Back to GetFilings.com
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 March 31, 2003, or
/ / Transition report pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the transition period from to
- --------------------------------------------------------------------------------
COMMISSION FILE NUMBER 0-21639
- --------------------------------------------------------------------------------
NCO GROUP, INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
PENNSYLVANIA
- --------------------------------------------------------------------------------
(State or other jurisdiction of incorporation or organization)
507 Prudential Road, Horsham, Pennsylvania
- --------------------------------------------------------------------------------
(Address of principal executive offices)
23-2858652
- --------------------------------------------------------------------------------
(IRS Employer Identification Number)
19044
- --------------------------------------------------------------------------------
(Zip Code)
215-441-3000
- --------------------------------------------------------------------------------
(Registrant's telephone number including area code)
Not Applicable
- --------------------------------------------------------------------------------
(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
------ ------
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes X No
----- ------
The number of shares outstanding of each of the issuer's classes of
common stock was: 25,908,000 shares of common stock, no par value, outstanding
as of March 14, 2003.
NCO GROUP, INC.
INDEX
PAGE
PART I - FINANCIAL INFORMATION
Item 1 FINANCIAL STATEMENTS (Unaudited)
Condensed Consolidated Balance Sheets -
December 31, 2002 and March 31, 2003 1
Condensed Consolidated Statements of Income -
Three months ended March 31, 2002 and 2003 2
Condensed Consolidated Statements of Cash Flows -
Three months ended March 31, 2002 and 2003 3
Notes to Condensed Consolidated Financial Statements 4
Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 21
Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK 27
Item 4 CONTROLS AND PROCEDURES 27
PART II - OTHER INFORMATION 28
Item 1. LEGAL PROCEEDINGS
Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
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
SIGNATURES 29
CERTIFICATIONS 30
Part 1 - Financial Information
Item 1 - Financial Statements
NCO GROUP, INC.
Condensed Consolidated Balance Sheets
(Unaudited)
(Amounts in thousands)
March 31,
December 31, 2003
ASSETS 2002 (Unaudited)
--------- ---------
Current assets:
Cash and cash equivalents $ 25,159 $ 30,692
Restricted cash 900 900
Accounts receivable, trade, net of allowance for
doubtful accounts of $7,285 and $7,673, respectively 86,857 94,173
Purchased accounts receivable, current portion 60,693 59,210
Deferred income taxes 16,389 16,342
Bonus receivable, current portion 15,584 17,631
Prepaid expenses and other current assets 9,644 13,081
--------- ---------
Total current assets 215,226 232,029
Funds held on behalf of clients
Property and equipment, net 79,603 78,870
Other assets:
Goodwill 525,784 527,705
Other intangibles, net of accumulated amortization 14,069 12,886
Purchased accounts receivable, net of current portion 91,755 91,631
Bonus receivable, net of current portion 408 1,341
Other assets 39,436 39,477
--------- ---------
Total other assets 671,452 673,040
--------- ---------
Total assets $ 966,281 $ 983,939
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Long-term debt, current portion $ 39,847 $ 39,515
Income taxes payable 2,222 5,031
Accounts payable 8,285 7,559
Accrued expenses 31,426 33,069
Accrued compensation and related expenses 15,374 16,019
Deferred revenue, current portion 12,088 15,175
--------- ---------
Total current liabilities 109,242 116,368
Funds held on behalf of clients
Long-term liabilities:
Long-term debt, net of current portion 334,423 326,872
Deferred revenue, net of current portion 11,678 12,611
Deferred income taxes 48,605 51,292
Other long-term liabilities 2,144 1,823
Minority interest 24,427 24,982
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,
25,908 and 25,908 shares issued and outstanding, respectively 321,824 321,824
Other comprehensive loss (3,876) (839)
Retained earnings 117,814 129,006
--------- ---------
Total shareholders' equity 435,762 449,991
--------- ---------
Total liabilities and shareholders' equity $ 966,281 $ 983,939
========= =========
See accompanying notes.
1
NCO GROUP, INC.
Condensed Consolidated Statements of Income
(Unaudited)
(Amounts in thousands, except per share data)
For the Three Months
Ended March 31,
---------------------------------------
2002 2003
--------- ---------
Revenue $ 188,007 $ 189,017
Operating costs and expenses:
Payroll and related expenses 86,120 88,298
Selling, general and administrative expenses 61,073 68,958
Depreciation and amortization expense 6,226 7,856
--------- ---------
Total operating costs and expenses 153,419 165,112
--------- ---------
Income from operations 34,588 23,905
Other income (expense):
Interest and investment income 667 836
Interest expense (4,986) (5,819)
Other expense (595) -
--------- ---------
Total other income (expense) (4,914) (4,983)
--------- ---------
Income before income tax expense 29,674 18,922
Income tax expense 11,255 7,179
--------- ---------
Income before minority interest 18,419 11,743
Minority interest (972) (551)
--------- ---------
Net income $ 17,447 $ 11,192
========= =========
Net income per share:
Basic $ 0.68 $ 0.43
Diluted $ 0.61 $ 0.41
Weighted average shares outstanding:
Basic 25,855 25,908
Diluted 29,903 29,718
See accompanying notes.
2
NCO GROUP, INC
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)
For the Three Months
Ended March 31,
---------------------------------
2002 2003
-------- --------
Cash flows from operating activities:
Net income $ 17,447 $ 11,192
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 5,549 6,658
Amortization of intangibles 677 1,198
Provision for doubtful accounts 2,302 1,345
Impairment of purchased accounts receivable 797 330
Gain on insurance proceeds from property and equipment (847) -
Minority interest 972 551
Changes in operating assets and liabilities, net of acquisitions:
Accounts receivable, trade (4,921) (8,626)
Deferred income taxes 5,235 2,819
Bonus receivable (4,054) (2,980)
Other assets 2,571 (3,362)
Accounts payable and accrued expenses (9,593) 1,688
Income taxes payable 3,093 2,809
Deferred revenue (11,042) 4,020
Other long-term liabilities (465) (321)
-------- --------
Net cash provided by operating activities 7,721 17,321
Cash flows from investing activities:
Purchases of accounts receivable (9,238) (16,870)
Collections applied to principal of purchased accounts receivable 11,524 19,109
Purchases of property and equipment (10,366) (5,506)
Insurance proceeds from involuntary conversion of
property and equipment 2,633 -
-------- --------
Net cash used in investing activities (5,447) (3,267)
Cash flows from financing activities:
Repayment of notes payable (4,684) (6,717)
Borrowings under notes payable - 6,054
Borrowings under revolving credit agreement 370 1,000
Repayment of borrowings under revolving credit agreement (5,000) (9,130)
Payment of fees to acquire debt - (15)
Issuance of common stock, net 69 -
-------- --------
Net cash used in financing activities (9,245) (8,808)
Effect of exchange rate on cash (40) 287
-------- --------
Net (decrease) increase in cash and cash equivalents (7,011) 5,533
Cash and cash equivalents at beginning of the period 32,161 25,159
-------- --------
Cash and cash equivalents at end of the period $ 25,150 $ 30,692
======== ========
See accompanying notes.
3
NCO GROUP, INC.
Notes to Condensed 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 63 percent
of NCO Portfolio Management, Inc., a separate public company that purchases and
manages past due 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 condensed 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 period ended March 31, 2003, are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2003, 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, as amended, filed with the Securities
and Exchange Commission on March 14, 2003.
Principles of Consolidation:
The condensed 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 16) and, accordingly, their financial condition and
results of operations are not consolidated with the Company's financial
statements.
Revenue Recognition:
Contingency Fees:
Contingency fee revenue is recognized upon collection of funds on behalf of
clients.
Contractual Services:
Fees for contractual services are recognized as services are performed and
accepted by the client.
4
2. Accounting Policies (continued):
Revenue Recognition (continued):
Long-Term Collection Contract:
The Company has a long-term collection contract with a large client to provide
collection services. The Company receives a base service fee based on
collections. The Company also earns a bonus if collections are in excess of the
collection amounts guaranteed by the Company before the specified measurement
dates. The Company is required to pay the client if collections do not reach the
guaranteed level by specified measurement dates, however the Company is entitled
to recoup at least 90 percent of any such guarantee payments from subsequent
collections. Specified measurement dates occur annually from May 31, 2003
through May 31, 2005. The specified measurement date is determined based on when
the receivables are placed with the Company and all receivables placed with a
particular measurement date are referred to collectively as a tranche.
In accordance with the provision of Staff Accounting Bulletin No. 101 "Revenue
Recognition in Financial Statements," the Company defers all of the base service
fees until the collections exceed the collection guarantees. At the end of each
reporting period, the Company compares actual collections for each tranche to
the guaranteed collections for that tranche, to determine if the Company is in a
net bonus or penalty position. The Company also projects the position as of the
specified measurement date. Based on the results of this comparison, the Company
may limit the amount of additional bonus recorded, or may accrue additional
penalties as a contingent liability.
As of March 31, 2003, $4.6 million of the bonus for the tranche with a May 31,
2003 specified measurement date was not recognized in order to reflect a
guarantee provision of the contract.
Although the Company expects to continue to generate additional collections, in
the unlikely event that the Company does not generate any additional collections
from March 31, 2003 through May, 2005, the Company's maximum exposure would be
$5.5 million, $30.5 million, and $40.2 million on May 31, 2003, May 31, 2004 and
May 31, 2005, respectively.
Purchased Accounts Receivable:
The Company accounts for its investment in purchased accounts receivable on an
accrual basis under the guidance of American Institute of Certified Public
Accountants' Practice Bulletin 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 that are initially recorded at cost, which
includes external costs of acquiring portfolios. Once a portfolio is acquired,
the accounts in the portfolio are not changed. Proceeds from the sale of
accounts and return of accounts within a portfolio are accounted for as
collections in that portfolio. The discount between the cost of each portfolio
and the face value of the portfolio is not recorded since the Company expects to
collect a relatively small percentage of each portfolio's face value.
Collections on the portfolios are allocated to revenue and principal reduction
based on the estimated internal rate of return ("IRR") for each portfolio. The
IRR for each portfolio is derived based on the expected monthly collections over
the estimated economic life of each portfolio (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 applying
each portfolio's effective IRR for the quarter to its 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
portfolio may be increased by the difference between the revenue accrual and
collections.
5
2. Accounting Policies (continued):
Revenue Recognition (continued):
Purchased Accounts Receivable (continued):
To the extent actual collections differ from estimated projections, the Company
prospectively adjusts the IRR. If the carrying value of a particular portfolio
exceeds its expected future collections, 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 projection, after being adjusted prospectively for actual collection
results, is less than the current carrying value recorded. After the impairment
of a portfolio, all collections are recorded as a return of capital and no
income is recorded on that portfolio 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 collections, and actual
collections will vary from current estimates. The difference could be material.
Credit Policy:
The Company has two types of arrangements under which it collects its contingent
fee revenue. For certain clients, the Company remits funds collected on behalf
of the client net of the related contingent fees while, for other clients, the
Company remits gross funds collected on behalf of clients and bills the client
separately for its contingent fees.
Management carefully monitors its client relationships in order to minimize the
Company's credit risk and maintains a reserve for potential collection losses
when such losses are deemed to be probable. The Company generally does not
require collateral and it does not charge finance fees on outstanding trade
receivables. 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. Trade accounts receivable are written off to the
allowance for doubtful accounts when collection appears highly unlikely.
Investments in Debt and Equity Securities:
The Company accounts for investments, such as the investment in securitization,
Creditrust SPV 98-2, LLC, in accordance with Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities." As such, investments are recorded as either trading, available for
sale, or held to maturity based on management's intent relative to those
securities. The Company records its investment in securitization as an available
for sale debt security. Such a security is recorded at fair value, and the
unrealized gains or losses, net of the related tax effects, are not reflected in
earnings but are recorded as other comprehensive income in the condensed
consolidated statement of shareholders' equity until realized. A decline in the
value of an available for sale security below cost that is deemed other than
temporary is charged to income as an impairment and results in the establishment
of a new cost basis for the security.
The investment in securitization is included in other assets and represents the
residual interest in a securitized pool of purchased accounts receivable
acquired in connection with the merger of Creditrust Corporation ("Creditrust")
into NCO Portfolio Management, Inc. ("NCO Portfolio"). The investment in
securitization accrues interest at an internal rate of return that is estimated
based on the expected monthly collections over the estimated economic life of
the investment (approximately five years). Cost approximated fair value of this
investment as of December 31, 2002 and March 31, 2003 (see note 16).
6
2. Accounting Policies (continued):
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 (see note 8).
Other intangible assets consist primarily of deferred financing costs, which
relate to debt issuance costs incurred, and customer lists, which were acquired
as part of acquisitions. Deferred financing costs are amortized over the term of
the debt and customer lists are amortized over five years (see note 8).
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 separately in
shareholders' equity as "other comprehensive income (loss)" since the interest
rate swap agreements were designated and qualified as cash flow hedges. As of
March 31, 2003, "other comprehensive income (loss)" included a loss of $449,000,
or $292,000 net of a tax benefit. The Company determined that the interest rate
swap agreements qualified as effective cash flow hedges because the interest
payment dates, the underlying index (the London InterBank Offered Rate or
"LIBOR"), and the notional amounts coincide with LIBOR contracts from the
revolving credit facility. 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.
Stock Options:
The Company accounts for stock option grants in accordance with APB Opinion 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations. Under APB 25, because the exercise price of the stock options
equaled the fair value of the underlying common stock on the date of grant, no
compensation cost was recognized. In accordance with SFAS 123, "Accounting for
Stock-Based Compensation," the Company does not recognize compensation cost
based on the fair value of the options granted at grant date. If the Company had
elected to recognize compensation cost based on the fair value of the options
granted at grant date, net income and net income per share would have been
reduced to the pro forma amounts indicated in the following table (amounts in
thousands, except per share amounts):
For the Three Months
Ended March 31,
-----------------------
2002 2003
-------- --------
Net income - as reported $ 17,447 $ 11,192
Pro forma compensation cost, net of taxes 1,354 986
-------- --------
Net income - pro forma $ 16,093 $ 10,206
======== ========
Net income per share - as reported:
Basic $ 0.68 $ 0.43
Diluted $ 0.61 $ 0.41
Net income per share - pro forma:
Basic $ 0.62 $ 0.39
Diluted $ 0.57 $ 0.37
7
2. Accounting Policies (continued):
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.
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 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 a significant portion of 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 a long-term collection contract,
estimates are made by management as to the payments due to the client. 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 are 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 collections between revenue and principal reduction of the carrying
values of the purchased accounts receivable.
On an ongoing basis, the Company compares the historical trends of each
portfolio to projected collections. Future projected collections are then
increased, within preset limits, or decreased based on the actual cumulative
performance of each portfolio. Management reviews each portfolio's adjusted
projected collections to determine if further upward or downward adjustment is
warranted. Management regularly reviews the trends in collection patterns and
uses its best efforts to improve the collections of under-performing portfolios.
On newly acquired portfolios, additional reviews are made to determine if the
purchase budget requires upward or downward adjustment due to unusual collection
patterns in the early months of ownership. However, actual results will differ
from these estimates and a material change in these estimates could occur within
one reporting period (see note 6).
3. Restated Financial Statements:
On February 6, 2003, the Company's independent auditors informed the Company
that, based on their further internal review and consultation, they no longer
considered the methodology for revenue recognition for a long-term collection
contract appropriate under revenue recognition guidelines. Previously, revenue
under the contract was recorded based upon the collection of funds on behalf of
clients at the anticipated average fee over the life of the contract. Further
review by the Company with its independent auditors led the Company to conclude
that it should change its method of revenue recognition for the contract. The
change resulted in the deferral of the recognition of revenue under the contract
until such time as any contingencies related to the realization of revenue have
been resolved. The financial statements and the accompanying notes of the
Company for the three months ended March 31, 2002, have been restated for a
correction of an error due to this change.
8
3. Restated Financial Statements (continued):
The following table presents the impact of the restatement on the consolidated
financial statements (amounts in thousands, except per share amounts):
For the Three Months Ended
March 31, 2002
-----------------------------
As
Previously
Reported Restated
------------- ------------
Selected income statement data:
Revenue $ 178,907 $ 188,007
Income before income tax
expense 20,574 29,674
Income tax expense 7,797 11,255
Net income 11,805 17,447
Net income per share:
Basic $ 0.46 $ 0.68
Diluted $ 0.43 $ 0.61
4. Business Combinations:
The following acquisitions have been accounted for under the purchase method of
accounting. As part of the purchase accounting, the Company recorded accruals
for acquisition related expenses. These accruals included professional fees
related to the acquisition and termination costs related to certain redundant
personnel immediately eliminated at the time of the acquisitions.
On August 19, 2002, the Company 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 $10.1 million in cash. The Company
funded the purchase with borrowings under its revolving credit agreement. 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 nonrecourse financing provided by CFSC
Capital Corp. XXXIV (see note 9). This nonrecourse financing is collateralized
by the Great Lakes purchased accounts receivable portfolio. As part of the
acquisition, the Company and GE Capital signed a multi-year agreement under
which the Company will provide services to GE Capital. The Company allocated
$4.1 million of the purchase price to the customer list and recognized goodwill
of $2.1 million. All of the goodwill is deductible for tax purposes. 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 is a preliminary allocation of
the net purchased assets of Great Lakes, excluding the purchased accounts
receivable portfolio (amounts in thousands):
As of
August 19, 2002
---------------
Current assets $ 2,016
Property and equipment 4,316
Goodwill 2,053
Client list 4,063
Total assets 12,448
Current liabilities 2,313
9
4. Business Combinations (continued):
On December 9, 2002, the Company acquired all of the stock of The Revenue
Maximization Group, Inc. ("RevGro") for $17.5 million in cash, including the
repayment of $889,000 of RevGro's pre-acquisition debt. The Company funded the
purchase with $16.8 million of borrowings under its revolving credit agreement
and existing cash. The Company allocated $4.7 million of the purchase price to
the customer list and recognized goodwill of $9.2 million. None of the goodwill
is deductible for tax purposes. Because the closing balance sheet has not been
finalized, the allocation of the fair market value to the acquired assets and
liabilities of RevGro 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 is a
preliminary allocation of the net purchased assets of RevGro (amounts in
thousands):
As of
December 9, 2002
----------------
Current assets $ 7,054
Property and equipment 485
Goodwill 9,163
Client list 4,698
Other assets 185
Total assets 21,585
Current liabilities 4,090
Long-term liabilities 26
The following summarizes the unaudited pro forma results of operations for the
three months ended March 31, 2002, assuming the acquisitions of RevGro and Great
Lakes had occurred as of the beginning of the period. 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 Ended
March 31, 2002
--------------
Revenue $ 205,088
Net income $ 15,913
Net income per share:
Basic $ 0.62
Diluted $ 0.56
10
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
Ended March 31,
-------------------------
2002 2003
-------- --------
Net income $ 17,447 $ 11,192
Other comprehensive income:
Foreign currency translation adjustment (187) 2,869
Unrealized gain on interest rate swap 368 168
-------- --------
Comprehensive income $ 17,628 $ 14,229
======== ========
The income from the foreign currency translation during the three months ended
March 31, 2003 was attributable to favorable changes in the exchange rates used
to translate the financial statements of the Canadian and United Kingdom
subsidiaries into U.S. Dollars.
6. Purchased Accounts Receivable:
The Company's Portfolio Management and International Operations divisions
purchase defaulted consumer accounts receivable at a discount from the actual
principal balance. On certain international portfolios, Portfolio Management and
International Operations jointly purchase defaulted consumer accounts
receivable. The following summarizes the change in purchased accounts receivable
(amounts in thousands):
For the Three
For the Year Ended Months Ended
December 31, 2002 March 31, 2003
------------------ --------------
Balance, at beginning of period $ 140,001 $ 152,448
Purchases of accounts receivable 72,680 17,781
Collections on purchased accounts receivable (120,513) (37,565)
Purchase price adjustment (4,000) -
Revenue recognized 66,162 18,456
Impairment of purchased accounts receivable (1,999) (330)
Foreign currency translation adjustment 117 51
--------- ---------
Balance, at end of period $ 152,448 $ 150,841
========= =========
During the three months ended March 31, 2002 and 2003, impairments of $797,000
and $330,000, respectively, were recorded as a charge to income on portfolios
where the carrying values exceeded the expected future cash flows. No income
will be recorded on these portfolios until the carrying values have been fully
recovered. As of December 31, 2002 and March 31, 2003, the combined carrying
values on all impaired portfolios aggregated $6.1 million and $7.0 million,
respectively, or 4.0 percent and 4.6 percent of total purchased accounts
receivable, respectively, representing their net realizable value. Revenue from
fully cost recovered portfolios was $116,000 for the three months ended March
31, 2003. Included in collections for the three months ended March 31, 2003, was
$1.5 million in proceeds from the sale of accounts.
11
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 $60.2 million and $72.9 million at
December 31, 2002 and March 31, 2003, respectively, have been shown net of their
offsetting liability for financial statement presentation.
8. 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. Fair value estimates are based upon the discounted value of
estimated cash flows. The Company did not incur any impairment charges in
connection with the adoption of SFAS 142 or the annual impairment test performed
on October 1, 2002, and does not believe that goodwill is impaired as of March
31, 2003. The annual impairment analysis will be completed on October 1 of each
year.
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, 2002 March 31, 2003
----------------- --------------
U.S. Operations $ 495,575 $ 495,399
International Operations 30,209 32,306
--------- ---------
Total $ 525,784 $ 527,705
========= =========
The change in U.S. Operations' goodwill balance from December 31, 2002 to March
31, 2003 was due to adjustments to the purchase accounting for the RevGro
acquisition (see note 4). The change in International Operations' goodwill
balance from December 31, 2002 to March 31, 2003 was due to changes in the
exchange rates used for the foreign currency translation.
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
customer lists. The following represents the other intangible assets (amounts in
thousands):
December 31, 2002 March 31, 2003
-------------------------------- -------------------------------
Gross Carrying Accumulated Gross Carrying Accumulated
Amount Amortization Amount Amortization
-------------- ------------ -------------- ------------
Deferred financing costs $12,422 $ 6,969 $12,437 $ 7,686
Customer lists 8,761 357 8,761 804
Other intangible assets 900 688 900 722
------- ------- ------- -------
Total $22,083 $ 8,014 $22,098 $ 9,212
======= ======= ======= =======
12
8. Intangible Assets (continued):
Other Intangible Assets (continued):
The Company recorded amortization expense for all other intangible assets of
$677,000 and $1.2 million during the three months ended March 31, 2002 and 2003,
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
------------------- ---------------------
2003 $ 4,754
2004 3,429
2005 2,541
2006 1,965
2007 1,395
9. Long-Term Debt:
Long-term debt consisted of the following (amounts in thousands):
December 31, 2002 March 31, 2003
----------------- --------------
Revolving credit loan $ 193,180 $ 185,050
Convertible notes 125,000 125,000
Securitized debt 35,523 34,944
Nonrecourse debt 17,632 17,833
Capital leases and other 2,935 3,560
Less current portion (39,847) (39,515)
--------- ---------
$ 334,423 $ 326,872
========= =========
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 will become 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 4.25 percent at March 31, 2003), 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
1.31 percent at March 31, 2003). 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.
The Company's revolving credit facility allows it to provide NCO Portfolio with
a revolving line of credit in the form of a subfacility under its existing
credit facility. The borrowing capacity of the subfacility is subject to
quarterly reductions of $3.75 million until the earlier of the Maturity Date or
the date at which the subfacility 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.
13
9. Long-Term Debt: (continued):
Revolving Credit Facility: (continued):
Borrowings under the revolving credit facility are collateralized by
substantially all the assets of the Company, including the common stock of NCO
Portfolio that the Company owns, 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 March 31, 2003,
the Company was in compliance with all required covenants.
The following summarizes the availability under the revolving credit facility
(amounts in thousands):
March 31, 2003
-----------------------------------------
NCO Group NCO Portfolio Combined
--------- ------------- --------
Maximum capacity $205,275 $ 36,250 $241,525
Less:
Outstanding borrowings 148,800 36,250 185,050
Letters of credit 2,316 - 2,316
-------- -------- --------
Available $ 54,159 $ - $ 54,159
======== ======== ========
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:
NCO Portfolio assumed four securitized notes in connection with the Creditrust
merger, one of which is included in an unconsolidated subsidiary, Creditrust SPV
98-2, LLC (see note 16). The remaining three notes are reflected in long-term
debt. These notes were originally established to fund the purchase of accounts
receivable. Each of the notes payable is nonrecourse to the Company and NCO
Portfolio, is secured by a portfolio of purchased accounts receivable, and is
bound by an indenture and servicing agreement. Pursuant to the Creditrust
merger, the trustee appointed NCO as the successor servicer for each portfolio
of purchased accounts receivable within these securitized notes. When the notes
payable were established, a separate nonrecourse special purpose finance
subsidiary was created to house the assets and issue the debt. These 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 was established in September 1998 through a special
purpose finance subsidiary. This note 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
December 31, 2002 and March 31, 2003, and is restricted as to use until the
facility is retired. Interest expense, trustee fees and guarantee fees
aggregated $167,000 and $124,000 for the three months ended March 31, 2002 and
2003, respectively. As of December 31, 2002 and March 31, 2003, the amount
outstanding on the facility was $15.4 million and $15.0 million, respectively.
Pursuant to the Creditrust merger, the note issuer 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 16).
14
9. Long-Term Debt: (continued):
Securitized Debt: (continued):
The second securitized note was established in August 1999 through a special
purpose finance subsidiary. This note carried interest at 9.43 percent per
annum. This facility was repaid and retired in May 2002. Interest expense,
trustee fees and guarantee fees aggregated $52,000 for the three months ended
March 31, 2002.
The third securitized note was established in August 1999 through a special
purpose finance subsidiary. This note 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 $876,000 and $753,000 for the three months ended March 31, 2002 and
2003, respectively. As of December 31, 2002 and March 31, 2003, the amount
outstanding on the facility was $20.1 million and $19.9 million, respectively.
Nonrecourse 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 by NCO Portfolio with a purchase price in
excess of $4 million, with limited exceptions, must be first 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 two
years 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, unless otherwise negotiated, with floating interest at the prime
rate plus 3.25 percent (prime rate was 4.25 percent at March 31, 2003). Each
borrowing is due two years after the loan is made. Debt service payments equal
collections less servicing fees and interest expense. As additional interest,
Cargill will receive 40 percent of the residual cash flow, unless otherwise
negotiated, 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 imputed interest. Borrowings under this financing agreement
are nonrecourse to NCO Portfolio and NCO, except for the assets within the
special purpose entities established in connection with the financing agreement.
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 March 31,
2003, NCO Portfolio was in compliance with all required covenants.
Other:
At March 31, 2003, the Company had letters of credit of $2.3 million.
The Company leases certain equipment under agreements that are classified as
capital leases. The equipment leases have original terms ranging from 23 to 60
months and have purchase options at the end of the original lease term.
10. 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 March 31, 2002 and 2003, was $920,000.
Outstanding options, warrants and convertible securities have been utilized in
calculating diluted net income per share only when their effect would be
dilutive.
15
10. Earnings Per Share: (continued):
The reconciliation of basic to diluted weighted average shares outstanding was
as follows (amounts in thousands):
For the Three Months
Ended March 31,
------------------------
2002 2003
------ ------
Basic 25,855 25,908
Dilutive effect of convertible debt 3,797 3,797
Dilutive effect of options 251 13
------ ------
Diluted 29,903 29,718
====== ======
11. Interest Rate Hedge:
As of March 31, 2003, 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 $74.0 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.
12. Supplemental Cash Flow Information:
The following are supplemental disclosures of cash flow information (amounts in
thousands):
For the Three Months
Ended March 31,
--------------------------
2002 2003
------- -------
Noncash investing and financing activities:
Deferred portion of purchased accounts receivable $ - $911
Warrants exercised 875 -
13. Commitments and Contingencies:
Forward-Flow Agreement:
In May 2002, NCO Portfolio entered into a fixed price, three-month renewable
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 March 31, 2003, NCO Portfolio was
obligated to purchase accounts receivable at a maximum of $1.8 million per month
through May 2003. A portion of the purchase price is deferred for 12 months,
including a nominal rate of interest. At the time of this filing, an agreement
in principal has been reached to renew the forward-flow agreement that will
obligate NCO Portfolio to purchase accounts receivable for a maximum of $2.5
million per month through May 2004. A portion of the purchase price will be
deferred for twenty-four months, including a nominal rate of interest.
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.
16
13. Commitments and Contingencies: (continued):
Litigation: (continued):
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. As
previously reported, during the third quarter of 2001, the Company decided to
relocate its corporate headquarters to Horsham, Pennsylvania. The Company filed
a lawsuit in the Court of Common Pleas, Montgomery County, Pennsylvania (Civil
Action No. 01-15576) against the current landlord and the former landlord of the
Fort Washington facilities to terminate the leases and to obtain other relief.
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 April 2003, the former landlord defendants filed a joinder complaint against
Michael J. Barrist, the Chairman, President and Chief Executive Officer of the
Company, Charles C. Piola, Jr., a director and former Executive Vice President
of the Company, and Bernard R, Miller, a former Executive Vice President and
director of the Company, to name such persons as additional defendants
(collectively, the "Joinder Defendants"). The Joinder Defendants were partners
in a partnership that owned real estate (the "Prior Real Estate") that the
Company leased at a market rent prior to moving to the Fort Washington facility.
The joinder complaint alleges that the Joinder Defendants breached their
statutory and common law duties of care and loyalty to the Company and
perpetrated a fraud upon the Company and its shareholders by refraining or
causing the Company to refrain from further investigation into the issue of
prior water intrusion at the Fort Washington facility and that it was a
condition to the lease of the Fort Washington facility that the former landlord
defendants purchase the Prior Real Estate from the Joinder Defendants. The
joinder complaint seeks to impose liability on the Joinder Defendants for any
damages suffered by the Company as a result of the flood.
Based upon its initial review of the facts, the Company believes that the
Joinder Defendants did not breach any duties to, or commit a fraud upon the
Company or its shareholders and that the allegations of any wrongdoing by the
Joinder Defendants are without merit.
Pursuant to the Company's Bylaws and the Joinder Defendants' employment
agreements, the Joinder Defendants will be indemnified by the Company against
any expenses or awards incurred in this suit, subject to certain exceptions.
In the opinion of management no other pending 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. 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, 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 $748.3
million and $756.2 million at December 31, 2002 and March 31, 2003,
respectively. U.S. Operations provides accounts receivable management services
to Portfolio Management. U.S. Operations recorded revenue of $8.3 million and
$12.3 million for these services for the three months ended March 31, 2002 and
2003, respectively. The accounting policies used to record the revenue from
Portfolio Management are the same as those described in note 2, "Accounting
Policies."
17
14. Segment Reporting: (continued):
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 $167.8 million and $171.9 million
at December 31, 2002 and March 31, 2003, respectively.
International Operations provides accounts receivable management services across
Canada and the United Kingdom. International Operations had total assets, net of
any intercompany balances, of $50.2 million and $55.8 million at December 31,
2002 and March 31, 2003, respectively. International Operations provides
accounts receivable management services to U.S. Operations. International
Operations recorded revenue of $2.0 million and $5.8 million for these services
for the three months ended March 31, 2002 and 2003, respectively. The accounting
policies used to record the revenue from U.S. Operations are the same as those
described in note 2, "Accounting Policies."
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 March 31, 2002
(amounts in thousands)
---------------------------------------------------------------------------
Payroll and Selling, General
Related and Admin.
Revenue Expenses Expenses EBITDA
--------- --------- --------- ---------
U.S. Operations $ 171,377 $ 81,688 $ 56,957 $ 32,732
Portfolio Management 16,270 554 9,663 6,053
International Operations 10,649 5,867 2,753 2,029
Eliminations (10,289) (1,989) (8,300) -
--------- --------- --------- ---------
Total $ 188,007 $ 86,120 $ 61,073 $ 40,814
========= ========= ========= =========
For the Three Months Ended March 31, 2003
(amounts in thousands)
---------------------------------------------------------------------------
Payroll and Selling, General
Related and Admin.
Revenue Expenses Expenses EBITDA
--------- --------- --------- ---------
U.S. Operations $ 173,105 $ 84,501 $ 64,387 $ 24,217
Portfolio Management 18,232 480 13,121 4,631
International Operations 15,754 9,084 3,757 2,913
Eliminations (18,074) (5,767) (12,307) -
--------- --------- --------- ---------
Total $ 189,017 $ 88,298 $ 68,958 $ 31,761
========= ========= ========= =========
18
15. 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 three months ended March 31, 2002.
16. 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 nonrecourse note that is due the earlier of January
2004 or satisfaction of the note from collections, carries an interest rate of
8.61 percent, and had an outstanding balance of $2.4 million and $1.7 million as
of December 31, 2002 and March 31, 2003, respectively. 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 March 31, 2003, the investment in
securitization was $7.5 million, composed of $4.2 million in present value of
discounted residual cash flows plus $3.3 million in cash reserves. The
investment accrues noncash 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, collections
are split between income and amortization of the investment in securitization
based on the discounted cash flows. No income was recorded for the three months
ended March 31, 2003, as the investment was offset by a temporary decline in
market value. The Company recorded $28,000 of income on this investment during
the three months ended March 31, 2002. The off-balance sheet cash reserves of
$3.3 million plus the first $1.3 million in residual cash collections received,
after the securitization note has been repaid, have been pledged as collateral
against another securitized note (see note 9). The Company performs collection
services for Creditrust SPV 98-2, LLC and recorded service fee revenue of
$510,000 and $513,000 for the three months ended March 31, 2002 and 2003,
respectively.
19
16. Investments in Unconsolidated Subsidiaries (continued):
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
Sheets was NCO Portfolio's investment in the Joint Venture of $3.4 million and
$3.8 million as of December 31, 2002 and March 31, 2003, respectively. Included
in the Statements of Income, as "interest and investment income," were $83,000
and $473,000 for the three months ended March 31, 2002 and 2003, respectively,
representing NCO Portfolio'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 $891,000 and $937,000 for the
three months ended March 31, 2002 and 2003, respectively. The Joint Venture has
access to capital through CFSC Capital Corp. XXXIV ("Cargill Financial") who, at
its option, lends 90 percent of the cost of the purchased accounts receivable to
the Joint Venture. Borrowings carry interest at the prime rate plus 4.25 percent
(prime rate was 4.25 percent as of March 31, 2003). Debt service payments equal
total collections less servicing fees and expenses until each individual
borrowing is fully repaid and the Joint Venture's investment is returned,
including interest. Thereafter, Cargill Financial is paid a residual of 50
percent of collections less servicing costs. Individual loans are required to be
repaid based on collections, but not more than two years from the date of
borrowing. The debt is cross-collateralized by all portfolios in which the
lender participates, and is nonrecourse to NCO Portfolio and NCO. The following
tables summarize the financial information of the Joint Venture (amounts in
thousands):
As of
--------------------------------------
December 31, 2002 March 31, 2003
------------------ --------------
Total assets $ 11,638 $ 11,972
Total liabilities 4,944 4,346
For the Three Months
Ended March 31,
--------------------------------------
2002 2003
------------------ --------------
Revenue $ 1,860 $ 3,360
Operating income 166 946
20
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
terrorist attacks, war 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 threat or outbreak of war or hostilities, risks
related to the current economic condition in the United States, risks related to
the Company's foreign operations, 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, as
amended, for the year ended December 31, 2002, can cause actual results and
developments to be materially different from those expressed or implied by such
forward-looking statements.
The Company disclaims any intent or obligation to publicly update or revise
any forward-looking statements, regardless of whether new information becomes
available, future developments occur or otherwise.
The Company's website is www.ncogroup.com. The Company makes available,
free of charge, on its website, its Annual Report on Form 10-K, including all
amendments. In addition, the Company will provide additional paper or electronic
copies of its Annual Report on Form 10-K for 2002, as filed with the Securities
and Exchange Commission, without charge except for exhibits to the report.
Requests should be directed to: Steven L. Winokur, Executive Vice President,
Finance/CFO, NCO Group, Inc., 507 Prudential Rd., Horsham, PA 19044.
The information on the website listed above, is not and should not be
considered part of this Report on Form 10-Q and is not incorporated by reference
in this document. This website is and is only intended to be an inactive textual
reference.
Three Months Ended March 31, 2003, Compared to Three Months Ended
March 31, 2002
Revenue. Revenue increased $1.0 million, or 0.5 percent, to $189.0 million
for the three months ended March 31, 2003, from $188.0 million for the
comparable period in 2002. U.S. Operations, Portfolio Management and
International Operations accounted for $173.1 million, $18.2 million and $15.8
million, respectively, of the revenue for the three months ended March 31, 2003.
U.S. Operations' revenue included $12.3 million of revenue earned on services
performed for Portfolio Management that was eliminated upon consolidation.
International Operations' revenue included $5.8 million of revenue earned on
services performed for U.S. Operations that was eliminated upon consolidation.
U.S. Operations' revenue increased $1.7 million, or 1.0 percent, to $173.1
million for the three months ended March 31, 2003, from $171.4 million for the
comparable period in 2002. The increase in U.S. Operations' revenue was
primarily attributable to the acquisitions of Great Lakes Collection Bureau,
Inc.'s ("Great Lakes") collection operations in August 2002 and The Revenue
21
Maximization Group ("RevGro") in December 2002. The increase was also
attributable to an increase in fees from collection services performed for
Portfolio Management. These additional fees from Portfolio Management included
the fees from servicing the Great Lakes portfolio. These increases were
partially offset by a decrease in revenue recorded from a long-term collection
contract. The method of recognizing revenue for this long-term collection
contract defers certain revenues into future periods until collections exceed
collection guarantees. During the three months ended March 31, 2003 the U.S.
Operations deferred $1.0 million of revenue into future periods but during the
three months ended March 31, 2002 U.S. Operations recognized $9.1 million of
previously deferred revenue. In addition, the increases in revenue were also
partially offset by a further weakening of consumer payment patterns.
Portfolio Management's revenue increased $1.9 million, or 12.1 percent, to
$18.2 million for the three months ended March 31, 2003, from $16.3 million for
the comparable period in 2002. Portfolio Management's collections increased $9.4
million, or 34.4 percent, to $36.7 million for the three months ended March 31,
2003, from $27.3 million for the comparable period in 2002. Portfolio
Management's revenue represented 49 percent of collections for the three months
ended March 31, 2003, as compared to 60 percent of collections for the same
period in the prior year. Revenue increased due to the increase in collections
from new purchases, including the Great Lakes portfolio, and the $1.5 million of
proceeds from sale of nonperforming accounts. The effect of the increase in
collections on revenue was partially offset by the decrease in revenue
recognition rate. Revenue as a percentage of collections declined principally
due to a number of factors. First, purchases of accounts receivable made in the
latter half of 2001 and through March 31, 2003, have returns that were targeted
lower at the time of acquisition due to reduced collection estimates caused by
the tougher economic climate facing Portfolio Management in the near term.
Additionally, larger purchases with components of reperforming accounts (past
due accounts that are now performing) sometimes have lower targeted internal
rates of returns ("IRRs") set at the time of purchase. Second, the overall
percentage was lowered due to a slowdown in collections on existing portfolios
as a result of the continued weaknesses in the economy. Current period
collection shortfalls have the effect of lowering the future collection
projections on most older portfolios, which translated to lower IRRs and revenue
on purchased accounts receivable. Third, proceeds of $1.5 million from the
resale of accounts are included in collections and had a marginal impact on
revenue as the rate at which revenue from purchased accounts receivable 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. Finally,
portfolios with $6.7 million in carrying value, or 4.6 percent of Portfolio
Management's total purchased accounts receivable as of March 31, 2003, have been
impaired and placed on cost recovery status. Accordingly, no revenue from
purchased accounts receivable was recorded on these portfolios after their
impairment. All of these factors contributed to a lower ratio of revenue from
purchased accounts receivable to collections.
International Operations' revenue increased $5.2 million, or 47.9 percent,
to $15.8 million for the three months ended March 31, 2003, from $10.6 million
for the comparable period in 2002. 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 these increases was offset by unfavorable 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 increased $2.2
million to $88.3 million for the three months ended March 31, 2003, from $86.1
million for the comparable period in 2002, and increased as a percentage of
revenue to 46.7 percent from 45.8 percent.
U.S. Operations' payroll and related expenses increased $2.8 million to
$84.5 million for the three months ended March 31, 2003, from $81.7 million for
the comparable period in 2002, and increased as a percentage of revenue to 48.8
percent from 47.7 percent. The increase as a percentage of revenue was
attributable to the $9.1 million of previously deferred revenue from the
long-term collection contract that was recognized during the three months ended
March 31, 2002. Since the expenses associated with this revenue were expensed as
incurred in prior periods, this revenue decreased the payroll and related
expenses as a percentage of revenue for the three months ended March 31, 2002.
This increase was partially offset by the continued focus on managing the amount
of labor required to attain revenue goals.
Portfolio Management's payroll and related expenses decreased $74,000 to
$480,000 for the three months ended March 31, 2003, from $554,000 for the
comparable period in 2002, and decreased as a percentage of revenue to 2.6
percent from 3.4 percent. Portfolio Management outsources all of its collection
services to U.S. Operations and, therefore, has a relatively small fixed payroll
22
cost structure. However, the decrease in payroll and related expenses was
principally due to Portfolio Management's legal recovery group being transferred
to the U.S. Operations' attorney network during 2002.
International Operations' payroll and related expenses increased $3.2
million to $9.1 million for the three months ended March 31, 2003, from $5.9
million for the comparable period in 2002, and increased as a percentage of
revenue to 57.7 percent from 55.1 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. However, it is important to note that the
outsourcing services business is not necessarily less profitable because the
higher payroll costs are generally offset by a lower selling, general and
administrative cost structure.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased $7.9 million to $69.0 million for the three
months ended March 31, 2003, from $61.1 million for the comparable period in
2002, and increased as a percentage of revenue to 36.5 percent from 32.5
percent. The increase as a percentage of revenue was attributable to the $9.1
million of previously deferred revenue from the long-term collection contract
that was recognized during the three months ended March 31, 2002. Since the
expenses associated with this revenue were expensed as incurred in prior
periods, this revenue decreased the selling, general and administrative expenses
payroll and related expenses as a percentage of revenue for the three months
ended March 31, 2002. In addition, the increase was also attributable to
incremental costs associated with continuing efforts to maximize collections for
clients in a difficult economic environment. These costs included additional
legal and forwarding fees as a result of the increase in the use of our attorney
network.
Depreciation and amortization. Depreciation and amortization increased $1.7
million to $7.9 million for the three months ended March 31, 2003, from $6.2
million for the comparable period in 2002. This increase was the result of
additional depreciation resulting from normal capital expenditures made in the
ordinary course of business during 2002 and 2003. These capital expenditures
included expenditures related to the relocation of our corporate headquarters,
and predictive dialers and other equipment required to expand our infrastructure
to handle future growth. The increase was also attributable to the amortization
of the customer lists acquired in the Great Lakes and RevGro acquisitions.
Other income (expense). Interest and investment income increased $169,000
to $836,000 for the three months ended March 31, 2003, from $667,000 for the
comparable period in 2002. This increase was primarily attributable to an
increase in earnings from NCO Portfolio's investment in a joint venture that
purchases utility, medical and various other small balance accounts receivable.
A portion of the increase was offset by lower interest rates earned on operating
cash, funds held in trust on behalf of clients, and notes receivables. Interest
expense increased to $5.8 million for the three months ended March 31, 2003,
from $5.0 million for the comparable period in 2002. This increase was due to
Portfolio Management's additional borrowings from CFSC Capital Corp. XXXIV to
purchase accounts receivable, including the $20.6 million of borrowings to
purchase Great Lakes' accounts receivable portfolios. This increase was
partially offset by lower interest rates and lower principal balances as a
result of debt repayments made in excess of borrowings against the revolving
credit facility during 2002 and 2003.
Income tax expense. Income tax expense for the three months ended March 31,
2003, decreased to $7.2 million, or 37.9 percent of income before income tax
expense, from $11.3 million, or 37.9 percent of income before income tax
expense, for the comparable period in 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 $17.3 million for the three months ended March 31, 2003, as compared to $7.7
million for the same period in 2002. The increase in cash provided by operations
was primarily attributable to a $1.7 million increase in accounts payable and
accrued expenses as compared to a $9.6 million decrease for the same period in
the prior year. The decrease in 2002 was primarily attributable to the payment
23
of certain accruals made in connection with the $23.8 million of one-time
charges incurred during the second and third quarter of 2001. The increase in
cash provided by operations was also attributable to a $6.0 million deposit made
in the first quarter of 2002 in connection with a long-term collection contract.
This deposit is expected to be returned in June 2003. A portion of the increases
in cash provided by operations was offset by increases in accounts receivables
and other assets.
Cash Flows from Investing Activities. Cash used in investing activities was
$3.3 million for the three months ended March 31, 2003, compared to cash used in
investing activities of $5.4 million for the same period in 2002. Purchases of
accounts receivable for the three months ended March 31, 2003 were $16.9 million
as compared to $9.2 million for the comparable period in 2002, and collections
applied to principal of purchased accounts receivable was $19.1 million as
compared to $11.5 million. Purchases of property and equipment were $5.5 million
for the three months ended March 31, 2003, compared to $10.4 million for the
same period in 2002. The additional purchases of property and equipment for the
three months ended March 31, 2002 was primarily attributable to the relocation
of our corporate headquarters to Horsham, PA.
Cash Flows from Financing Activities. Cash used in financing activities was
$8.8 million for the three months ended March 31, 2003, compared to cash used in
financing activities of $9.2 million for the same period in 2002. The cash used
in financing activities during the three months ended March 31, 2003, 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 $1.0 million borrowed by Portfolio Management under
the revolving credit facility to fund the purchase of accounts receivable and
the $6.1 million borrowed from CFSC Capital Corp. XXXIV to purchase accounts
receivable. The cash used in financing activities during the three months ended
March 31, 2002, resulted from repayments of borrowings under our revolving
credit facility and repayments of securitized debt assumed as part of the
Creditrust merger.
Credit Facility. We have a credit agreement with Citizens Bank of
Pennsylvania, formerly Mellon Bank, N.A., referred to as 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 March 31, 2003, the maximum borrowing capacity
and the availability under the revolving credit facility were $241.5 million and
$54.2 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 4.25 percent at March 31, 2003),
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 1.31 percent at March 31, 2003). 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.
In connection with the Creditrust merger, the revolving credit facility was
amended to provide NCO Portfolio with a revolving line of credit in the form of
a subfacility under the existing revolving credit facility. The borrowing
capacity of the subfacility is subject to mandatory reductions of $3.75 million
until the earlier of the May 20, 2004, maturity date, or the date at which the
subfacility 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 March 31, 2003, there was no borrowing availability under
the NCO Portfolio subfacility.
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 March 31, 2003, a notional amount of $74.0 million was covered by
the interest rate swap agreements.
24
Borrowings under the revolving credit facility are collateralized by
substantially all of our assets, including the common stock of NCO Portfolio
that we own, 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 March 31, 2003, 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.
Nonrecourse Debt. In August 2002, NCO Portfolio entered into a four-year
financing agreement with CFSC Capital Corp. XXXIV, referred to as Cargill, to
provide financing for larger purchases of accounts receivable at 90 percent of
the purchase price, unless otherwise negotiated. Cargill, at their sole
discretion, has the right to finance any purchase of $4.0 million or more.
Cargill may or may not choose to finance a transaction. This agreement gives NCO
Portfolio the financing to purchase larger portfolios that they may not
otherwise be able to purchase, and has no minimum or maximum credit
authorization. Borrowings carry interest at the prime rate plus 3.25 percent
(prime rate was 4.25 percent at March 31, 2003) and are nonrecourse to NCO
Portfolio and NCO Group, except for the assets financed through Cargill. Debt
service payments equal total collections less servicing fees and expenses until
each individual borrowing is fully repaid and NCO Portfolio's original
investment is returned, including interest. Thereafter, Cargill is paid a
residual 40 percent of collections, less servicing costs, unless otherwise
negotiated. Individual loans are required to be repaid based on collection, but
not more than two years from the date of borrowing. Total debt outstanding under
this facility as of March 31, 2003, was $17.9 million. As of March 31, 2003, NCO
Portfolio was in compliance with all of the financial 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 Creditrust merger. This transaction qualified for gain on sale
accounting when the purchased accounts receivable were originally securitized by
Creditrust. This securitization issued a nonrecourse note that is due the
earlier of January 2004 or satisfaction of the note from collections, carries an
interest rate of 8.61 percent, and had an outstanding balance of $2.4 million
and $1.7 million as of December 31, 2002 and March 31, 2003, respectively. 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 March 31, 2003, the investment in
securitization was $7.5 million, composed of $4.2 million in present value of
discounted residual cash flows plus $3.3 million in cash reserves. The
investment accrues noncash 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, collections
are split between income and amortization of the investment in securitization
based on the discounted cash flows. No income was recorded for the three months
ended March 31, 2003, as the investment was offset by a temporary decline in
market value. The Company recorded $28,000 of income on this investment during
the three months ended March 31, 2002. The off-balance sheet cash reserves of
$3.3 million plus the first $1.3 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 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
Sheets was NCO Portfolio's investment in the Joint Venture of $3.4 million and
$3.8 million as of December 31, 2002 and March 31, 2003, respectively. Included
in the Statements of Income, as "interest and investment income," was $83,000
and $473,000 for the three months ended March 31, 2002 and 2003, respectively,
representing NCO Portfolio's 50 percent share of operating income from this
unconsolidated subsidiary. The Joint Venture has access to capital through CFSC
25
Capital Corp. XXXIV ("Cargill Financial") who, at its option, lends 90 percent
of the cost of the purchased accounts receivable to the Joint Venture.
Borrowings carry interest at the prime rate plus 4.25 percent (prime rate was
4.25 percent as of March 31, 2003). Debt service payments equal total
collections less servicing fees and expenses until each individual borrowing is
fully repaid and the Joint Venture's investment is returned, including interest.
Thereafter, Cargill Financial is paid a residual of 50 percent of collections
less servicing costs. Individual loans are required to be repaid based on
collections, but not more than two years from the date of borrowing. The debt is
cross-collateralized by all portfolios in which the lender participates, and is
nonrecourse to NCO Portfolio and NCO Group.
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.
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 a long-term
collection contract and purchased accounts receivable; goodwill; 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
2002 financial statements contained in our Annual Report on Form 10-K, as
amended, for the year ended December 31, 2002.
Impact of Recently Issued and Proposed Accounting Pronouncements
During 2001, the Accounting Staff Executive Committee approved an exposure
draft on Accounting for Certain Purchased Loans or Debt Securities (formerly
known as Discounts Related to Credit Quality) (Exposure Draft-December 1998).
The proposal would apply to all companies that acquire loans for which it is
probable at the acquisition date that all contractual amounts due under the
acquired loans will not be collected. The proposal addresses accounting for
differences between contractual and expected future cash flows from an
investor's initial investment in certain loans when such differences are
attributable, in part, to credit quality. The scope also includes such loans
acquired in purchased business combinations. If adopted, the proposed Statement
of Position, referred to as SOP, would supersede Practice Bulletin 6,
Amortization of Discounts on Certain Acquired Loans. In June 2001, the Financial
Accounting Standards Board, referred to as FASB, cleared the SOP for issuance
subject to minor editorial changes and planned to issue a final SOP in early
2002. The SOP has not yet been issued. 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,
referred to as 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.
In January 2003, FASB issued Interpretation No. 46 ("FIN" 46),
"Consolidation of Variable Interest Entities". The objective of FIN 46 is to
improve financial reporting by companies involved with variable interest
entities. FIN 46 defines variable interest entities and requires that variable
interest entities be consolidated by a company if that company is subject to a
majority of the risk of loss from the variable interest entity's activities or
is entitled to receive a majority of the entity's residual returns or both. The
26
disclosure requirements are effective for periods ending after December 15,
2002. The consolidation requirements apply immediately to variable interest
entities created after January 31, 2003, and apply to existing variable interest
entities in the first fiscal year or interim period beginning after June 15,
2003. Effective December 31, 2002, we adopted the disclosure requirements of FIN
46, and do not believe the adoption of FIN 46 will have a material impact on our
financial position and results of operations.
In April 2003, the FASB indicated that it plans to have a new rule in place
by the end of 2004 that will require that stock based compensation be recorded
as a cost that is recognized in the financial statements.
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 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.
27
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. As previously reported, during the third quarter of 2001,
the Company decided to relocate its corporate headquarters to Horsham,
Pennsylvania. The Company filed a lawsuit in the Court of Common Pleas,
Montgomery County, Pennsylvania (Civil Action No. 01-15576) against the
current landlord and the former landlord of the Fort Washington facilities
to terminate the leases and to obtain other relief. 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 April 2003, the former landlord defendants filed a joinder complaint
against Michael J. Barrist, the Chairman, President and Chief Executive
Officer of the Company, Charles C. Piola, Jr., a director and former
Executive Vice President of the Company, and Bernard R. Miller, a former
Executive Vice President and director of the Company, to name such persons
as additional defendants (collectively, the "Joinder Defendants"). The
Joinder Defendants were partners in a partnership that owned real estate
(the "Prior Real Estate") that the Company leased at a market rent prior to
moving to the Fort Washington facility. The joinder complaint alleges that
the Joinder Defendants breached their statutory and common law duties of
care and loyalty to the Company and perpetrated a fraud upon the Company
and its shareholders by refraining or causing the Company to refrain from
further investigation into the issue of prior water intrusion at the Fort
Washington facility and that it was a condition to the lease of the Fort
Washington facility that the former landlord defendants purchase the Prior
Real Estate from the Joinder Defendants. The joinder complaint seeks to
impose liability on the Joinder Defendants for any damages suffered by the
Company as a result of the flood.
Based upon its initial review of the facts, the Company believes that
the Joinder Defendants did not breach any duties to, or commit a fraud upon
the Company or its shareholders and that the allegations of any wrongdoing
by the Joinder Defendants are without merit.
Pursuant to the Company's Bylaws and the Joinder Defendants' employment
agreements, the Joinder Defendants will be indemnified by the Company
against any expenses or awards incurred in this suit, subject to certain
exceptions.
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 and Use of Proceeds
-----------------------------------------
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
-----------------
None - not applicable
Item 6. Exhibits and Reports on Form 8-K
--------------------------------
(a) Exhibits
99.1 Consolidating Schedule
99.2 Chief Executive Officer Section 906 Certification
99.3 Chief Financial Officer Section 906 Certification
(b) Reports on Form 8-K
Date of Filing Item Reported
-------------- -------------
2/12/03 Item 7 and Item 9 - Press release from the earnings release for the fourth quarter
of 2002
2/21/03 Item 7 and Item 9 - Press release and conference call transcript from the earnings
release for the fourth 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: May 15, 2003 By: Michael J. Barrist
----------------------
Michael J. Barrist
Chairman of the Board, President
and Chief Executive Officer
(principal executive officer)
Date: May 15, 2003 By: Steven L. Winokur
---------------------
Steven L. Winokur
Executive Vice President, Finance,
Chief Financial Officer and Treasurer
(principal financial and
accounting officer)
29
CERTIFICATION
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: May 15, 2003
Michael J. Barrist
- ------------------
Michael J. Barrist
Chief Executive Officer,
and President
(Principal Executive Officer)
30
CERTIFICATION
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: May 15, 2003
Steven L. Winokur
- -----------------
Steven L. Winokur
Executive Vice President, Finance, Chief Financial
Officer and Treasurer
(Principal Financial and Accounting Officer)
31