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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
/X/ Quarterly report pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2003, or
/ / Transition report pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the transition period from to
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COMMISSION FILE NUMBER 0-21639
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NCO GROUP, INC.
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(Exact name of registrant as specified in its charter)
PENNSYLVANIA
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(State or other jurisdiction of incorporation or organization)
507 Prudential Road, Horsham, Pennsylvania
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(Address of principal executive offices)
23-2858652
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(IRS Employer Identification Number)
19044
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(Zip Code)
215-441-3000
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(Registrant's telephone number including area code)
Not Applicable
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes X No
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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 August 13, 2003.
NCO GROUP, INC.
INDEX
PAGE
PART I - FINANCIAL INFORMATION
Item 1 FINANCIAL STATEMENTS (Unaudited)
Condensed Consolidated Balance Sheets -
December 31, 2002 and June 30, 2003 1
Condensed Consolidated Statements of Income -
Three and six months ended June 30, 2002 and 2003 2
Condensed Consolidated Statements of Cash Flows -
Six months ended June 30, 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 30
Item 4 CONTROLS AND PROCEDURES 30
PART II - OTHER INFORMATION 31
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 33
Part 1 - Financial Information
Item 1 - Financial Statements
NCO GROUP, INC.
Condensed Consolidated Balance Sheets
(Amounts in thousands)
June 30,
December 31, 2003
ASSETS 2002 (Unaudited)
---------- -----------
Current assets:
Cash and cash equivalents $ 25,159 $ 29,706
Restricted cash 900 900
Accounts receivable, trade, net of allowance for
doubtful accounts of $7,285 and $7,098, respectively 86,857 90,844
Purchased accounts receivable, current portion 60,693 56,471
Deferred income taxes 16,389 16,170
Bonus receivable, current portion 15,584 13,660
Prepaid expenses and other current assets 9,644 14,258
--------- ---------
Total current assets 215,226 222,009
Funds held on behalf of clients
Property and equipment, net 79,603 76,843
Other assets:
Goodwill 525,784 530,900
Other intangibles, net of accumulated amortization 14,069 11,742
Purchased accounts receivable, net of current portion 91,755 89,826
Bonus receivable, net of current portion 408 48
Other assets 39,436 40,541
--------- ---------
Total other assets 671,452 673,057
--------- ---------
Total assets $ 966,281 $ 971,909
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Long-term debt, current portion $ 39,847 $ 26,133
Income taxes payable 2,222 2,968
Accounts payable 8,285 6,180
Accrued expenses 31,426 30,575
Accrued compensation and related expenses 15,374 15,910
Deferred revenue, current portion 12,088 16,735
--------- ---------
Total current liabilities 109,242 98,501
Funds held on behalf of clients
Long-term liabilities:
Long-term debt, net of current portion 334,423 321,040
Deferred revenue, net of current portion 11,678 7,429
Deferred income taxes 48,605 51,810
Other long-term liabilities 2,144 3,254
Minority interest 24,427 25,337
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) income (3,876) 3,431
Retained earnings 117,814 139,283
--------- ---------
Total shareholders' equity 435,762 464,538
--------- ---------
Total liabilities and shareholders' equity $ 966,281 $ 971,909
========= =========
See accompanying notes.
-1-
NCO GROUP, INC.
Condensed Consolidated Statements of Income
(Unaudited)
(Amounts in thousands, except per share data)
For the Three Months For the Six Months
Ended June 30, Ended June 30,
---------------------------- ----------------------------
2002 2003 2002 2003
--------- --------- --------- ---------
Revenue $ 175,099 $ 188,574 $ 363,106 $ 377,591
Operating costs and expenses:
Payroll and related expenses 83,480 88,330 169,600 176,628
Selling, general and administrative expenses 61,343 70,718 122,416 139,676
Depreciation and amortization expense 6,521 8,039 12,747 15,895
--------- --------- --------- ---------
Total operating costs and expenses 151,344 167,087 304,763 332,199
--------- --------- --------- ---------
Income from operations 23,755 21,487 58,343 45,392
Other income (expense):
Interest and investment income 787 789 1,454 1,625
Interest expense (4,963) (5,862) (9,949) (11,681)
Other income (expense) 305 726 (290) 726
--------- --------- --------- ---------
Total other income (expense) (3,871) (4,347) (8,785) (9,330)
--------- --------- --------- ---------
Income before income tax expense 19,884 17,140 49,558 36,062
Income tax expense 7,542 6,504 18,797 13,683
--------- --------- --------- ---------
Income before minority interest 12,342 10,636 30,761 22,379
Minority interest (633) (359) (1,605) (910)
--------- --------- --------- ---------
Net income $ 11,709 $ 10,277 $ 29,156 $ 21,469
========= ========= ========= =========
Net income per share:
Basic $ 0.45 $ 0.40 $ 1.13 $ 0.83
Diluted $ 0.42 $ 0.38 $ 1.04 $ 0.78
Weighted average shares outstanding:
Basic 25,891 25,908 25,873 25,908
Diluted 29,977 29,768 29,940 29,743
See accompanying notes.
-2-
NCO GROUP, INC
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)
For the Six Months
Ended June 30,
-----------------------------------
2002 2003
---------------- ----------------
Cash flows from operating activities:
Net income $ 29,156 $ 21,469
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 11,383 13,526
Amortization of intangibles 1,364 2,369
Provision for doubtful accounts 5,537 2,100
Impairment of purchased accounts receivable 1,211 962
Gain on insurance proceeds from property and equipment (847) -
Loss on disposal of fixed assets - 330
Equity income on investment in joint venture (303) (952)
Other income - (726)
Minority interest 1,606 906
Changes in operating assets and liabilities, net of acquisitions:
Restricted cash 225 -
Accounts receivable, trade (1,318) (5,859)
Deferred income taxes 8,228 3,411
Bonus receivable (7,141) 2,285
Other assets 2,247 (3,494)
Accounts payable and accrued expenses (11,158) (2,234)
Income taxes payable (1,176) 747
Deferred revenue (10,325) 398
Other long-term liabilities (1,308) 509
--------- ----------
Net cash provided by operating activities 27,381 35,747
Cash flows from investing activities:
Purchases of accounts receivable (16,823) (29,190)
Collections applied to principal of purchased accounts receivable 24,007 36,938
Purchases of property and equipment (18,141) (10,169)
Net (investment in) distribution from joint venture (542) 72
Proceeds from notes receivable 1,000 -
Insurance proceeds from involuntary conversion of
property and equipment 2,633 -
--------- ----------
Net cash used in investing activities (7,866) (2,349)
Cash flows from financing activities:
Repayment of notes payable (8,544) (14,239)
Borrowings under notes payable - 10,640
Borrowings under revolving credit agreement 370 1,000
Repayment of borrowings under revolving credit agreement (17,250) (27,130)
Payment of fees to acquire debt (253) (42)
Issuance of common stock, net 747 -
--------- ----------
Net cash used in financing activities (24,930) (29,771)
Effect of exchange rate on cash 371 920
--------- ----------
Net (decrease) increase in cash and cash equivalents (5,044) 4,547
Cash and cash equivalents at beginning of the period 32,161 25,159
--------- ----------
Cash and cash equivalents at end of the period $ 27,117 $ 29,706
========= ==========
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. ("NCO Portfolio"), 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 and six-month periods ended June 30, 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 accrue additional penalties as a contingent liability.
Although the Company expects to continue to generate additional collections, in
the unlikely event that the Company does not generate any additional collections
from June 30, 2003 through May, 2005, the Company's maximum exposure would be
$19.4 million and $61.2 million on 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 in February 2001. 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 June 30, 2003 (see note 16).
-6-
2. Accounting Policies (continued):
Intangibles:
Goodwill represents the excess of purchase price, including acquisition related
costs, 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
June 30, 2003, "other comprehensive income (loss)" included a loss of $168,000,
or $109,000 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 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 For the Six Months Ended
Ended June 30, June 30,
-------------------------- ---------------------------
2002 2003 2002 2003
----------- ----------- ----------- ------------
Net income - as reported $ 11,709 $ 10,277 $ 29,156 $ 21,469
Pro forma compensation cost, net of taxes 1,354 1,068 2,708 2,138
-------- -------- -------- --------
Net income - pro forma $ 10,355 $ 9,209 $ 26,448 $ 19,331
======== ======== ======== ========
Net income per share - as reported:
Basic $ 0.45 $ 0.40 $ 1.13 $ 0.83
Diluted $ 0.42 $ 0.38 $ 1.04 $ 0.78
Net income per share - pro forma:
Basic $ 0.40 $ 0.36 $ 1.02 $ 0.75
Diluted $ 0.38 $ 0.34 $ 0.95 $ 0.71
-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
estimated collections at the time of purchase require 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).
During the three months ended June 30, 2003, the Company adjusted one of the
calculations used to determine the historical trends, that in part, computes
future collections. This adjustment increased the estimated remaining
collections on several portfolios that increased revenue for the three and six
months ended June 30, 2003. This change was made because there are other
procedures in place that make this aspect of the calculation unnecessary. The
effect of this change was to increase net income and diluted earnings per share
by $178,000 and $0.01, respectively, for three and six months ended June 30,
2003.
-8-
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 and six months ended June 30, 2002, have been restated for
a correction of an error due to this change.
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 For the Six Months Ended
June 30, 2002 June 30, 2002
------------------------------- ----------------------------
As As
Previously Previously
Reported Restated Reported Restated
-------------- ------------- ------------ ------------
Selected income statement data:
Revenue $ 177,678 $ 175,099 $ 356,585 $ 363,106
Income before income tax
expense 22,463 19,884 43,037 49,558
Income tax expense 8,522 7,542 16,319 18,797
Net income 13,308 11,709 25,113 29,156
Net income per share:
Basic $ 0.51 $ 0.45 $ 0.97 $ 1.13
Diluted $ 0.48 $ 0.42 $ 0.90 $ 1.04
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 identified for elimination 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 credit facility. 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 $2.7 million. All
of the goodwill is deductible for tax purposes. 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. During the three months
ended June 30, 2003, the Company revised the estimated allocation of the fair
market value that resulted in an increase in goodwill of $680,000. 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.
-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 credit facility 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. 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. During the three months ended March 31, 2003, the Company revised the
estimated allocation of the fair market value that resulted in a decrease in
goodwill of $175,000. 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.
5. Comprehensive Income:
Comprehensive income consists of net income from operations, plus certain
changes in assets and liabilities that are not included in net income but are
reported as a separate component of shareholders' equity. The Company's
comprehensive income was as follows (amounts in thousands):
For the Three Months For the Six Months
Ended June 30, Ended June 30,
------------------------- ------------------------
2002 2003 2002 2003
------------ ----------- ----------- -----------
Net income $ 11,709 $ 10,277 $ 29,156 $ 21,469
Other comprehensive income:
Foreign currency translation adjustment 2,511 4,087 2,324 6,956
Unrealized (loss) gain on interest rate
swap (684) 183 (316) 351
-------- -------- -------- --------
Comprehensive income $ 13,536 $ 14,547 $ 31,164 $ 28,776
======== ======== ======== ========
The income from the foreign currency translation during the three and six months
ended June 30, 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.
-10-
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 Year Ended For the Six Months
December 31, 2002 Ended June 30, 2003
--------------------- --------------------
Balance at beginning of period $ 140,001 $152,448
Purchases of accounts receivable 72,680 31,573
Collections on purchased accounts receivable (120,513) (73,874)
Purchase price adjustment (4,000) -
Revenue recognized 66,162 36,936
Impairment of purchased accounts receivable (1,999) (962)
Foreign currency translation adjustment 117 176
--------- --------
Balance at end of period $ 152,448 $146,297
========= ========
During the three months ended June 30, 2002 and 2003, impairment charges of
$414,000 and $632,000, respectively, were recorded as charges to income on
portfolios where the carrying values exceeded the expected future cash flows.
During the six months ended June 30, 2002 and 2003, impairment charges of $1.2
million and $962,000, respectively, were recorded as charges to income. No
income will be recorded on these portfolios until the carrying values have been
fully recovered. As of December 31, 2002 and June 30, 2003, the combined
carrying values on all impaired portfolios aggregated $6.1 million and $9.9
million, respectively, or 4.0 percent and 6.8 percent of total purchased
accounts receivable, respectively, representing their net realizable value.
Revenue from fully cost recovered portfolios was $147,000 and $300,000 for the
three and six months ended June 30, 2003, respectively. Included in collections
for the six months ended June 30, 2003, was $1.5 million in proceeds from the
sale of accounts.
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 $65.9 million at
December 31, 2002 and June 30, 2003, respectively, have been shown net of their
offsetting liability for financial statement presentation.
-11-
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 June
30, 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 June 30, 2003
----------------- --------------
U.S. Operations $ 495,575 $ 496,080
International Operations 30,209 34,820
--------- ---------
Total $ 525,784 $ 530,900
========= =========
The change in U.S. Operations' goodwill balance from December 31, 2002 to June
30, 2003 was due to adjustments to the purchase accounting for the Great Lakes
and RevGro acquisitions (see note 4). The change in International Operations'
goodwill balance from December 31, 2002 to June 30, 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 June 30, 2003
---------------------------------- ---------------------------------
Gross Carrying Accumulated Gross Carrying Accumulated
Amount Amortization Amount Amortization
----------------- --------------- ---------------- ---------------
Deferred financing costs $ 12,422 $ 6,969 $ 12,464 $ 8,401
Customer lists 357 8,761 1,228
8,761
Other intangible assets 900 688 900 754
-------- ------- -------- --------
Total $ 22,083 $ 8,014 $ 22,125 $ 10,383
======== ======= ======== ========
-12-
8. Intangible Assets (continued):
Other Intangible Assets (continued):
The Company recorded amortization expense for all other intangible assets of
$687,000 and $1.2 million during the three months ended June 30, 2002 and 2003,
respectively, and $1.4 million and $2.4 million during the six months ended June
30, 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 $ 4,164
2004 3,275
2005 3,162
2006 2,115
2007 1,395
9. Long-Term Debt:
Long-term debt consisted of the following (amounts in thousands):
December 31, 2002 June 30, 2003
----------------- -------------
Credit facility $ 193,180 $ 167,050
Convertible notes 125,000 125,000
Securitized non recourse debt 35,523 34,312
Other nonrecourse debt 17,632 15,625
Capital leases and other 2,935 5,186
Less current portion (39,847) (26,133)
--------- ---------
$ 334,423 $ 321,040
========= =========
Credit Facility:
On August 13, 2003, the Company amended its credit agreement with Citizens Bank
of Pennsylvania, formerly Mellon Bank, N.A., ("Citizens Bank"), for itself and
as administrative agent for other participating lenders. The amendment extended
the maturity date from May 20, 2004 to March 15, 2006 (the "Maturity Date"). The
amended credit facility is structured as a $150 million term loan and a $50
million revolving credit facility. The Company is required to make quarterly
repayments of $6.3 million beginning on September 30, 2003, and continuing until
the Maturity Date. The remaining balance outstanding under the term loan will
become due on the Maturity Date. The balance under the revolving credit facility
will become due on the Maturity Date.
At the option of NCO, the borrowings bear interest at a rate equal to either
Citizens Bank's prime rate plus a margin of 0.75 percent to 1.25 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 4.00 percent at June 30, 2003), or the London
InterBank Offered Rate ("LIBOR") plus a margin of 2.25 percent to 3.00 percent
depending on the Company's consolidated funded debt to EBITDA ratio (LIBOR was
1.12 percent at June 30, 2003). The Company is charged a fee on the unused
portion of the credit facility ranging from 0.38 percent to 0.50 percent
depending on the Company's consolidated funded debt to EBITDA ratio.
Borrowings under the credit agreement are collateralized by substantially all
the assets of the Company, including the common stock of NCO Portfolio that the
Company owns, and its rights under the revolving credit agreement with NCO
Portfolio (see note 17). 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 June 30, 2003, the Company was in compliance with all
required covenants.
-13-
9. Long-Term Debt (continued):
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 credit facility.
Securitized Nonrecourse 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.
Securitized Nonrecourse Debt (continued):
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 June 30, 2003, and is restricted as to use until the
facility is retired. Interest expense, trustee fees and guarantee fees
aggregated $160,000 and $121,000 for the three months ended June 30, 2002 and
2003, respectively. Interest expense, trustee fees and guarantee fees aggregated
$328,000 and $245,000 for the six months ended June 30, 2002 and 2003,
respectively. As of December 31, 2002 and June 30, 2003, the amount outstanding
on the facility was $15.4 million and $14.6 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).
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 $4,000 and $52,000 for the three and
six months ended June 30, 2002, respectively.
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 $832,000 and $748,000 for the three months ended June 30, 2002 and
2003, respectively. Interest expense and trustee fees aggregated $1.7 million
and $1.5 million for the six months ended June 30, 2002 and 2003, respectively.
As of December 31, 2002 and June 30, 2003, the amount outstanding on the
facility was $20.1 million and $19.7 million, respectively.
-14-
9. Long-Term Debt (continued):
Other 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 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 two 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 4.00 percent at June 30, 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 June 30, 2003, NCO Portfolio
was in compliance with all required covenants.
Capital Leases:
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 was $920,000 for the three months ended June 30, 2002 and 2003, and
$1.8 million for the six months ended June 30, 2002 and 2003. Outstanding
options, warrants and convertible securities have been utilized in calculating
diluted net income per share only when their effect would be dilutive.
The reconciliation of basic to diluted weighted average shares outstanding was
as follows (amounts in thousands):
For the Three Months For the Six Months Ended
Ended June 30, June 30,
------------------------- --------------------------
2002 2003 2002 2003
------------ ----------- ------------ ------------
Basic 25,891 25,908 25,873 25,908
Dilutive effect of convertible debt 3,797 3,797 3,797 3,797
Dilutive effect of options 289 63 270 38
------ ------ ------ ------
Diluted 29,977 29,768 29,940 29,743
====== ====== ====== ======
-15-
11. Interest Rate Hedge:
As of June 30, 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 $62.0 million of the variable-rate debt outstanding under
the credit facility. The interest rate swap agreements mature in September 2003.
12. Supplemental Cash Flow Information:
The following are supplemental disclosures of cash flow information (amounts in
thousands):
For the Six Months Ended
June 30,
---------------------------
2002 2003
----------- ------------
Noncash investing and financing activities:
Deferred portion of purchased accounts receivable $ 349 $ 2,383
Warrants exercised 875 -
13. Commitments and Contingencies:
Forward-Flow Agreement:
In May 2003, NCO Portfolio renewed a fixed price 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 June 30, 2003, NCO Portfolio was obligated to purchase accounts
receivable at a maximum of $2.5 million per month through May 2004. A portion of
the purchase price is deferred for 24 months, including a nominal rate of
interest. The deferred purchase price payable, included in long-term debt, as of
December 31, 2002 and June 30, 2003, was $2.1 million and $4.3 million,
respectively.
Litigation:
The Company is party, from time to time, to various legal proceedings and
regulatory investigations incidental to its business. The Company continually
monitors these legal proceedings and regulatory investigations to determine the
impact and any required accruals.
In June 2001, the first floor of the Company's Fort Washington, Pennsylvania,
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.
-16-
13. Commitments and Contingencies (continued):
Litigation (continued):
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.
Letters of Credit:
At June 30, 2003, the Company had unused letters of credit of $2.2 million.
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 $745.6 million at December 31, 2002 and June 30, 2003, respectively.
U.S. Operations also provides accounts receivable management services to
Portfolio Management. U.S. Operations recorded revenue of $8.1 million and $12.1
million for these services for the three months ended June 30, 2002 and 2003,
respectively, and $16.4 million and $24.4 million for these services for the six
months ended June 30, 2002 and 2003, respectively.
Portfolio Management purchases and manages defaulted consumer accounts
receivable from consumer creditors such as banks, finance companies, retail
merchants, and other consumer oriented companies. Portfolio Management had total
assets, net of any intercompany balances, of $167.8 million and $164.4 million
at December 31, 2002 and June 30, 2003, respectively.
-17-
14. Segment Reporting (continued):
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 $61.9 million at December 31,
2002 and June 30, 2003, respectively. International Operations also provides
accounts receivable management services to U.S. Operations. International
Operations recorded revenue of $2.6 million and $6.8 million for these services
for the three months ended June 30, 2002 and 2003, respectively, and $4.6
million and $12.5 million for these services for the six months ended June 30,
2002 and 2003, respectively.
The following tables represent the revenue, payroll and related expenses,
selling, general and administrative expenses, and earnings before interest,
taxes, depreciation, and amortization ("EBITDA") for each segment. EBITDA is
used by the Company's management to measure the segments' operating performance
and is not intended to report the segments' operating results in conformity with
accounting principles generally accepted in the United States.
For the Three Months Ended June 30, 2002
(amounts in thousands)
--------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
-------- ----------- --------------- --------
U.S. Operations $ 159,737 $ 78,563 $ 56,905 $ 24,269
Portfolio Management 14,108 549 9,271 4,288
International Operations 11,951 7,001 3,231 1,719
Eliminations (10,697) (2,633) (8,064) -
--------- -------- --------- --------
Total $ 175,099 $ 83,480 $ 61,343 $ 30,276
========= ======== ========= ========
For the Three Months Ended June 30, 2003
(amounts in thousands)
--------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
-------- ----------- --------------- --------
U.S. Operations $ 172,011 $ 84,411 $ 65,214 $ 22,386
Portfolio Management 18,086 563 13,382 4,141
International Operations 17,361 10,128 4,234 2,999
Eliminations (18,884) (6,772) (12,112) -
--------- -------- --------- --------
Total $ 188,574 $ 88,330 $ 70,718 $ 29,526
========= ======== ========= ========
-18-
14. Segment Reporting (continued):
For the Six Months Ended June 30, 2002
(amounts in thousands)
--------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
-------- ----------- --------------- --------
U.S. Operations $ 331,114 $160,251 $ 113,862 $ 57,001
Portfolio Management 30,378 1,103 18,934 10,341
International Operations 22,600 12,868 5,984 3,748
Eliminations (20,986) (4,622) (16,364) -
--------- -------- --------- --------
Total $ 363,106 $169,600 $ 122,416 $ 71,090
========= ======== ========= ========
For the Six Months Ended June 30, 2003
(amounts in thousands)
--------------------------------------------------------------
Payroll and Selling,
Related General and
Revenue Expenses Admin. Expenses EBITDA
-------- ----------- --------------- --------
U.S. Operations $ 345,116 $168,912 $ 129,601 $ 46,603
Portfolio Management 36,318 1,043 26,503 8,772
International Operations 33,115 19,212 7,991 5,912
Eliminations (36,958) (12,539) (24,419) -
--------- -------- --------- --------
Total $ 377,591 $176,628 $ 139,676 $ 61,287
========= ======== ========= ========
15. Net Loss Due to Flood and Relocation of Corporate Headquarters:
In June 2001, the first floor of the Company's Fort Washington, Pennsylvania,
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, Pennsylvania. 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 six months ended June 30, 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 $1.1 million as
of December 31, 2002 and June 30, 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 June 30, 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 and six
months ended June 30, 2003, as the income was offset by a temporary decline in
market value. The Company recorded income of $47,000 and $75,000 on this
investment during the three and six months ended June 30, 2002, respectively.
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 $445,000 and $379,000 for the three months
ended June 30, 2002 and 2003, respectively, and $955,000 and $892,000 for the
six months ended June 30, 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. Gains and losses are shared equally between NCO
Portfolio and IMNV. Included in "other assets" on the Balance Sheets was NCO
Portfolio's investment in the Joint Venture of $3.4 million and $4.2 million as
of December 31, 2002 and June 30, 2003, respectively. Included in the Statements
of Income, as "interest and investment income," for the three months ended June
30, 2002 and 2003, was $220,000 and $479,000, respectively, representing NCO
Portfolio's 50 percent share of operating income from this unconsolidated
subsidiary. Income of $303,000 and $952,000 was recorded from this
unconsolidated subsidiary for the six months ended June 30, 2002 and 2003,
respectively. The Company performs collection services for the Joint Venture and
recorded service fee revenue of $1.2 million and $959,000 for the three months
ended June 30, 2002 and 2003, respectively, and $2.2 million and $1.9 million
for the six months ended June 30, 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 4.00 percent as of June 30, 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 June 30, 2003
----------------- ---------------
Total assets $ 11,638 $ 11,437
Total liabilities 4,944 2,941
For the Six Months Ended
June 30,
--------------------------
2002 2003
------------ -----------
Revenue $ 4,192 $ 6,440
Operating income 606 1,903
17. Related Party Transactions:
The Company provides NCO Portfolio with a revolving line of credit with a
borrowing capacity of $32.5 million as of June 30, 2003. The borrowing capacity
is subject to reductions of $3.75 million during the third and fourth quarter of
2003. As of December 31, 2003 and until its maturity on March 15, 2006, the
borrowing capacity will be $25 million. NCO Portfolio's borrowings bear interest
at a rate equal to NCO's interest rate under its credit facility plus 1.00
percent. As of December 31, 2002 and June 30, 2003, there was $36.9 million and
$26.3 million outstanding under the revolving line of credit, respectively.
Borrowings under the revolving line of credit are collateralized by certain
assets of NCO Portfolio. The revolving credit agreement contains certain
financial covenants such as maintaining funded debt to EBITDA requirements, and
includes restrictions on, among other things, acquisitions and distributions to
shareholders. As of June 30, 2003, NCO Portfolio was in compliance with all
required covenants.
-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 of
Finance, Chief Financial Officer, and Chief Operating Officer of Shared
Services, 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 Quarterly 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 June 30, 2003, Compared to Three Months Ended June 30,
2002
Revenue. Revenue increased $13.5 million, or 7.7 percent, to $188.6 million
for the three months ended June 30, 2003, from $175.1 million for the comparable
period in 2002. U.S. Operations, Portfolio Management and International
Operations accounted for $172.0 million, $18.1 million and $17.4 million,
respectively, of the revenue for the three months ended June 30, 2003. U.S.
Operations' revenue included $12.1 million of intercompany revenue earned on
services performed for Portfolio Management that was eliminated upon
consolidation. International Operations' revenue included $6.8 million of
intercompany revenue earned on services performed for U.S. Operations that was
eliminated upon consolidation.
-21-
U.S. Operations' revenue increased $12.3 million, or 7.7 percent, to $172.0
million for the three months ended June 30, 2003, from $159.7 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
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 acquired by NCO Portfolio in
August 2002. 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 June 30, 2003, U.S. Operations deferred $1.7 million of revenue, on a net
basis, into future periods, but during the three months ended June 30, 2002,
U.S. Operations recognized $2.4 million of previously deferred revenue, on a net
basis. In addition, the increases in revenue were also partially offset by a
further weakening of consumer payment patterns that began during the second half
of 2002.
Portfolio Management's revenue increased $4.0 million, or 28.2 percent, to
$18.1 million for the three months ended June 30, 2003, from $14.1 million for
the comparable period in 2002. Portfolio Management's collections increased $9.3
million, or 35.3 percent, to $35.6 million for the three months ended June 30,
2003, from $26.3 million for the comparable period in 2002. Portfolio
Management's revenue represented 51 percent of collections for the three months
ended June 30, 2003, as compared to 54 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. 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 including timing of collections and lower
targeted returns on more recent portfolios due to the current economic
environment.
International Operations' revenue increased $5.4 million, or 45.3 percent,
to $17.4 million for the three months ended June 30, 2003, from $12.0 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 and favorable changes in the foreign currency exchange rates used to
translate the International Operations' results of operations into U.S. dollars.
In addition, a portion of the increase was attributable to the addition of new
clients and growth in business from existing clients.
Payroll and related expenses. Payroll and related expenses increased $4.8
million to $88.3 million for the three months ended June 30, 2003, from $83.5
million for the comparable period in 2002, but decreased as a percentage of
revenue to 46.8 percent from 47.7 percent.
U.S. Operations' payroll and related expenses increased $5.8 million to
$84.4 million for the three months ended June 30, 2003, from $78.6 million for
the comparable period in 2002, but decreased as a percentage of revenue to 49.1
percent from 49.2 percent. This decrease in the percentage of revenue was
primarily attributable to the shift of more of the collection work to the
attorney network and other third party service providers, and the
rationalization of the collection staff. This shift was associated with the
continuing efforts to maximize collections for clients, particularly as we
approached the first reconciliation date of the long-term collection contract.
The costs associated with the increase in the use of the attorney network and
other third party service providers are included in selling, general and
administrative expenses. A portion of this decrease as a percentage of revenue
was offset by the $2.4 million of previously deferred revenue, on a net basis,
from the long-term collection contract that was recognized during the three
months ended June 30, 2002, as compared to the $1.7 million of additional
deferred revenue, on a net basis, that was recorded during the three months
ended June 30, 2003. Because the expenses associated with this revenue are
expensed as incurred, the recognition of previously deferred revenue decreases
the payroll and related expenses as a percentage of revenue and the deferral of
additional revenue increases the payroll and related expenses as percentage of
revenue.
-22-
Portfolio Management's payroll and related expenses increased $14,000 to
$563,000 for the three months ended June 30, 2003, from $549,000 for the
comparable period in 2002, and decreased as a percentage of revenue to 3.1
percent from 3.9 percent. Portfolio Management outsources all of its collection
services to U.S. Operations and, therefore, has a relatively small fixed payroll
cost structure. However, 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 $3.1
million to $10.1 million for the three months ended June 30, 2003, from $7.0
million for the comparable period in 2002, but decreased as a percentage of
revenue to 58.3 percent from 58.6 percent. The decrease as a percentage of
revenue was attributable to the continued focus on managing the amount of labor
required to attain revenue goals.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased $9.4 million to $70.7 million for the three
months ended June 30, 2003, from $61.3 million for the comparable period in
2002, and increased as a percentage of revenue to 37.5 percent from 35.0
percent. This increase in the percentage of revenue was partially attributable
to the shift of more of the collection work to the attorney network and other
third party service providers. This shift was associated with the continuing
efforts to maximize collections for clients, particularly as we approached the
first reconciliation date of the long-term collection contract. A portion of
this increase was also attributable to the $2.4 million of previously deferred
revenue, on a net basis, from the long-term collection contract that was
recognized during the three months ended June 30, 2002, as compared to the $1.7
million of additional deferred revenue, on a net basis, that was recorded during
the three months ended June 30, 2003. Because the expenses associated with this
revenue are expensed as incurred, the recognition of previously deferred revenue
decreases the selling, general and administrative expenses as a percentage of
revenue and the deferral of additional revenue increases the payroll and related
expenses as percentage of revenue.
Depreciation and amortization. Depreciation and amortization increased $1.5
million to $8.0 million for the three months ended June 30, 2003, from $6.5
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 $2,000 to
$789,000 for the three months ended June 30, 2003, from $787,000 for the
comparable period in 2002. Interest expense increased to $5.9 million for the
three months ended June 30, 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
credit facility during 2002 and 2003. Other income for the three months ended
June 30, 2003, included $476,000 of income from our ownership interest in one of
our insurance carriers that was sold. Other income for the three months ended
June 30, 2002 and 2003, included $305,000 and $250,000, respectively, of income
from a partial recoveries from a third parties of an environmental liability
that was paid by us in 2002. The environmental liability was originally recorded
during the first quarter of 2002 and was the result of contamination that
allegedly occurred in the pre-acquisition operations of a company acquired by a
subsidiary of Medaphis Services Corporation. We acquired Medaphis Services
Corporation in November 1998. These operations that caused the environment
liability were unrelated to the accounts receivable outsourcing business.
Income tax expense. Income tax expense for the three months ended June 30,
2003, decreased to $6.5 million, or 37.9 percent of income before income tax
expense, from $7.5 million, or 37.9 percent of income before income tax expense,
for the comparable period in 2002.
-23-
Six Months Ended June 30, 2003, Compared to Six Months Ended June 30, 2002
Revenue. Revenue increased $14.5 million, or 4.0 percent, to $377.6 million
for the six months ended June 30, 2003, from $363.1 million for the comparable
period in 2002. U.S. Operations, Portfolio Management and International
Operations accounted for $345.1 million, $36.3 million and $33.1 million,
respectively, of the revenue for the six months ended June 30, 2003. U.S.
Operations' revenue included $24.4 million of intercompany revenue earned on
services performed for Portfolio Management that was eliminated upon
consolidation. International Operations' revenue included $12.5 million of
intercompany revenue earned on services performed for U.S. Operations that was
eliminated upon consolidation.
U.S. Operations' revenue increased $14.0 million, or 4.2 percent, to $345.1
million for the six months ended June 30, 2003, from $331.1 million for the
comparable period in 2002. The increase in U.S. Operations' revenue was
primarily attributable to the acquisitions of Great Lakes collection operations
in August 2002 and 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 acquired by NCO Portfolio in August
2002. 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 six months ended June 30,
2003, U.S. Operations deferred $2.7 million of revenue, on a net basis, into
future periods, but during the six months ended June 30, 2002, U.S. Operations
recognized $11.5 million of previously deferred revenue, on a net basis. In
addition, the increases in revenue were also partially offset by a further
weakening of consumer payment patterns that began during the second half of
2002.
Portfolio Management's revenue increased $5.9 million, or 19.6 percent, to
$36.3 million for the six months ended June 30, 2003, from $30.4 million for the
comparable period in 2002. Portfolio Management's collections increased $18.7
million, or 34.9 percent, to $72.4 million for the six months ended June 30,
2003, from $53.7 million for the comparable period in 2002. Portfolio
Management's revenue represented 50 percent of collections for the six months
ended June 30, 2003, as compared to 57 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. 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 including timing of collections and lower
targeted returns on more recent portfolios due to the current economic
environment.
International Operations' revenue increased $10.5 million, or 46.5 percent,
to $33.1 million for the six months ended June 30, 2003, from $22.6 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 and
favorable changes in the foreign currency exchange rates used to translate the
International Operations' results of operations into U.S. dollars. In addition,
a portion of the increase was attributable to the addition of new clients and
growth in business from existing clients.
Payroll and related expenses. Payroll and related expenses increased $7.0
million to $176.6 million for the six months ended June 30, 2003, from $169.6
million for the comparable period in 2002, and increased as a percentage of
revenue to 46.8 percent from 46.7 percent.
U.S. Operations' payroll and related expenses increased $8.6 million to
$168.9 million for the six months ended June 30, 2003, from $160.3 million for
the comparable period in 2002, and increased as a percentage of revenue to 48.9
percent from 48.4 percent. The increase in the percentage of revenue was
primarily attributable to the $11.5 million of previously deferred revenue, on a
net basis, from the long-term collection contract that was recognized during the
six months ended June 30, 2002, as compared to the $2.7 million of additional
deferred revenue, on a net basis, that was recorded during the six months ended
June 30, 2003. Since the expenses associated with this revenue are expensed as
incurred, the recognition of previously deferred revenue decreases the payroll
and related expenses as a percentage of revenue and the deferral of additional
revenue increases the payroll and related expenses as percentage of revenue. The
increase in the percentage of revenue was partially offset by the shift of more
of the collection work to the attorney network and other third party service
providers, and the rationalization of the collection staff. This shift was
associated with the continuing efforts to maximize collections for clients,
particularly as we approached the first reconciliation date of the long-term
collection contract. The costs associated with the increase in the use of the
attorney network and other third party service providers are included in
selling, general and administrative expenses.
-24-
Portfolio Management's payroll and related expenses decreased $60,000 to
$1.0 million for the six months ended June 30, 2003, from $1.1 million for the
comparable period in 2002, and decreased as a percentage of revenue to 2.9
percent from 3.6 percent. Portfolio Management outsources all of its collection
services to U.S. Operations and, therefore, has a relatively small fixed payroll
cost structure. 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 $6.3
million to $19.2 million for the six months ended June 30, 2003, from $12.9
million for the comparable period in 2002, and increased as a percentage of
revenue to 58.0 percent from 56.9 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. A portion of this increase was offset by the
effects from the continued focus on managing the amount of labor required to
attain revenue goals.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased $17.3 million to $139.7 million for the six
months ended June 30, 2003, from $122.4 million for the comparable period in
2002, and increased as a percentage of revenue to 37.0 percent from 33.7
percent. The increase in the percentage of revenue was partially attributable to
the $11.5 million of previously deferred revenue, on a net basis, from the
long-term collection contract that was recognized during the six months ended
June 30, 2002, as compared to the $2.7 million of additional deferred revenue,
on a net basis, that was recorded during the six months ended June 30, 2003.
Because the expenses associated with this revenue are expensed as incurred, the
recognition of previously deferred revenue decreases the selling, general and
administrative expenses as a percentage of revenue and the deferral of
additional revenue increases the payroll and related expenses as percentage of
revenue. A portion of the increase in the percentage of revenue was attributable
to the shift of more of the collection work to the attorney network and other
third party service providers. This shift was associated with the continuing
efforts to maximize collections for clients, particularly as we approached the
first reconciliation date of the long-term collection contract.
Depreciation and amortization. Depreciation and amortization increased $3.2
million to $15.9 million for the six months ended June 30, 2003, from $12.7
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.
-25-
Other income (expense). Interest and investment income increased $171,000
to $1.6 million for the six months ended June 30, 2003, from $1.5 million 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.
Interest expense increased to $11.7 million for the six months ended June 30,
2003, from $9.9 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 credit
facility during 2002 and 2003. Other income (expense) for the six months ended
June 30, 2003, included $476,000 of income from our ownership interest in one of
our insurance carriers that was sold. Other expense for the six months ended
June 30, 2002, included an expense of $1.3 million from the estimated settlement
of an environmental liability, net of a $305,000 recovery from a third party.
Other income for the six months ended June 30, 2003, included $250,000 of income
from a partial recovery from a third party of an environmental liability that
was paid by us. The environmental liability was originally recorded during the
first quarter of 2002 and was the result of contamination that allegedly
occurred in the pre-acquisition operations of a company acquired by a subsidiary
of Medaphis Services Corporation. We acquired Medaphis Services Corporation in
November 1998. The operations that caused the environment liability were
unrelated to the accounts receivable outsourcing business. Other expense for the
six months ended June 30, 2002, also included a $1.0 million insurance gain that
resulted from the settlement of the insurance claim related to the June 2001
flood of the Fort Washington facilities. The insurance gain was principally due
to greater than estimated insurance proceeds.
Income tax expense. Income tax expense for the six months ended June 30,
2003, decreased to $13.7 million, or 37.9 percent of income before income tax
expense, from $18.8 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 $35.7 million for the six months ended June 30, 2003, as compared to $27.4
million for the same period in 2002. The increase in cash provided by operations
was primarily attributable to a $2.2 million decrease in accounts payable and
accrued expenses as compared to a $11.2 million decrease for the same period in
the prior year. The decrease in 2002 was primarily attributable to the payment
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 was returned in July 2003. A portion of the increases in cash
provided by operations was offset by increases in other assets, deferred income
taxes and accounts receivable.
Cash Flows from Investing Activities. Cash used in investing activities was
$2.3 million for the six months ended June 30, 2003, compared to cash used in
investing activities of $7.9 million for the same period in 2002. Cash purchases
of accounts receivable for the six months ended June 30, 2003 were $29.2 million
as compared to $16.8 million for the comparable period in 2002, and collections
applied to principal of purchased accounts receivable were $36.9 million as
compared to $24.0 million. Purchases of property and equipment were $10.2
million for the six months ended June 30, 2003, compared to $18.1 million for
the same period in 2002. The additional purchases of property and equipment for
the six months ended June 30, 2002 was primarily attributable to the relocation
of our corporate headquarters to Horsham, Penssylvania.
-26-
Cash Flows from Financing Activities. Cash used in financing activities was
$29.8 million for the six months ended June 30, 2003, compared to cash used in
financing activities of $24.9 million for the same period in 2002. The cash used
in financing activities during the six months ended June 30, 2003, resulted from
repayments of borrowings under our credit facility, nonrecourse debt used to
purchase large accounts receivable portfolios, and securitized debt assumed as
part of the Creditrust merger. These repayments were partially offset by the
$10.6 million borrowed from CFSC Capital Corp. XXXIV to purchase accounts
receivable. The cash used in financing activities during the six months ended
June 30, 2002, resulted from repayments of borrowings under our credit facility
and repayments of securitized debt assumed as part of the Creditrust merger.
Credit Facility. On August 13, 2003, we amended our credit agreement with
Citizens Bank of Pennsylvania, formerly Mellon Bank, N.A., ("Citizens Bank"),
for itself and as administrative agent for other participating lenders. The
amendment extended the maturity date from May 20, 2004 to March 15, 2006 (the
"Maturity Date"). The amended credit facility is structured as a $150 million
term loan and a $50 million revolving credit facility. We are required to make
quarterly repayments of $6.3 million beginning on September 30, 2003, and
continuing until the Maturity Date. The remaining balance outstanding under the
term loan will become due on the Maturity Date. The balance under the revolving
credit facility will become due on the Maturity Date.
At our option, the borrowings bear interest at a rate equal to either
Citizens Bank's prime rate plus a margin of 0.75 percent to 1.25 percent, which
is determined quarterly based upon our consolidated funded debt to earnings
before interest, taxes, depreciation, and amortization ("EBITDA") ratio
(Citizens Bank's prime rate was 4.00 percent at June 30, 2003), or the London
InterBank Offered Rate ("LIBOR") plus a margin of 2.25 percent to 3.00 percent
depending on our consolidated funded debt to EBITDA ratio (LIBOR was 1.12
percent at June 30, 2003). We are charged a fee on the unused portion of the
credit facility ranging from 0.38 percent to 0.50 percent depending on our
consolidated funded debt to EBITDA ratio. We are currently exploring potential
risk management strategies that may include the use of derivatives such as
interest rate swap agreements to manage the exposure to changes in LIBOR.
Borrowings under the credit agreement are collateralized by substantially
all of our assets, including the common stock of NCO Portfolio that we own, and
our rights under the revolving credit agreement with NCO Portfolio (see note
17). 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 June 30, 2003, we were in compliance with all required
covenants.
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 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
June 30, 2003, a notional amount of $62.0 million was covered by the interest
rate swap agreements.
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 credit facility.
-27-
Other 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 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 two
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 4.00 percent at June 30, 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 June 30, 2003,
NCO Portfolio was in compliance with all required covenants.
Off-Balance Sheet Arrangements
NCO Portfolio owns a 100 percent retained residual interest in an
investment in securitization, Creditrust SPV 98-2, LLC, which was acquired as
part of the 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 $1.1 million as of December 31, 2002 and June 30, 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 June 30, 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 and six
months ended June 30, 2003, as the income was offset by a temporary decline in
market value. We recorded income of $47,000 and $75,000 on this investment
during the three and six months ended June 30, 2002, respectively. 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. Gains and losses are shared equally between NCO
Portfolio and IMNV. Included in "other assets" on the Balance Sheets was NCO
Portfolio's investment in the Joint Venture of $3.4 million and $4.2 million as
of December 31, 2002 and June 30, 2003, respectively. Included in the Statements
of Income, as "interest and investment income," for the three months ended June
30, 2002 and 2003, was $220,000 and $479,000, respectively, representing NCO
Portfolio's 50 percent share of operating income from this unconsolidated
subsidiary. Income of $303,000 and $952,000 was recorded from this
unconsolidated subsidiary for the six months ended June 30, 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 4.00 percent as of
June 30, 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.
-28-
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.
Effective January 1, 2003, we adopted FASB Interpretation No. 45 ("FIN
45"), "Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others." FIN 45 elaborates on
the disclosures required by guarantors in their interim and annual financial
statements. FIN 45 also requires a guarantor to recognize a liability at the
date of inception for the fair value of the obligation it assumes under the
guarantee. The disclosure requirements were effective for periods ending after
December 15, 2002. The initial recognition and measurement provisions apply on a
prospective basis to guarantees issued or modified after December 31, 2002. We
have several guarantee arrangements for which a liability has not been
recognized as all such guarantees were issued prior to December 31, 2002.
Accordingly, the adoption of FIN 45 did not have a material impact on our
consolidated financial position, consolidated results of operations, or
liquidity.
-29-
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
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 the consolidation requirements 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
The Company, under the supervision and with the participation of its
management, including its principal executive officer and principal financial
officer, evaluated the effectiveness of the design and operation of its
disclosure controls and procedures as of the end of the period covered by this
report. Based on this evaluation, the principal executive officer and principal
financial officer concluded that the Company's disclosure controls and
procedures are effective in reaching a reasonable level of assurance that
information required to be disclosed by the Company in the reports that it files
or submits under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time period specified in the Securities and
Exchange Commission's rules and forms.
The principal executive officer and principal financial officer also
conducted an evaluation of internal control over financial reporting ("Internal
Control") to determine whether any changes in Internal Controls occurred during
the quarter that have materially affected or which are reasonably likely to
materially affect Internal Controls. Based on that evaluation, there has been no
such change during the quarter covered by this report.
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. Because of the inherent limitations in a cost-effective control
system, misstatements due to error or fraud may occur and not be detected.
-30-
Part II. Other Information
Item 1. Legal Proceedings
In June 2001, the first floor of the Company's Fort Washington,
Pennsylvania, 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
-31-
Item 4. Submission of Matters to a Vote of Shareholders
The Annual Meeting of Shareholders of the Company was held on May 19,
2003. At the Annual Meeting, the shareholders elected Michael J. Barrist
and Leo J. Pound as directors to serve for a term of three years as
described below:
Number of Votes
---------------
Withhold
Name For Authority
---- --- ---------
Michael J. Barrist 17,592,714 7,105,726
Leo J. Pound 23,710,062 988,378
In addition, the terms of the following directors continued after the
Annual Meeting: William C. Dunkelberg, Ph.D., Eric S. Siegel, Charles C.
Piola, Jr. and Allen F. Wise.
At the Annual Meeting, the shareholders also approved the amendments to
the 1996 Stock Option Plan as follows:
For Against Abstain Broker Non-Vote
--- ------- ------- ---------------
20,939,743 3,734,442 24,255 0
Item 5. Other Information
None - not applicable
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Section 1350 Certification
99.1 Consolidating Schedule
(b) Reports on Form 8-K
Date of Filing Item Reported
5/9/03 Item 7 and Item 9 - Press release from the earnings
release for the first quarter
of 2003
5/13/03 Item 7 and Item 9 - Press release and conference call
transcript from the earnings
release for the first quarter of
2003
-32-
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: August 14, 2003 By: /s/ Michael J. Barrist
----------------------
Michael J. Barrist
Chairman of the Board, President
and Chief Executive Officer
(principal executive officer)
Date: August 14, 2003 By: /s/ Steven L. Winokur
---------------------
Steven L. Winokur
Executive Vice President of Finance,
Chief Financial Officer, Chief Operating
Officer of Shared Services and Treasurer
(principal financial and
accounting officer)
-33-