign currency translation adjustment (1,911) (1,664) (2,342) 660
Unrealized loss on interest rate swap - (265) - (581)
------ ------- -------- --------
Comprehensive (loss) income $ (959) $ 5,772 $ 15,336 $ 32,893
====== ======= ======== ========
-9-
6. Purchased Accounts Receivable:
The Company's Portfolio Management and International Operations divisions
purchase defaulted consumer receivables at a discount from the actual principal
balance. As of September 30, 2002, the carrying values of Portfolio Management's
and International Operations' purchased accounts receivable were $145.6 million
and $3.8 million, respectively. The following summarizes the change in purchased
accounts receivable (amounts in thousands):
For the For the
Year Ended December Nine Months Ended
31, 2001 September 30, 2002
--------------------- ---------------------
Balance, at beginning of period $ 34,475 $ 140,001
Purchased accounts receivable acquired from Creditrust 93,518 -
Purchases of accounts receivable 50,621 52,256
Collections on purchased accounts receivable (99,868) (86,428)
Purchase price adjustment - (4,000)
Revenue recognized 64,065 49,070
Impairment of purchased accounts receivable (2,738) (1,629)
Foreign currency translation adjustment (72) 79
--------- ---------
Balance, at end of period $ 140,001 $ 149,349
========= =========
During the three months ended September 30, 2001 and 2002, impairments of $1.3
million and $418,000, respectively, were recorded as a charge to income on
portfolios where the carrying amounts exceeded the expected future cash flows.
During the nine months ended September 30, 2001 and 2002, impairments of $1.8
million and $1.6 million, respectively, were recorded as a charge to income on
portfolios where the carrying amounts exceeded the expected future cash flows.
No revenue will be recorded on these portfolios until the carrying values have
been fully recovered. As of September 30, 2002, the combined carrying values on
all previously impaired portfolios aggregated $6.6 million, or 4.4 percent of
the total purchased accounts receivable, representing their net realizable
value. During the three months ended September 30, 2002, NCO Portfolio concluded
a contract re-negotiation with the seller of several existing portfolios
resulting in a $4.0 million cash price reduction on several purchases from 2000
and 2001. The re-negotiation included a purchase price adjustment, as well as a
reimbursement for estimated lost earnings. The $4.0 million proceeds were
recorded as a reduction to purchase price of the affected portfolios in the
quarter ended September 30, 2002. On several previously impaired portfolios, the
cash price reduction reduced the carrying value of such portfolios, resulting in
the carrying value of certain of the portfolios becoming fully recovered.
Included in revenue for the three and nine months ended September 30, 2002 was
$803,000 from these fully recovered portfolios. Revenue of approximately
$354,000 was recorded during the quarter ended September 30, 2002 on several
non-impaired portfolios due to the improved IRRs as a result of the cash price
reduction. Additionally, included in collections for the three and nine months
ended September 30, 2002, was $1.7 million received as a partial payment on the
sale of certain accounts to a leading credit card issuer.
-10-
7. Funds Held on Behalf of Clients:
In the course of the Company's regular business activities as a provider of
accounts receivable management services, the Company receives clients' funds
arising from the collection of accounts placed with the Company. These funds are
placed in segregated cash accounts and are generally remitted to clients within
30 days. Funds held on behalf of clients of $56.8 million and $60.8 million at
December 31, 2001 and September 30, 2002, respectively, have been shown net of
their offsetting liability for financial statement presentation.
8. Long-term Debt:
Long-term debt consisted of the following (amounts in thousands):
December 31, 2001 September 30, 2002
------------------- --------------------
Revolving credit loan $ 206,630 $ 179,880
Convertible notes 125,000 125,000
Securitized debt 45,379 36,633
Non-recourse debt - 19,408
Capital leases and other 2,781 2,435
Less current portion (21,922) (31,906)
--------- ---------
$ 357,868 $ 331,450
========= =========
Revolving Credit Facility:
The Company has a credit agreement with Citizens Bank of Pennsylvania, formerly
Mellon Bank, N.A., ("Citizens Bank"), for itself and as administrative agent for
other participating lenders, structured as a revolving credit facility. The
balance under the revolving credit facility is due on May 20, 2004 (the
"Maturity Date"). The borrowing capacity of the revolving credit facility is
subject to quarterly reductions of $5.2 million until the Maturity Date, and 50
percent of the net proceeds received from any offering of debt or equity.
At the option of NCO, the borrowings bear interest at a rate equal to either
Citizens Bank's prime rate plus a margin of 0.25 percent to 0.50 percent, which
is determined quarterly based upon the Company's consolidated funded debt to
earnings before interest, taxes, depreciation, and amortization ("EBITDA") ratio
(Citizens Bank's prime rate was 4.75 percent at September 30, 2002), or the
London InterBank Offered Rate ("LIBOR") plus a margin of 1.25 percent to 2.25
percent depending on the Company's consolidated funded debt to EBITDA ratio
(LIBOR was 1.82 percent at September 30, 2002). The Company is charged a fee on
the unused portion of the credit facility ranging from 0.13 percent to 0.38
percent depending on the Company's consolidated funded debt to EBITDA ratio.
In connection with the merger of Creditrust into NCO Portfolio, the Company
amended its revolving credit facility to allow the Company to provide NCO
Portfolio with a $50 million revolving line of credit in the form of a
sub-facility under its existing credit facility. The borrowing capacity of the
sub-facility is subject to mandatory reductions including four quarterly
reductions of $2.5 million beginning March 31, 2002 through December 31, 2002.
Effective March 31, 2003, quarterly reductions of $3.75 million are required
until the earlier of the Maturity Date or the date at which the sub-facility is
reduced to $25 million. NCO Portfolio's borrowings bear interest at a rate equal
to NCO's interest rate under the revolving credit facility plus 1.00 percent.
-11-
8. Long-term Debt (continued):
The following summarizes the availability under the revolving credit facility as
of September 30, 2002 (amounts in thousands):
NCO Group NCO Portfolio Combined
--------------- ------------------ ---------------
Maximum capacity $ 209,425 $ 42,500 $ 251,925
Less:
Outstanding borrowings 146,000 33,880 179,880
Unused letters of credit 2,345 - 2,345
--------- -------- ---------
Available $ 61,080 $ 8,620 $ 69,700
========= ======== =========
Borrowings under the revolving credit facility are collateralized by
substantially all the assets of the Company, including the common stock of NCO
Portfolio, and certain assets of NCO Portfolio. The credit agreement contains
certain financial covenants such as maintaining net worth and funded debt to
EBITDA requirements, and includes restrictions on, among other things,
acquisitions and distributions to shareholders. As of September 30, 2002, the
Company was in compliance with all required covenants.
Convertible Debt:
In April 2001, the Company completed the sale of $125.0 million aggregate
principal amount of 4.75 percent Convertible Subordinated Notes due 2006
("Notes") in a private placement pursuant to Rule 144A and Regulation S under
the Securities Act of 1933. The Notes are convertible into NCO common stock at
an initial conversion price of $32.92 per share. The Company will be required to
repay the $125.0 million of aggregate principal if the Notes are not converted
prior to their maturity in April 2006. The Company used the $121.3 million of
net proceeds from this offering to repay debt under its revolving credit
facility. In accordance with the terms of the credit agreement, 50 percent of
the net proceeds from the Notes permanently reduced the maximum borrowings
available under the revolving credit facility.
Securitized Debt:
Prior to the Creditrust merger, Creditrust established four securitized notes
payable to fund the purchase of accounts receivable, of which one was included
in an unconsolidated subsidiary, Creditrust SPV98-2, LLC (see note 15). The
remaining three securitized notes payable are included on the balance sheet
under long-term debt. Each of the notes payable is non-recourse to the Company
and NCO Portfolio, secured by a portfolio of purchased accounts receivable, and
is bound by an indenture and servicing agreement. Pursuant to the acquisition,
the trustee appointed NCO as the successor servicer for each portfolio of
purchased accounts receivable. When the notes payable were established, a
separate special purpose finance subsidiary was created to house the assets and
debt. These notes are term notes without the ability to re-borrow. Monthly
principal payments on the notes equal all collections after servicing fees,
collection costs, interest expense and administrative fees.
The first securitized note ("Warehouse Facility") was established in September
1998 through Creditrust Funding I LLC, a special purpose finance subsidiary. The
Warehouse Facility carries a floating interest rate of LIBOR plus 0.65 percent
per annum, and the final due date of all payments under the facility is the
earlier of March 2005, or satisfaction of the note from collections. A $900,000
liquidity reserve is included in restricted cash as of September 30, 2002, and
is restricted as to use until the facility is retired. Interest expense, trustee
fees and guarantee fees aggregated $271,000 and $155,000 for the three months
ended September 30, 2001 and 2002, respectively. Interest expense, trustee fees
and guarantee fees aggregated $744,000 and $483,000 for the period from February
21, 2001, to September 30, 2001, and for the nine months ended September 30,
2002, respectively. As of September 30, 2002, $15.9 million was outstanding on
this facility. The note issuer, Radian Asset Assurance, Inc., formerly Asset
Guaranty Insurance Company, has been guaranteed against loss by NCO Portfolio
for up to $4.5 million, which will be reduced if and when reserves and residual
cash flows from another securitization, Creditrust SPV 98-2, LLC, are posted as
additional collateral for this facility (see note 15).
The second securitized note ("SPV99-1 Financing") was established in August 1999
through Creditrust SPV99-1, LLC, a special purpose finance subsidiary. SPV99-1
Financing carried interest at 9.43 percent per annum, with a final payment date
of the earlier of August 2004, or satisfaction of the note from collections. In
May 2002, the note was paid off, and the $225,000 liquidity reserve was returned
to NCO Portfolio. Interest expense, trustee fees and guarantee fees aggregated
$177,000 for the three months ended September 30, 2001. Interest expense,
trustee fees and guarantee fees aggregated $575,000 and $56,000 for the period
from February 21, 2001, to September 30, 2001, and for the nine months ended
September 30, 2002, respectively.
The third securitized note ("SPV99-2 Financing") was established in August 1999
through Creditrust SPV99-2, LLC, a special purpose finance subsidiary. SPV99-2
Financing carries interest at 15.00 percent per annum, with a final payment date
of the earlier of December 2004, or satisfaction of the note from collections.
Interest expense and trustee fees aggregated $1.0 million and $796,000 for the
three months ended September 30, 2001 and 2002, respectively. Interest expense,
trustee fees and guarantee fees aggregated $2.4 million and $2.5 million for the
period from February 21, 2001, to September 30, 2001, and for the nine months
ended September 30, 2002, respectively. As of September 30, 2002, $20.8 million
was outstanding on this facility.
-12-
8. Long-term Debt (continued):
Non-Recourse Debt:
In August 2002, NCO Portfolio entered into a four-year exclusivity agreement
with CFSC Capital Corp. XXXIV ("Cargill"). The agreement stipulates that all
purchases of accounts receivable with a purchase price in excess of $4 million,
with limited exceptions, shall be offered to Cargill for financing at its
discretion. The agreement has no minimum or maximum credit authorization. NCO
Portfolio may terminate the agreement at any time after 24 months for a cost of
$125,000 per month for each month of the remaining four years, payable monthly.
If Cargill chooses to participate in the financing of a portfolio of accounts
receivable, the financing will be at 90 percent of the purchase price, with
floating interest at Prime plus 3.25 percent. Each borrowing is due twenty-four
months after the loan is made. Debt service payments equal collections less
servicing fees and interest expense. As additional interest, Cargill will
receive a residual of 40 percent in perpetuity, which is defined as all cash
collections after servicing fees, floating rate interest, repayment of the note
and the initial investment by NCO Portfolio, including interest. The financing
is non-recourse to NCO Portfolio's other assets. This loan agreement contains a
collections performance requirement, among other covenants, that, if not met,
provides for cross-collateralization with any other Cargill financed portfolios,
in addition to other remedies. As of September 30, 2002, the Company was in
compliance with all required covenants.
9. Earnings Per Share:
Basic earnings per share ("EPS") was computed by dividing the net income by the
weighted average number of common shares outstanding. Diluted EPS was computed
by dividing the adjusted net income by the weighted average number of common
shares outstanding plus all common equivalent shares. Net income is adjusted to
add-back convertible interest expense, net of taxes, if the convertible debt is
dilutive. The convertible interest, net of taxes, included in the diluted EPS
calculation for the three months ended September 30, 2001 and 2002, was zero and
$920,000, respectively. The convertible interest, net of taxes, included in the
diluted EPS calculation for the nine months ended September 30, 2001 and 2002,
was $1.5 million and $2.8 million, respectively. Outstanding options, warrants
and convertible securities have been utilized in calculating diluted net income
per share only when their effect would be dilutive.
The reconciliation of basic to diluted weighted average shares outstanding was
as follows (amounts in thousands):
For the Three Months For the Nine Months Ended
Ended September 30, September 30,
-------------------------- ---------------------------
2001 2002 2001 2002
------ ------ ------ ------
Basic 25,811 25,908 25,760 25,884
Dilutive effect of convertible debt -
3,797 2,476 3,797
Dilutive effect of options 82 16 297 186
Dilutive effect of warrants 64 - 118 -
------ ------ ------ ------
Diluted 25,957 29,721 28,651 29,867
====== ====== ====== ======
10. Interest Rate Hedge:
As of September 30, 2002, the Company was party to two interest rate swap
agreements, which qualified as cash flow hedges, to fix LIBOR at 2.8225 percent
on an aggregate amount of $91.0 million of the variable-rate debt outstanding
under the revolving credit facility. The aggregate notional amount of the
interest rate swap agreements is subject to quarterly reductions that will
reduce the aggregate notional amount to $62 million by maturity in September
2003.
-13-
11. Supplemental Cash Flow Information:
The following are supplemental disclosures of cash flow information (amounts in
thousands):
For the Nine Months Ended
September 30,
----------------------------
2001 2002
----------- ------------
Non-cash investing and financing activities:
Fair value of assets acquired $ 123,978 $ 13,543
Liabilities assumed from acquisitions 109,394 2,943
Deferred portion of purchased accounts receivable - 1,135
Acquisition of purchased accounts receivable paid
for in October 2002 - 946
Warrants exercised - 875
12. Commitments and Contingencies:
Forward-Flow Agreement
NCO Portfolio currently has a fixed price, term agreement ("forward-flow") with
a major financial institution that obligates NCO Portfolio to purchase, on a
monthly basis, portfolios of charged-off accounts receivable meeting certain
criteria. As of September 30, 2002, NCO Portfolio is obligated to purchase
accounts receivable at a maximum of $1.8 million per month through November
2002, with an option to renew for two additional three-month terms. A portion of
the purchase price is deferred for twelve months, including a nominal rate of
interest. The Company has guaranteed the obligations of NCO Portfolio under the
forward-flow agreement.
Litigation
The Company is party, from time to time, to various legal proceedings and
regulatory investigations incidental to its business. The Company continually
monitors these legal proceedings and regulatory investigations to determine the
impact and any required accruals.
In June 2001, the first floor of the Company's Fort Washington, PA, headquarters
was severely damaged by a flood caused by remnants of Tropical Storm Allison.
During the third quarter of 2001, the Company decided to relocate its corporate
headquarters to Horsham, PA. The Company has filed a lawsuit against the
landlord of the Fort Washington facilities to terminate the leases. Due to the
uncertainty of the outcome of the lawsuit, the Company recorded the full amount
of rent due under the remaining terms of the leases during the third quarter of
2001.
In the opinion of management no other legal proceedings or regulatory
investigations, individually or in the aggregate, will have a materially adverse
effect on the financial position, results of operations, cash flows, or
liquidity of the Company.
-14-
13. Segment Reporting:
The Company's business consists of three operating divisions: U.S. Operations,
Portfolio Management and International Operations. The accounting policies of
the segments are the same as those described in note 2, "Accounting Policies."
U.S. Operations provides accounts receivable management services to consumer and
commercial accounts for all market sectors including financial services,
healthcare, retail and commercial, utilities, education, telecommunications, and
government. U.S. Operations serves clients of all sizes in local, regional and
national markets. In addition to traditional accounts receivable collections,
these services include developing the client relationship beyond bad debt
recovery and delinquency management, and delivering cost-effective accounts
receivable and customer relationship management solutions to all market sectors.
U.S. Operations had total assets, net of any intercompany balances, of $732.4
million and $738.7 million at December 31, 2001 and September 30, 2002,
respectively.
Portfolio Management purchases and manages defaulted consumer accounts
receivable from consumer creditors such as banks, finance companies, retail
merchants, and other consumer oriented companies. Portfolio Management had total
assets, net of any intercompany balances, of $153.7 million and $163.1 million
at December 31, 2001 and September 30, 2002, respectively.
International Operations provides accounts receivable management services across
Canada and the United Kingdom. U.S. Operations uses International Operations as
a subcontractor to perform accounts receivable management services for some of
its clients. International Operations had total assets, net of any intercompany
balances, of $44.9 million and $52.4 million at December 31, 2001 and September
30, 2002, respectively.
The following tables represent the revenue, payroll and related expenses,
selling, general and administrative expenses, and earnings before interest,
taxes, depreciation, and amortization ("EBITDA") for each segment. EBITDA is
used by the Company's management to measure the segments' operating performance
and is not intended to report the segments' operating results in conformity with
accounting principles generally accepted in the United States.
For the Three Months Ended September 30, 2001
(amounts in thousands)
------------------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
---------------- ----------------- ----------------- ---------------
U.S. Operations $ 157,337 $ 80,810 $ 64,713 $ 11,814
Portfolio Management 16,189 525 9,080 6,584
International Operations 9,724 5,526 2,581 1,617
Eliminations (8,903) (1,556) (7,347) -
--------- -------- --------- --------
Total $ 174,347 $ 85,305 $ 69,027 $ 20,015
========= ======== ========= ========
For the Three Months Ended September 30, 2002
(amounts in thousands)
------------------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
---------------- ----------------- ----------------- ---------------
U.S. Operations $ 153,976 $ 76,857 $ 58,735 $ 18,384
Portfolio Management 16,338 328 10,045 5,965
International Operations 11,899 7,423 3,363 1,113
Eliminations (11,671) (2,739) (8,932) -
--------- -------- --------- --------
Total $ 170,542 $ 81,869 $ 63,211 $ 25,462
========= ======== ========= ========
-15-
13. Segment Reporting (continued):
For the Nine Months Ended September 30, 2001
(amounts in thousands)
------------------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
---------------- ----------------- ----------------- ---------------
U.S. Operations $ 477,951 $ 253,432 $ 166,991 $ 57,528
Portfolio Management 46,723 1,333 23,984 21,406
International Operations 27,768 16,325 7,732 3,711
Eliminations (23,791) (3,398) (20,393) -
--------- --------- --------- --------
Total $ 528,651 $ 267,692 $ 178,314 $ 82,645
========= ========= ========= ========
For the Nine Months Ended September 30, 2002
(amounts in thousands)
------------------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
---------------- ----------------- ----------------- ---------------
U.S. Operations $ 478,569 $ 237,108 $ 172,597 $ 68,864
Portfolio Management 46,716 1,431 28,979 16,306
International Operations 34,499 20,291 9,347 4,861
Eliminations (32,657) (7,361) (25,296) -
--------- --------- --------- --------
Total $ 527,127 $ 251,469 $ 185,627 $ 90,031
========= ========= ========= ========
14. Net Loss Due to Flood and Relocation of Corporate Headquarters:
In June 2001, the first floor of the Company's Fort Washington, PA headquarters
was severely damaged by a flood caused by remnants of Tropical Storm Allison.
During the third quarter of 2001, the Company decided to relocate its corporate
headquarters to Horsham, PA. The Company has filed a lawsuit against the
landlord of the Fort Washington facilities to terminate the leases. Due to the
uncertainty of the outcome of the lawsuit, the Company has recorded the full
amount of rent due under the remaining terms of the leases during the third
quarter of 2001. The Company has also recorded other expenses and expected
insurance proceeds during the third quarter of 2001 in connection with the flood
and the relocation of the corporate headquarters. The net effect of the charges
and the gain from the insurance proceeds included in selling, general, and
administrative expenses during the third quarter of 2001 was an expense of $11.2
million. During the first quarter of 2002, the Company received insurance
proceeds in excess of its original estimate, which resulted in a gain of
approximately $1.0 million. This gain was included in the Statement of Income in
"other income (expense)" for the nine months ended September 30, 2002.
-16-
15. Investments in Unconsolidated Subsidiaries:
NCO Portfolio owns a 100 percent retained residual interest in an investment in
securitization, Creditrust SPV 98-2, LLC, which was acquired as part of the
Creditrust merger. This transaction qualified for gain on sale accounting when
the purchased accounts receivable were originally securitized by Creditrust.
This securitization issued a note that is due the earlier of January 2004 or
satisfaction of the note from collections, and had an outstanding balance of
$3.1 million as of September 30, 2002. The retained interest represents the
present value of the residual interest in the securitization using discounted
future cash flows after the securitization note is fully repaid plus a cash
reserve. As of September 30, 2002, the investment in securitization was $7.4
million, composed of $4.1 million in present value of discounted residual cash
flows plus $3.3 million in cash reserves. The investment accrues non-cash income
at a rate of 8 percent per annum on the residual cash flow component only. The
income earned increases the investment balance until the securitization note has
been repaid. After repayment of the note, collections are split between income
and amortization of the investment in securitization based on the discounted
cash flows. The Company recorded $30,000 and $105,000 of income on this
investment during the three and nine months ended September 30, 2002,
respectively. The cash reserves of $3.3 million plus the first $1.2 million in
residual cash collections received after the securitization note has been repaid
have been pledged as collateral against the Warehouse Facility (see note 8). The
Company performs collection services for Creditrust SPV 98-2, LLC and recorded
service fee revenue of $644,000 and $422,000 for the three months ended
September 30, 2001 and 2002, respectively, and $1.4 million for the nine months
ended September 30, 2001 and 2002.
NCO Portfolio has a 50 percent ownership interest in a joint venture,
InoVision-MEDCLR NCOP Ventures, LLC ("Joint Venture"), with IMNV Holdings, LLC
("IMNV"). The Joint Venture was established in 2001 to purchase utility, medical
and various other small balance accounts receivable and is accounted for using
the equity method of accounting. Included in "other assets" on the balance sheet
is the Company's investment in the Joint Venture of $3.0 million as of September
30, 2002. Included in the Statements of Income, as "interest and investment
income," were $72,000 and $375,000 for the three and nine months ended September
30, 2002, respectively, representing the Company's 50 percent share of operating
income from this unconsolidated subsidiary. The Company performs collection
services for the joint venture and recorded service fee revenue of $1.1 million
and $3.3 million for the three and nine months ended September 30, 2002,
respectively. The Joint Venture has access to capital through a specialty
finance lender who, at its option, lends 90 percent of the value of the
purchased accounts receivable to the Joint Venture. The debt is
cross-collateralized by all portfolios within the Joint Venture in which the
lender participates, and is non-recourse to NCO Portfolio. The following table
summarizes the financial information of the Joint Venture as of and for the nine
months ended September 30, 2002 (amounts in thousands):
Total assets $ 10,868
Total liabilities 4,969
Revenue 6,732
Net income 750
-17-
Item 2
Management's Discussion and Analysis of
Financial Condition and Results of Operations
Certain statements included in this Report on Form 10-Q, other than
historical facts, are forward-looking statements (as such term is defined in the
Securities Exchange Act of 1934, and the regulations thereunder) which are
intended to be covered by the safe harbors created thereby. Forward-looking
statements include, without limitation, statements as to the Company's expected
future results of operations, the Company's growth strategy, the Company's
Internet and e-commerce strategy, the final outcome of the environmental
liability and the Company's litigation with its former landlord, the effects of
the terrorist attacks and the economy on the Company's business, expected
increases in operating efficiencies, anticipated trends in the accounts
receivable management industry, estimates of future cash flows of purchased
accounts receivable, estimates of goodwill impairments and amortization expense
for other intangible assets, the effects of legal or governmental proceedings,
the effects of changes in accounting pronouncements and statements as to trends
or the Company's or management's beliefs, expectations and opinions.
Forward-looking statements are subject to risks and uncertainties and may be
affected by various factors that may cause actual results to differ materially
from those in the forward-looking statements. In addition to the factors
discussed in this report, certain risks, uncertainties and other factors,
including, without limitation, the risk that the Company will not be able to
achieve expected future results of operations, the risk that the Company will
not be able to implement its growth strategy as and when planned, risks
associated with NCO Portfolio Management, Inc., risks associated with growth and
future acquisitions, the risk that the Company will not be able to realize
operating efficiencies in the integration of its acquisitions, fluctuations in
quarterly operating results, risks relating to the timing of contracts, risks
related to purchased accounts receivable, risks associated with technology, the
Internet and the Company's e-commerce strategy, risks related to the
environmental liability, risks relating to the Company's litigation and
regulatory investigations, risks related to past or possible future terrorist
attacks, risks related to the economy, and other risks detailed from time to
time in the Company's filings with the Securities and Exchange Commission,
including the Company's Annual Report on Form 10-K, filed March 19, 2002, can
cause actual results and developments to be materially different from those
expressed or implied by such forward-looking statements.
A copy of the Annual Report on Form 10-K can be obtained, without charge
except for exhibits, by written request to Steven L. Winokur, Executive Vice
President, Finance/CFO, NCO Group, Inc., 507 Prudential Rd., Horsham, PA 19044.
Three Months Ended September 30, 2002, Compared to Three Months Ended
September 30, 2001
Revenue. Revenue decreased $3.8 million, or 2.2 percent, to $170.5 million
for the three months ended September 30, 2002, from $174.3 million for the
comparable period in 2001. U.S. Operations, Portfolio Management and
International Operations accounted for $154.0 million, $16.3 million and $11.9
million, respectively, of the revenue for the three months ended September 30,
2002. U.S. Operations' revenue included $8.9 million of revenue earned on
services performed for Portfolio Management that was eliminated upon
consolidation. International Operations' revenue included $2.8 million of
revenue earned on services performed for U.S. Operations that was eliminated
upon consolidation.
U.S. Operations' revenue decreased $3.3 million, or 2.1 percent, to $154.0
million for the three months ended September 30, 2002, from $157.3 million for
the comparable period in 2001. The decrease in U.S. Operations' revenue was
primarily attributable to a further weakening of consumer payment patterns
during the third quarter. A portion of this decrease was offset by revenue from
the acquisition of Great Lakes Collection Bureau, Inc.'s ("Great Lakes")
collection operations in August 2002, and fees from servicing the Great Lakes
portfolio for Portfolio Management. A portion of the decrease was also offset by
the addition of new clients and the growth in business from certain existing
clients.
-18-
Portfolio Management's revenue increased $149,000, or 0.9 percent, to $16.3
million for the three months ended September 30, 2002, from $16.2 million for
the comparable period in 2001. Portfolio Management's collections increased $2.3
million, or 8.0 percent, to $30.7 million for the three months ended September
30, 2002, from $28.4 million for the comparable period in 2001. Portfolio
Management's revenue represented 53 percent of collections for the three months
ended September 30, 2002, as compared to 57 percent of collections for the same
period in the prior year. Revenue remained relatively unchanged due to the
increase in collections offset by the decrease in revenue recognition rate.
Revenue as a percentage of collections declined principally due to changes in
the composition of purchased accounts receivable in 2001 versus 2002. Purchased
accounts receivable acquired in, and subsequent to, the Creditrust merger were
acquired at a lower internal rate of return ("IRR") compared to accounts
receivable purchased prior to the Creditrust merger. Purchases of accounts
receivable made in the last quarter of 2001 and the first nine months of 2002
have returns that have been targeted lower at the time of acquisition due to the
tougher economic climate. The overall percentage was also lowered due to a
slow-down in collections as a result of the softening economic climate in the
last quarter of 2001 and the first nine months of 2002. Additionally, included
in collections is approximately $1.7 million received as a partial payment on
the sale of certain accounts to a leading credit card issuer. These additional
proceeds included in collections had a marginal impact on revenue as the rate at
which revenue is recognized period-to-period is not affected at the same rate as
changes in collections due to the effective interest method of computing
revenue. Additionally, portfolios with $6.5 million in carrying value, or 4.5
percent of purchased accounts receivable, as of September 30, 2002, have been
impaired to date and placed on cost recovery. Accordingly, no revenue will be
recorded on these portfolios after their impairment until their carrying value
has been fully recovered, resulting in a lower percentage of revenue to
collections. However, during the third quarter of 2002, Portfolio Management
concluded a contract re-negotiation with the seller of several existing
portfolios resulting in a $4.0 million cash price reduction on several purchases
from 2000 and 2001. The re-negotiation included a purchase price adjustment, as
well as a reimbursement for estimated lost earnings. The $4.0 million proceeds
were recorded as an adjustment to purchase price of the affected portfolios in
the quarter ended September 30, 2002. On several previously impaired portfolios,
the cash price carrying value reduction reduced the carrying value of such
portfolios, resulting in the carrying value of certain of the portfolios
becoming fully recovered. Included in revenue for the three months ended
September 30, 2002, was $803,000 from these fully recovered portfolios.
Furthermore, revenue of approximately $354,000 was recorded during the quarter
ended September 30, 2002, on several non-impaired portfolios due to the improved
IRRs as a result of the cash price reduction.
International Operations' revenue increased $2.2 million, or 22.4 percent,
to $11.9 million for the three months ended September 30, 2002, from $9.7
million for the comparable period in 2001. The increase in International
Operations' revenue was primarily attributable to new services provided for our
U.S. Operations, the addition of new clients, and growth in business from
existing clients. A portion of the increase was offset by changes in the foreign
currency exchange rates used to translate the International Operations' results
of operations into U.S. dollars.
Payroll and related expenses. Payroll and related expenses decreased $3.4
million to $81.9 million for the three months ended September 30, 2002, from
$85.3 million for the comparable period in 2001, and decreased as a percentage
of revenue to 48.0 percent from 48.9 percent.
U.S. Operations' payroll and related expenses decreased $3.9 million to
$76.9 million for the three months ended September 30, 2002, from $80.8 million
for the comparable period in 2001, and decreased as a percentage of revenue to
49.9 percent from 51.4 percent. The decrease as a percentage of revenue was
primarily attributable to our continued focus on managing the amount of labor
required to attain our revenue goals. A portion of the decrease was offset by
the further deterioration in consumer payment patterns during the quarter that
resulted in a reduction in revenue without a corresponding decrease in the fixed
portion of our payroll cost structure.
Portfolio Management's payroll and related expenses decreased $197,000 to
$328,000 for the three months ended September 30, 2002, from $525,000 for the
comparable period in 2001, and decreased as a percentage of revenue to 2.0
percent from 3.2 percent. Portfolio Management outsources all of its collection
services to U.S. Operations and, therefore, has a relatively small fixed payroll
cost structure. However, the decrease in payroll and related expenses was
principally due to the legal recovery group being transferred to the U.S.
Operations' attorney network, and the decrease of estimated incentive accruals
to more appropriately reflect the year-end earnings projections.
-19-
International Operations' payroll and related expenses increased $1.9
million to $7.4 million for the three months ended September 30, 2002, from $5.5
million for the comparable period in 2001, and increased as a percentage of
revenue to 62.4 percent from 56.8 percent. The increase as a percentage of
revenue was attributable to an increase in outsourcing services because those
services typically have a higher payroll cost structure than the remainder of
International Operations' business. The higher payroll cost structure of the
outsourcing services was offset by a lower selling, general and administrative
cost structure than the remainder of International Operations' business.
Selling, general and administrative expenses. Selling, general and
administrative expenses decreased $5.8 million to $63.2 million for the three
months ended September 30, 2002, from $69.0 million for the comparable period in
2001, and decreased as a percentage of revenue to 37.1 percent from 39.6
percent. The decrease as a percentage of revenue was primarily attributable to
$11.2 million of one-time charges incurred during the third quarter of 2001.
These one-time charges were incurred in connection with the June 2001 flood of
the Company's Fort Washington, PA corporate headquarters and the resultant
decision to relocate the corporate headquarters to Horsham, PA. The decrease
from the one-time charges was partially offset by higher costs in the third
quarter of 2002 from the reduced collectibility within our contingency revenue
stream due to the further weakening of consumer payment patterns. Accordingly,
in order to mitigate the effects of the decreased collectibility while
maintaining performance for our clients, we had to increase spending for direct
costs of collections. These costs included telephone, letter writing and
postage, third party servicing fees, credit reporting, skiptracing, and legal
and forwarding fees.
Depreciation and amortization. Depreciation and amortization decreased $2.8
million to $7.0 million for the three months ended September 30, 2002, from $9.8
million for the comparable period in 2001. This decrease was the result of the
adoption of Statement of Financial Accounting Standard No. 142, "Goodwill and
Other Intangibles" ("SFAS 142") on January 1, 2002. SFAS 142 eliminated the
amortization of goodwill, which was $3.9 million for the three months ended
September 30, 2001. Partially offsetting the $3.9 million decrease was
additional depreciation resulting from normal capital expenditures made in the
ordinary course of business during 2001 and 2002. These capital expenditures
included purchases associated with our planned migration towards a single,
integrated information technology platform, the relocation of our corporate
headquarters to Horsham, PA, and the acquisition of predictive dialers and other
equipment required to expand our infrastructure to handle future growth. The
decrease was also partially offset by the amortization of the customer list
acquired in the Great Lakes asset acquisition.
Other income (expense). Interest and investment income decreased $73,000 to
$690,000 for the three months ended September 30, 2002, from $763,000 for the
comparable period in 2001. This decrease was primarily attributable to lower
interest rates earned on operating cash, funds held in trust on behalf of
clients, and notes receivables. Interest expense decreased to $5.3 million for
the three months ended September 30, 2002, from $6.6 million for the comparable
period in 2001. This decrease was primarily attributable to lower interest rates
and lower principal balances as a result of debt repayments made during 2001 and
2002. The decrease was partially offset by Portfolio Management's borrowings
used to purchase accounts receivable portfolios, including the $20.6 million of
borrowings to purchase Great Lakes' accounts receivable portfolios.
Additionally, the decrease was also partially offset by the $10.5 million of
borrowings under the revolving credit facility used to fund the acquisition of
certain assets and related operations of Great Lakes.
Income tax expense. Income tax expense for the three months ended September
30, 2002, increased to $5.2 million, or 37.9 percent of income before income tax
expense, from $2.4 million, or 55.6 percent of income before income tax expense,
for the comparable period in 2001. The decrease in the effective rate was
primarily attributable to the elimination of the amortization of nondeductible
goodwill related to certain acquisitions. The goodwill amortization was
eliminated upon the adoption of SFAS 142 on January 1, 2002.
Nine Months Ended September 30, 2002, Compared to Nine Months Ended
September 30, 2001
Revenue. Revenue decreased $1.6 million, or 0.3 percent, to $527.1 million
for the nine months ended September 30, 2002, from $528.7 million for the
comparable period in 2001. U.S. Operations, Portfolio Management and
International Operations accounted for $478.6 million, $46.7 million and $34.5
million, respectively, of the revenue for the nine months ended September 30,
2002. U.S. Operations' revenue included $25.3 million of revenue earned on
services performed for Portfolio Management that was eliminated upon
consolidation. International Operations' revenue included $7.4 million of
revenue earned on services performed for U.S. Operations that was eliminated
upon consolidation.
-20-
U.S. Operations' revenue increased $618,000 to $478.6 million for the nine
months ended September 30, 2002, from $478.0 million for the comparable period
in 2001. During the nine months ended September 30, 2002, U.S. Operations'
revenue included incremental revenue from the addition of new clients and the
growth in business from existing clients, including a positive effect on revenue
attributable to an amendment of a long-term contract with a significant client
during the second quarter of 2002. In addition, a portion of the increase was
attributable to revenue from the acquisition of Great Lakes' collection
operations in August 2002, and fees from servicing the Great Lakes portfolio for
Portfolio Management. These increases were partially offset by a reduction in
consumer payment patterns and volume fluctuations in our early stage delinquency
business.
Portfolio Management's revenue was $46.7 million for the nine months ended
September 30, 2002 and 2001. Portfolio Management's collections increased $9.1
million, or 11.7 percent, to $87.2 million for the nine months ended September
30, 2002, from $78.1 million for the comparable period in 2001. Portfolio
Management's revenue represented 54 percent of collections for the nine months
ended September 30, 2002, as compared to 60 percent of collections for the same
period in the prior year. Although collections increased, revenue remained
unchanged due to the decrease in the revenue recognition rate. Revenue as a
percentage of collections declined principally due to changes in the composition
of purchased accounts receivable in 2001 versus 2002. Purchased accounts
receivable acquired in, and subsequent to, the Creditrust merger were acquired
at a lower internal rate of return ("IRR") compared to accounts receivable
purchased prior to the Creditrust merger. Purchases of accounts receivable made
in the last quarter of 2001 and the first nine months of 2002 have returns that
have been targeted lower at the time of acquisition due to the tougher economic
climate. The overall percentage was also lowered due to a slow-down in
collections as a result of the softening economic climate in the last quarter of
2001 and the first nine months of 2002. Additionally, included in collections
for the nine months ended September 30, 2002, was approximately $1.7 million
received as a partial payment on the sale of certain accounts to a leading
credit card issuer. These additional proceeds included in collections had a
marginal impact on revenue as the rate at which revenue is recognized
period-to-period is not affected at the same rate as changes in collections due
to the effective interest method of computing revenue. Additionally, portfolios
with $6.5 million in carrying value, or 4.5 percent of purchased accounts
receivable, as of September 30, 2002, have been impaired and placed on cost
recovery. Accordingly, no revenue will be recorded on these portfolios after
their impairment until their carrying value has been fully recovered, resulting
in a lower percentage of revenue to collections. However, during the third
quarter of 2002, Portfolio Management concluded a contract re-negotiation with
the seller of several existing portfolios resulting in a $4.0 million cash price
reduction on purchases from 2000 and 2001. The re-negotiation included a
purchase price adjustment, as well as a reimbursement for estimated lost
earnings. The $4.0 million proceeds were recorded as an adjustment to purchase
price of the affected portfolios in the quarter ended September 30, 2002. On
several previously impaired portfolios, the cash price reduction reduced the
carrying value of such portfolios, resulting in the carrying value of certain of
the portfolios becoming fully recovered. Included in revenue for the nine months
ended September 30, 2002, was $803,000 from these fully recovered portfolios.
Furthermore, revenue of approximately $354,000 was recorded during the nine
months ended September 30, 2002, on several non-impaired portfolios due to the
improved IRRs as a result of the cash price reduction.
International Operations' revenue increased $6.7 million, or 24.2 percent,
to $34.5 million for the nine months ended September 30, 2002, from $27.8
million for the comparable period in 2001. This increase in International
Operations' revenue was primarily attributable to new services provided for our
U.S. Operations, the addition of new clients, and growth in business from
existing clients. A portion of the increase was offset by changes in the foreign
currency exchange rates used to translate the International Operations' results
of operations into U.S. dollars.
Payroll and related expenses. Payroll and related expenses decreased $16.2
million to $251.5 million for the nine months ended September 30, 2002, from
$267.7 million for the comparable period in 2001, and decreased as a percentage
of revenue to 47.7 percent from 50.6 percent.
U.S. Operations' payroll and related expenses decreased $16.3 million to
$237.1 million for the nine months ended September 30, 2002, from $253.4 million
for the comparable period in 2001, and decreased as a percentage of revenue to
49.5 percent from 53.0 percent. The decrease as a percentage of revenue was
primarily attributable to $10.0 million of one-time charges incurred by U.S.
Operations during the second quarter of 2001. These charges related to a
comprehensive streamlining of its expense structure designed to counteract the
effects of operating in a more difficult collection environment. These costs
primarily consisted of the elimination or acceleration of certain contractual
employment obligations, severance costs related to terminated employees, and
costs related to a decision to change the structure of our healthcare benefit
programs from a large, singular benefit platform to individual plans across the
country. The decrease was also attributable to our continued focus on managing
our staffing levels to our business volumes, despite the difficult collection
environment.
-21-
Portfolio Management's payroll and related expenses increased $98,000 to
$1.4 million for the nine months ended September 30, 2002, from $1.3 million for
the comparable period in 2001, and increased as a percentage of revenue to 3.1
percent from 2.9 percent. Portfolio Management outsources all of its collection
services to U.S. Operations and, therefore, has a relatively small fixed payroll
cost structure. However, due to the expansion of this division and the
Creditrust merger in February 2001, Portfolio Management hired additional
employees during March 2001 to operate NCO Portfolio Management, Inc. as a
separate public company. The increase was attributable to a full nine months of
these additional employees during 2002. Offsetting a portion of this increase in
payroll and related expenses was the transfer of the legal recovery group to the
U.S. Operations' attorney network, and the decrease of estimated incentive
accruals to more appropriately reflect our year-end earnings projections.
International Operations' payroll and related expenses increased $4.0
million to $20.3 million for the nine months ended September 30, 2002, from
$16.3 million for the comparable period in 2001, and remained constant as a
percentage of revenue at 58.8 percent. Although payroll and related expenses
remained at 58.8 percent, the prior year expenses included $736,000 of one-time
charges incurred by International Operations during the second quarter of 2001.
These charges related to a comprehensive streamlining of its expense structure.
These costs primarily consisted of the elimination or acceleration of certain
contractual employment obligations and severance costs related to terminated
employees. Excluding the one-time charges, the payroll and related expenses
increased as a percentage of revenue due to an increase in outsourcing services
because those services typically have a higher payroll cost structure than the
remainder of International Operations' business. The higher payroll cost
structure of the outsourcing services was offset by a lower selling, general and
administrative cost structure than the remainder of International Operations'
business.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased $7.3 million to $185.6 million for the nine
months ended September 30, 2002, from $178.3 million for the comparable period
in 2001, and increased as a percentage of revenue to 35.2 percent from 33.7
percent. The increase as a percentage of revenue was primarily attributable to
reduced collectibility within our contingency revenue stream due to the effects
of the difficult collection environment. Accordingly, in order to mitigate the
effects of the decreased collectibility while maintaining performance for our
clients, we had to increase spending for direct costs of collections. These
costs included telephone, letter writing and postage, third party servicing
fees, credit reporting, skiptracing, and legal and forwarding fees. The increase
as a percentage of revenue was partially offset by $11.2 million of one-time
charges incurred during the third quarter of 2001. These one-time charges were
incurred in connection with the June 2001 flood of the Company's Fort
Washington, PA corporate headquarters and the resultant decision to relocate the
corporate headquarters to Horsham, PA. Additionally, a portion of the increase
was offset by $1.8 million of one-time charges incurred during the second
quarter of 2001 related to a comprehensive streamlining of its expense structure
designed to counteract the effects of operating in a more difficult collection
environment. These costs primarily related to real estate obligations for closed
facilities and equipment rental obligations.
Depreciation and amortization. Depreciation and amortization decreased $8.6
million to $19.8 million for the nine months ended September 30, 2002, from
$28.4 million for the comparable period in 2001. This decrease was the result of
the adoption of Statement of Financial Accounting Standard No. 142, "Goodwill
and Other Intangibles" ("SFAS 142") on January 1, 2002. SFAS 142 eliminated the
amortization of goodwill, which was $11.7 million for the nine months ended
September 30, 2001. Partially offsetting the $11.7 million decrease was
additional depreciation resulting from normal capital expenditures made in the
ordinary course of business during 2001 and 2002. These capital expenditures
included purchases associated with our planned migration towards a single,
integrated information technology platform, the relocation of our corporate
headquarters to Horsham, PA, and the acquisition of predictive dialers and other
equipment required to expand our infrastructure to handle future growth. The
decrease was also partially offset by the amortization of the customer list
acquired in the Great Lakes asset acquisition.
Other income (expense). Interest and investment income decreased $423,000
to $2.1 million for the nine months ended September 30, 2002, from $2.6 million
for the comparable period in 2001. This decrease was primarily attributable to
lower interest rates earned on operating cash, funds held in trust on behalf of
clients, and notes receivables. Interest expense decreased to $15.2 million for
the nine months ended September 30, 2002, from $21.3 million for the comparable
period in 2001. This decrease was primarily attributable to lower interest rates
and lower principal balances as a result of debt repayments made during 2001 and
2002. The decrease was partially offset by a full nine months of interest from
the Portfolio Management's $36.3 million of borrowings made in connection with
the Creditrust merger in February 2001 and its subsequent borrowings used to
purchase accounts receivable portfolios, including the $20.6 million of
borrowings to purchase Great Lakes' accounts receivable portfolios. In addition,
a portion of the decrease was offset by a full nine months of interest from
securitized debt that was assumed as part of the Creditrust merger. During the
nine months ended September 30, 2002, we recorded a net expense of $290,000.
This expense was the net effect of a $1.0 million insurance gain, and a $1.3
million net expense from the estimated settlement of an environmental liability.
The gain resulted from the settlement of the insurance claim related to the June
2001 flood of the Fort Washington facilities. The insurance gain was principally
due to greater than estimated insurance proceeds. The expense from the
environmental liability was the result of contamination that allegedly occurred
in the pre-acquisition operations of a company acquired by a subsidiary of
Medaphis Services Corporation. We acquired Medaphis Services Corporation in
November 1998. These operations were unrelated to the accounts receivable
outsourcing business.
-22-
Income tax expense. Income tax expense for the nine months ended September
30, 2002, increased to $21.6 million, or 37.9 percent of income before income
tax expense, from $14.8 million, or 41.7 percent of income before income tax
expense, for the comparable period in 2001. The decrease in the effective rate
was primarily attributable to the elimination of the amortization of
nondeductible goodwill related to certain acquisitions. The goodwill
amortization was eliminated upon the adoption of SFAS 142 on January 1, 2002.
Liquidity and Capital Resources
Historically, our primary sources of cash have been bank borrowings, equity
and debt offerings, and cash flows from operations. Cash has been used for
acquisitions, repayments of bank borrowings, purchases of equipment, purchases
of accounts receivable, and working capital to support our growth.
Cash Flows from Operating Activities. Cash provided by operating activities
was $56.1 million for the nine months ended September 30, 2002, compared to
$61.3 million for the same period in 2001. The decrease in cash provided by
operations was primarily attributable to a $9.2 million decrease in accounts
payable and accrued expenses as compared to a $17.9 million increase for the
same period in the prior year. The increase in 2001 was primarily attributable
to the accruals made in connection with the $23.8 million of one-time charges
incurred during the second and third quarter of 2001. The payment of many of
these accruals occurred during 2002, including the termination liability from
our prior healthcare plan. A portion of the decrease was offset by less of an
increase in accounts receivable as a result of our increased efforts to improve
the collectibility of our accounts receivables. Of the $15.1 million increase in
net income, $6.2 million represented the increase after the elimination of
goodwill amortization. This increase in net income, net of goodwill
amortization, also partially offset the decrease.
Cash Flows from Investing Activities. Cash used in investing activities was
$39.9 million for the nine months ended September 30, 2002, compared to $41.5
million for the same period in 2001. Purchases of accounts receivables for the
nine months ended September 30, 2002 was $50.2 million, including the $22.9
purchase of the Great Lakes portfolio, as compared to $39.5 million for the
comparable period in 2001, and collections applied to principal of purchased
accounts receivable was $41.4 million as compared to $26.8 million. The increase
in collections applied to principal was due to collections from accounts
receivables purchased during 2001 and 2002, and a full nine months of
collections from the accounts receivables purchased as part of the February
2001, Creditrust Corporation ("Creditrust") merger. Net cash paid during the
nine months ended September 30, 2002, in connection with the acquisition of
Great Lakes in August 2002, was $10.9 million, as compared to $11.1 million of
net cash paid during the nine months ended September 30, 2001, in connection
with the Creditrust merger.
Purchases of property and equipment were $23.8 million for the nine months
ended September 30, 2002, compared to $20.5 million for the same period in 2001.
Cash Flows from Financing Activities. Cash used in financing activities was
$17.3 million for the nine months ended September 30, 2002, compared to cash
used in financing activities of $5.5 million for the same period in 2001. The
cash used in financing activities during the nine months ended September 30,
2002 resulted from repayments of borrowings under our revolving credit facility
and repayments of securitized debt assumed as part of the Creditrust merger.
These repayments were partially offset by the $10.5 million borrowed from under
the revolving credit facility to fund the acquisition of Great Lakes' collection
operations and the $20.6 million borrowed from CFSC Capital Corp. XXXIV to
purchase Great Lakes' accounts receivable portfolio. The cash used in financing
activities during the nine months ended September 30, 2001 related to the net
borrowings under the revolving credit facility made in connection with the
Creditrust merger that were used to repay the acquired notes payable, finance
purchased accounts receivable, and other acquisition related liabilities.
Credit Facility. We have a credit agreement with Citizens Bank of
Pennsylvania, formerly Mellon Bank, N.A., ("Citizens Bank"), for itself and as
administrative agent for other participating lenders, structured as a revolving
credit facility. The balance under the revolving credit facility is due on May
20, 2004 (the "Maturity Date"). The borrowing capacity of the revolving credit
facility is subject to quarterly reductions of $5.2 million until the Maturity
Date, and 50 percent of the net proceeds received from any offering of debt or
equity. As of September 30, 2002, the maximum borrowing capacity and the
availability under the revolving credit facility were $251.9 million and $69.7
million, respectively.
At our option, the borrowings bear interest at a rate equal to either
Citizens Bank's prime rate plus a margin of 0.25 percent to 0.50 percent, which
is determined quarterly based upon our consolidated funded debt to earnings
before interest, taxes, depreciation, and amortization, also referred to as
EBITDA, ratio (Citizens Bank's prime rate was 4.75 percent at September 30,
2002), or the London InterBank Offered Rate, also referred to as LIBOR, plus a
margin of 1.25 percent to 2.25 percent depending on our consolidated funded debt
to EBITDA ratio (LIBOR was 1.82 percent at September 30, 2002). We are charged a
fee on the unused portion of the credit facility ranging from 0.13 percent to
0.38 percent depending on our consolidated funded debt to EBITDA ratio.
-23-
In connection with the Creditrust merger, the revolving credit facility was
amended to provide NCO Portfolio with a $50 million revolving line of credit in
the form of a sub-facility under the existing revolving credit facility. The
borrowing capacity of the sub-facility is subject to mandatory reductions
including four quarterly reductions of $2.5 million beginning March 31, 2002,
through December 31, 2002. Effective March 31, 2003, quarterly reductions of
$3.75 million are required until the earlier of the Maturity Date or the date at
which the sub-facility is reduced to $25 million. NCO Portfolio's borrowings
bear interest at a rate equal to NCO's interest rate under the revolving credit
facility plus 1.00 percent. As of September 30, 2002, there was $8.6 million
available under the NCO Portfolio sub-facility.
During February 2002, we entered into two interest rate swap agreements,
which qualified as cash flow hedges, to fix LIBOR at 2.8225 percent on an
original aggregate amount of $102 million of the variable-rate debt outstanding
under the revolving credit facility. The aggregate notional amount of the
interest rate swap agreements is subject to quarterly reductions that will
reduce the aggregate notional amount to $62 million by maturity in September
2003. As of September 30, 2002, a notional amount of $91.0 million was covered
by the interest rate swap agreements.
Borrowings under the revolving credit facility are collateralized by
substantially all of our assets, including the common stock of NCO Portfolio,
and certain assets of NCO Portfolio. The balance under the revolving credit
facility will become due on May 20, 2004. The credit agreement contains certain
financial covenants such as maintaining net worth and funded debt to EBITDA
requirements, and includes restrictions on, among other things, acquisitions and
distributions to shareholders. As of September 30, 2002, we were in compliance
with all required covenants.
Convertible Notes. In April 2001 we completed the sale of $125.0 million
aggregate principal amount of 4.75 percent Convertible Subordinated Notes due
2006 ("Notes") in a private placement pursuant to Rule 144A and Regulation S
under the Securities Act of 1933. The Notes are convertible into our common
stock at an initial conversion price of $32.92 per share and are payable in
April 2006. We used the $121.3 million of net proceeds from this offering to
repay debt under our revolving credit agreement. In accordance with the terms of
the credit agreement, 50 percent of the net proceeds from the Notes permanently
reduced the maximum borrowings available under the revolving credit facility.
Non-Recourse Debt. In August 2002, NCO Portfolio entered into a four-year
exclusivity agreement with CFSC Capital Corp. XXXIV ("Cargill"). The agreement
stipulates that all purchases of accounts receivable with a purchase price in
excess of $4 million, with limited exceptions, shall be offered to Cargill for
financing at its discretion. The agreement has no minimum or maximum credit
authorization. NCO Portfolio may terminate the agreement at any time after 24
months for a cost of $125,000 per month for each month of the remaining four
years, payable monthly. If Cargill chooses to participate in the financing of a
portfolio of accounts receivable, the financing will be at 90 percent of the
purchase price, with floating interest at Prime plus 3.25 percent. Each
borrowing is due twenty-four months after the loan is made. Debt service
payments equal collections less servicing fees and interest expense. As
additional interest, Cargill will receive a residual of 40 percent in
perpetuity, which is defined as all cash collections after servicing fees,
floating rate interest, repayment of the note and the initial investment by NCO
Portfolio, including interest. The financing is non-recourse to NCO Portfolio's
other assets. This loan agreement contains a collections performance
requirement, among other covenants, that, if not met, provides for
cross-collateralization with any other Cargill financed portfolios, in addition
to other remedies. As of September 30, 2002, we were in compliance with all
required covenants.
Off-Balance Sheet Arrangements
NCO Portfolio owns a 100 percent retained residual interest in an
investment in securitization, Creditrust SPV 98-2, LLC, which was acquired as
part of the merger with Creditrust. This transaction qualified for gain on sale
accounting when the purchased accounts receivable were originally securitized.
This securitization issued a note that is due in January 2004 and had a balance
of $3.1 million as of September 30, 2002. The retained interest represents the
present value of the residual interest in the securitization using discounted
future cash flows after the securitization note is fully repaid plus a cash
reserve. As of September 30, 2002, the investment in securitization was $7.4
million, composed of $4.1 million in present value of discounted residual cash
flows plus $3.3 million in cash reserves. The investment accrues non-cash income
at a rate of 8 percent per annum on the residual cash flow component only. The
income earned increases the investment balance until the securitization note has
been repaid, after which the collections are split between income and
amortization of the investment in securitization based on the discounted cash
flows. NCO Portfolio recorded $30,000 and $105,000 of income on this investment
for the three months and nine months ended September 30, 2002, respectively. The
off-balance sheet cash reserves of $3.3 million plus the first $1.2 million in
residual cash collections received after the securitization note has been repaid
have been pledged as collateral against another securitized note.
NCO Portfolio has a 50 percent ownership interest in a joint venture,
InoVision-MEDCLR NCOP Ventures, LLC ("Joint Venture"), with IMNV Holdings, LLC
("IMNV"). The Joint Venture was set up in 2001 to purchase utility, medical and
various other small balance accounts receivable and is accounted for using the
equity method of accounting. NCO Portfolio and IMNV each had an investment in
the Joint Venture of $3.0 million as of September 30, 2002. Included in the
Statements of Income, as "interest and investment income," were $72,000 and
$375,000 for the three and nine months ended September 30, 2002, respectively,
representing NCO Portfolio's 50 percent share of operating income from this
unconsolidated subsidiary. The Joint Venture has access to capital through a
specialty finance lender who, at its option, lends 90 percent of the value of
the purchased accounts receivable to the Joint Venture. The debt is
cross-collateralized by all portfolios within the Joint Venture in which the
lender participates, and is non-recourse to NCO Portfolio.
-24-
Market Risk
We are exposed to various types of market risk in the normal course of
business, including the impact of interest rate changes, foreign currency
exchange rate fluctuations, and changes in corporate tax rates. A material
change in these rates could adversely affect our operating results and cash
flows. A 25 basis-point increase in interest rates could increase our annual
interest expense by $250,000 for each $100 million of variable debt outstanding
for the entire year. We employ risk management strategies that may include the
use of derivatives such as interest rate swap agreements, interest rate ceilings
and floors, and foreign currency forwards and options to manage these exposures.
Goodwill
Our balance sheet includes amounts designated as "goodwill." Goodwill
represents the excess of purchase price over the fair market value of the net
assets of the acquired businesses, based on their respective fair values at the
date of acquisition.
As of September 30, 2002, our balance sheet included goodwill that
represented 54.2 percent of total assets and 115.4 percent of shareholders'
equity.
Effective January 1, 2002, we adopted Statement of Financial Accounting
Standard No. 142, "Goodwill and Other Intangibles" ("SFAS 142"). As a result of
adopting SFAS 142, we no longer amortize goodwill. Goodwill must be tested at
least annually for impairment, including an initial test that was completed in
connection with the adoption of SFAS 142. The test for impairment uses a
fair-value based approach, whereby if the implied fair value of a reporting
unit's goodwill is less than its carrying amount, goodwill would be considered
impaired. We did not incur any impairment charges in connection with the
adoption of SFAS 142 and do not believe that goodwill is impaired at September
30, 2002.
Critical Accounting Policies
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and the accompanying notes. Actual results could differ
from those estimates. We believe that the following accounting policies include
the estimates that are the most critical and could have the most potential
impact on our results of operations: revenue recognition for purchased accounts
receivable and long-term contingency fee contracts; bad debts; and deferred
taxes. These and other critical accounting policies are described in Note 2 to
these financial statements, and in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and Note 2 to our 2001 financial
statements contained in our Annual Report on Form 10-K for the year ended
December 31, 2001.
Impact of Recently Issued and Proposed Accounting Pronouncements
During 2001, the Accounting Staff Executive Committee approved an exposure
draft on a proposed Statement of Position, "Accounting for Discounts Related to
Credit Quality" ("SOP"). The proposed SOP would limit the revenue that may be
accrued to the excess of the estimate of expected future cash flows over a
portfolio's initial cost of accounts receivable acquired. The proposed SOP would
require that the excess of the contractual cash flows over expected future cash
flows not be recognized as an adjustment of revenue, expense or on the balance
sheet. The proposed SOP would freeze the internal rate of return ("IRR")
originally estimated when the accounts receivable are purchased for subsequent
impairment testing. Rather than lower the estimated IRR if the original
collection estimates are not received, the carrying value of a portfolio would
be written down to maintain the original IRR. Increases in expected future cash
flows would be recognized prospectively through adjustment of the IRR over a
portfolio's remaining life. The exposure draft provides that previously issued
annual financial statements would not need to be restated. Until final issuance
of this SOP, we cannot ascertain its effect on our reporting.
-25-
Item 3
Quantitative and Qualitative Disclosures about Market Risk
Included in Item 2, Management's Discussion and Analysis of Financial
Condition and Results of Operations, of this Report on Form 10-Q.
Item 4
Controls and Procedures
Quarterly evaluation of the Company's Disclosure Controls. Within the 90
days prior to the date of this Quarterly Report on Form 10-Q, the Company
evaluated the effectiveness of the design and operation of its "disclosure
controls and procedures" ("Disclosure Controls"). This evaluation ("Controls
Evaluation") was done under the supervision and with the participation of
management, including the Chief Executive Officer ("CEO") and Chief Financial
Officer ("CFO").
Limitations on the Effectiveness of Controls. The Company's management,
including the CEO and CFO, does not expect that its Disclosure Controls or and
its "internal controls and procedures for financial reporting" ("Internal
Controls") will prevent all error and all fraud. A control system, no matter how
well conceived and operated, can provide only reasonable, not absolute,
assurance that the objectives of the control system are met. Further, the design
of a control system must reflect the fact that there are resource constraints,
and the benefits of controls must be considered relative to their costs. Because
of the inherent limitations in all control systems, no evaluation of controls
can provide absolute assurance that all control issues and instances of fraud,
if any, within the Company have been detected. These inherent limitations
include the realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error or mistake. Additionally, controls
can be circumvented by the individual acts of some persons, by collusion of two
or more people, or by management override of the control. The design of any
system of controls also is based in part upon certain assumptions about the
likelihood of future events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions;
over time, control may become inadequate because of changes in conditions, or
the degree of compliance with the policies or procedures may deteriorate.
Because of the inherent limitations in a cost-effective control system,
misstatements due to error or fraud may occur and not be detected.
Conclusions. Based upon the Controls Evaluation, the CEO and CFO have
concluded that, to the best of their knowledge and subject to the limitations
noted above, the Disclosure Controls are effective to timely alert management to
material information relating to the Company during the period when its periodic
reports are being prepared.
In accord with SEC requirements, the CEO and CFO note that, to the best of
their knowledge, since the date of the Controls Evaluation to the date of this
Quarterly Report, there have been no significant changes in Internal Controls or
in other factors that could significantly affect Internal Controls, including
any corrective actions with regard to significant deficiencies and material
weaknesses.
-26-
Part II. Other Information
Item 1. Legal Proceedings
In June 2001, the first floor of the Company's Fort Washington, PA,
headquarters was severely damaged by a flood caused by remnants of Tropical
Storm Allison. During the third quarter of 2001, the Company decided to
relocate its corporate headquarters to Horsham, PA. The Company has filed a
lawsuit against the landlord of the Fort Washington facilities to terminate
the leases. Due to the uncertainty of the outcome of the lawsuit, the
Company recorded the full amount of rent due under the remaining terms of
the leases during the third quarter of 2001.
AssetCare, Inc., a subsidiary of the Company acquired as part of the
Medaphis Services Corporation acquisition, was identified in an
administrative order issued by the State of California as a party that is
partially responsible for cleanup costs associated with a former scrap
recycling site next to Humboldt Bay in California. The subsidiary was
identified as a successor-in-interest to a former scrap recycler who
conducted limited operations at the site. The subsidiary was also named in
a civil proceeding brought by one of the owners of the site as a party that
is responsible for the costs that will be incurred by the owner for
complying with the terms of the order. AssetCare agreed to pay $1,410,000
to settle the claims in the litigation with the owner in exchange for a
full release from the owner. Subsequently, the Company reached an agreement
with the former owner of Medaphis Services Corporation pursuant to which
they agreed to partially reimburse the Company an agreed amount for its
indemnification claims under the acquisition agreement.
The Company is involved in legal proceedings and regulatory
investigations from time to time in the ordinary course of its business.
Management believes that none of these legal proceedings or regulatory
investigations will have a materially adverse effect on the financial
condition or results of operations of the Company.
Item 2. Changes in Securities
None - not applicable
Item 3. Defaults Upon Senior Securities
None - not applicable
Item 4. Submission of Matters to a Vote of Shareholders
None - not applicable
Item 5. Other Information
During the period beginning on July 30, 2002 (the date of the
enactment of the Sarbanes-Oxley Act of 2002) and September 30, 2002, the
Company's Audit Committee approved the performance of the following
non-audit services by the Company's independent auditors, Ernst & Young
LLP:
o The Company routinely utilizes the services of Ernst & Young LLP
to review the financial records of companies that are potential
acquisition canadates. Such services do not always culminate
in an acquisition of the target company. During the quarter
ended September 30, 2002, Ernst & Young LLP was engaged to
perform two such engagements.
o An assessment and implementation review of the Company's
compliance with the Health Insurance Portability and
Accountability Act of 1996.
-27-
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.1 Ninth Amendment and Consent, dated October 31, 2002, to the
Fifth Amended and Restated Credit Agreement dated as of December
31, 1999 by and among NCO Group, Inc., as Borrower, Citizens
Bank of Pennsylvania (successor to Mellon Bank, N.A.), as
Administrative Agent and a Lender, and the Financial
Institutions identified therein as Lenders and such other Agents
as may be appointed from time to time. NCO will furnish to the
Securities and Exchange Commission a copy of any omitted
schedules upon request.
99.1 Consolidating Schedule
99.2 Chief Executive Officer Certification of Financial Statements
99.3 Chief Financial Officer Certification of Financial Statements
(b) Reports on Form 8-K
Date of Filing Item Reported
-------------- -------------
8/21/02 Item 7 and Item 9 - Press release and conference
call transcript from the earnings release
for the second quarter of 2002
8/22/02 Item 7 and Item 9 - Press release announcing the
acquisition of the net assets and results of
operations of Great Lakes Collection Bureau,
Inc.
9/03/02 Item 2 and Item 7 - Great Lakes Collection Bureau,
Inc. acquisition
9/18/02 Item 7 and Item 9 - Press release announcing
investor guidance for the third quarter of
2002
9/25/02 Item 7 and Item 9 - Amendment to the Form 8-K for
the press release and conference call
transcript from the earnings release for the
second quarter of 2002
-28-
Signatures
Pursuant to the requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 14, 2002 By: /s/ Michael J. Barrist
----------------------
Michael J. Barrist
Chairman of the Board, President
and Chief Executive Officer
(principal executive officer)
Date: November 14, 2002 By: /s/ Steven L. Winokur
---------------------
Steven L. Winokur
Executive Vice President, Finance,
Chief Financial Officer and
Treasurer
(principal financial and accounting
officer)
-29-
CERTIFICATIONS
I, Michael J. Barrist, certify that:
1. I have reviewed this quarterly report on Form 10-Q of NCO Group, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
b. evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have
identified for the registrant's auditors any material weaknesses in
internal controls; and
b. any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 14, 2002
/s/ Michael J. Barrist
- ----------------------
Michael J. Barrist
Chairman, Chief Executive Officer,
and President
(Principal Executive Officer)
-30-
CERTIFICATIONS
I, Steven L. Winokur, certify that:
1. I have reviewed this quarterly report on Form 10-Q of NCO Group, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined
in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a. designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;
b. evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent function):
a. all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to
record, process, summarize and report financial data and have identified
for the registrant's auditors any material weaknesses in internal
controls; and
b. any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 14, 2002
/s/ Steven L. Winokur
- ---------------------
Steven L. Winokur
Executive Vice President, Finance, Chief Financial
Officer and Treasurer
(Principal Financial and Accounting Officer)
-31-