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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark one)
/X/ Quarterly report pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2004, 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 23-2858652
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(State or other jurisdiction of (IRS Employer Identification Number)
incorporation or organization)
507 Prudential Road, Horsham, Pennsylvania 19044
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(Address of principal executive offices) (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 (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ______
---
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes X No ______
---
The number of shares outstanding of each of the issuer's classes of
common stock as of August 6, 2004 was: 31,851,396 shares of common stock, no par
value.
NCO GROUP, INC.
INDEX
PAGE
PART I - FINANCIAL INFORMATION
Item 1 FINANCIAL STATEMENTS (Unaudited)
Condensed Consolidated Balance Sheets -
June 30, 2004 and December 31, 2003 1
Condensed Consolidated Statements of Income -
Three and six months ended June 30, 2004 and 2003 2
Condensed Consolidated Statements of Cash Flows -
Six months ended June 30, 2004 and 2003 3
Notes to Condensed Consolidated Financial Statements 4
Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 22
Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK 29
Item 4 CONTROLS AND PROCEDURES 29
PART II - OTHER INFORMATION 30
Item 1. Legal Proceedings
Item 2. Changes in Securities, Use of Proceeds and
Issuer Purchases of equity securities
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Shareholders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
Signatures 33
PART 1 - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
NCO GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN THOUSANDS)
JUNE 30,
2004 DECEMBER 31,
ASSETS (UNAUDITED) 2003
---------- --------
Current assets:
Cash and cash equivalents $ 58,798 $ 45,644
Restricted cash 1,381 5,850
Accounts receivable, trade, net of allowance for
doubtful accounts of $8,149 and $7,447, respectively 111,921 80,640
Purchased accounts receivable, current portion 44,608 59,371
Deferred income taxes 25,336 12,280
Bonus receivable, current portion 2,562 7,646
Prepaid expenses and other current assets 18,801 18,021
---------- --------
Total current assets 263,407 229,452
Funds held on behalf of clients
Property and equipment, net 109,829 74,085
Other assets:
Goodwill 585,526 506,370
Other intangibles, net of accumulated amortization 33,983 12,375
Purchased accounts receivable, net of current portion 86,222 93,242
Bonus receivable, net of current portion - 320
Other assets 31,253 30,267
---------- --------
Total other assets 736,984 642,574
---------- --------
Total assets $1,110,220 $946,111
========== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Long-term debt, current portion $ 72,235 $ 66,523
Accounts payable 11,469 4,281
Accrued expenses 45,379 25,901
Accrued compensation and related expenses 27,489 15,601
Deferred revenue, current portion 17,193 10,737
---------- --------
Total current liabilities 173,765 123,043
Funds held on behalf of clients
Long-term liabilities:
Long-term debt, net of current portion 229,048 248,964
Deferred revenue, net of current portion 697 13,819
Deferred income taxes 32,025 38,676
Other long-term liabilities 18,610 4,344
Minority interest - 26,848
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,
31,830 and 25,988 shares issued and outstanding, respectively 464,653 323,511
Other comprehensive income 5,381 6,646
Deferred compensation (621) -
Retained earnings 186,662 160,260
---------- --------
Total shareholders' equity 656,075 490,417
---------- --------
Total liabilities and shareholders' equity $1,110,220 $946,111
========== ========
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,
------------------------ ------------------------
2004 2003 2004 2003
-------- -------- -------- --------
Revenue $255,255 $188,574 $456,486 $377,591
Operating costs and expenses:
Payroll and related expenses 132,823 88,330 223,862 176,628
Selling, general and administrative expenses 83,752 70,718 160,397 139,676
Depreciation and amortization expense 11,147 8,039 18,925 15,895
-------- -------- -------- --------
Total operating costs and expenses 227,722 167,087 403,184 332,199
-------- -------- -------- --------
Income from operations 27,533 21,487 53,302 45,392
Other income (expense):
Interest and investment income 599 789 1,595 1,625
Interest expense (5,256) (5,862) (10,544) (11,681)
Other income 621 726 621 726
-------- -------- -------- --------
Total other income (expense) (4,036) (4,347) (8,328) (9,330)
-------- -------- -------- --------
Income before income tax expense 23,497 17,140 44,974 36,062
Income tax expense 9,078 6,504 17,966 13,683
-------- -------- -------- --------
Income before minority interest 14,419 10,636 27,008 22,379
Minority interest - (359) (606) (910)
-------- -------- -------- --------
Net income $ 14,419 $ 10,277 $ 26,402 $ 21,469
======== ======== ======== ========
Net income per share:
Basic $ 0.46 $ 0.40 $ 0.92 $ 0.83
Diluted $ 0.43 $ 0.38 $ 0.86 $ 0.78
Weighted average shares outstanding:
Basic 31,502 25,908 28,814 25,908
Diluted 35,723 29,768 32,979 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,
-----------------------
2004 2003
-------- --------
Cash flows from operating activities:
Net income $26,402 $21,469
Adjustments to reconcile income from operations
to net cash provided by operating activities:
Depreciation 15,444 13,526
Amortization of intangibles 3,481 2,369
Amortization of deferred compensation 56 -
Amortization of deferred training asset 174 -
Provision for doubtful accounts 1,784 2,100
Impairment of purchased accounts receivable 449 962
Accrued noncash interest 2,937 2,016
Loss on disposal of property and equipment 38 330
Changes in non-operating income (1,036) (1,678)
Minority interest 606 906
Changes in operating assets and liabilities, net of acquisitions:
Restricted cash 4,469 -
Accounts receivable, trade (9,287) (5,859)
Deferred income taxes 7,789 3,411
Bonus receivable 5,404 2,285
Other assets (750) (3,494)
Accounts payable and accrued expenses 1,313 (4,250)
Income taxes payable 2,446 747
Deferred revenue (8,495) 398
Other long-term liabilities 2,103 509
-------- --------
Net cash provided by operating activities 55,327 35,747
Cash flows from investing activities:
Purchases of accounts receivable (22,947) (29,190)
Collections applied to principal of purchased accounts receivable 45,309 36,938
Purchases of property and equipment (14,479) (10,169)
Net distribution from joint venture 1,420 72
Proceeds from notes receivable 617 -
Net cash paid for acquisitions and related costs (12,358) -
-------- --------
Net cash used in investing activities (2,438) (2,349)
Cash flows from financing activities:
Repayment of notes payable (21,702) (14,239)
Borrowings under notes payable 5,388 10,640
Repayment of acquired notes payable (11,447) -
Borrowings under revolving credit agreement - 1,000
Repayment of borrowings under revolving credit agreement (22,500) (27,130)
Payment of fees to acquire debt (90) (42)
Issuance of common stock, net 10,696 -
-------- --------
Net cash used in financing activities (39,655) (29,771)
Effect of exchange rate on cash (80) 920
-------- --------
Net increase in cash and cash equivalents 13,154 4,547
Cash and cash equivalents at beginning of the period 45,644 25,159
-------- --------
Cash and cash equivalents at end of the period $58,798 $29,706
======== ========
See accompanying notes.
-3-
NCO GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. NATURE OF OPERATIONS:
NCO Group, Inc., referred to as the Company or NCO, is a leading global provider
of business process outsourcing solutions, offering accounts receivable
management, referred to as ARM, customer relationship management, referred to as
CRM, and other services. NCO provides services through over 90 offices in the
United States, Canada, the United Kingdom, India, the Philippines, Barbados and
Panama. The Company provides services to more than 50,000 clients including many
of the Fortune 500, supporting a broad spectrum of industries, including
financial services, healthcare, retail and commercial, telecommunications,
utility, education, government services and technology. These clients are
primarily located throughout the United States of America, Canada, the United
Kingdom, and Puerto Rico. The Company's largest client is in the financial
services sector and represented 10.9 percent of the Company's consolidated
revenue for the six months ended June 30, 2004. The Company also purchases and
manages past due consumer accounts receivable from consumer creditors such as
banks, finance companies, retail merchants, and other consumer-oriented
companies.
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, 2004,
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2004, or for any other interim period. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Company's Annual Report on Form 10-K filed with the
Securities and Exchange Commission on March 15, 2004.
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 (see note 14) and,
accordingly, its financial condition and results of operations are not
consolidated with the Company's financial statements.
Revenue Recognition:
ARM Contingency Fees:
ARM contingency fee revenue is recognized upon collection of funds on behalf of
clients.
ARM Contractual Services:
Fees for ARM 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 that includes guaranteed collections, subject to limits. The
Company also earns a bonus to the extent collections are in excess of the
guarantees. The Company is required to pay the client, subject to limits, if
collections do not reach the guarantees. Any guarantees in excess of the limits
will only be satisfied with future collections. The Company is entitled to
recoup at least 90 percent of any such guarantee payments from subsequent
collections in excess of any remaining guarantees. This long-term collection
contract only covers placements by the client from January 1, 2000 through
December 31, 2003.
The Company defers all of the base service fees, subject to the limits, until
the collections exceed the collection guarantees. At the end of each reporting
period, the Company assesses the need to record an additional liability if
deferred fees are less than the estimated guarantee payments, if any, due to the
client, subject to the limits. There was no additional liability recorded as of
June 30, 2004 and December 31, 2003.
CRM Hourly:
Revenue is recognized based on the billable hours of each CRM representative as
defined in the client contract. The rate per billable hour charged is based on a
predetermined contractual rate, as agreed in the underlying contract. The
contractual rate can fluctuate based on certain pre-determined objective
performance criteria related to quality and performance. The impact of the
performance criteria on the rate per billable hour is continually updated as
revenue is recognized. Some clients are contractually entitled to penalties when
the Company is not in compliance with certain obligations as defined in the
client contract. Penalties are recorded as a reduction to revenues as incurred.
CRM Performance Based:
Under performance-based arrangements, the Company is paid by its customers based
on achievement of certain levels of sales or other client-determined criteria
specified in the client contract. The Company recognizes performance-based
revenue by measuring its actual results against the performance criteria
specified in the contracts. Amounts collected from customers prior to the
performance of services are recorded as deferred revenues.
Training Revenues:
In connection with the provisions of certain inbound and outbound CRM services,
the Company incurs costs to train its CRM representatives. Training programs
relate to both program start-up training in connection with new CRM programs,
referred to as Start-up Training, and on-going training for updates of existing
CRM programs, referred to as On-going Training. The Company bills some of its
customers for the costs incurred under these training programs based on the
terms in the contract. Training revenue is integral to CRM revenues being
generated over the course of a contract and cannot be separated as a discrete
earning process under SEC Staff Accounting Bulletin No. 104. As a result, all
training revenues are deferred. Start-up Training and On-going Training revenues
are amortized over the term of the customer contract, or over the period to be
benefited. Direct costs associated with providing Start-up Training and On-going
Training, which consist exclusively of salary and benefit costs, are also
deferred and amortized over a time period consistent with the deferred training
revenues. When a business relationship is terminated with one of the Company's
customers, the unamortized deferred training revenue and unamortized deferred
direct costs associated with that customer are immediately recognized.
-5-
2. ACCOUNTING POLICIES (CONTINUED):
Revenue Recognition (continued):
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, referred to as 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 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 revenue. In this situation, the
carrying value of the portfolio may be increased by the difference between
revenue and collections.
To the extent actual collections differ from estimated projections, the Company
prospectively adjusts projected collections, which 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. 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 are 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 ARM
contingency 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 ARM 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.
-6-
2. ACCOUNTING POLICIES (CONTINUED):
Goodwill:
Goodwill represents the excess of purchase price over the fair market value of
the net assets of the acquired businesses based on their respective fair values
at the date of acquisition. The Company accounts for goodwill pursuant to
Statement of Financial Accounting Standard No. 142, "Goodwill and Other
Intangible Assets," referred to as SFAS 142. Under SFAS 142, goodwill is no
longer amortized but instead must be tested for impairment at least annually and
as triggering events occur, 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 subsequent annual impairment tests, and does not
believe that goodwill is impaired as of June 30, 2004. The annual impairment
analysis is completed on October 1st of each year (see note 7).
Other Intangible Assets:
Other intangible assets consist primarily of customer relationships and deferred
financing costs, which relate to debt issuance costs incurred. Customer
relationships are amortized over five years and deferred financing costs are
amortized over the term of the debt (see note 7).
Stock Options:
The Company accounts for stock option grants in accordance with APB Opinion 25,
"Accounting for Stock Issued to Employees," referred to as 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 the grant date. If the Company
had elected to recognize compensation cost based on the fair value of the
options granted at the 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 June 30, Ended June 30,
-------------------- -----------------
2004 2003 2004 2003
------- ------- ------- -------
Net income - as reported $14,419 $10,277 $26,402 $21,469
Pro forma compensation cost, net of taxes 855 1,068 1,711 2,138
------- ------- ------- -------
Net income - pro forma $13,564 $ 9,209 $24,691 $19,331
======= ======= ======= =======
Net income per share - as reported:
Basic $0.46 $0.40 $0.92 $0.83
Diluted $0.43 $0.38 $0.86 $0.78
Net income per share - pro forma:
Basic $0.43 $0.36 $0.86 $0.75
Diluted $0.41 $0.34 $0.80 $0.71
In May 2004, the Company's shareholders approved the 2004 Equity Incentive Plan,
referred to as the 2004 Plan. The 2004 Plan authorizes grants to employees and
directors of incentive stock options, options not intended to qualify as
incentive stock options, stock appreciation rights, restricted and unrestricted
stock awards, restricted stock units, performance awards, supplemental cash
awards and combinations of the foregoing. The aggregate number of shares of
Common Stock for which awards may be granted under the 2004 Plan is 2.0 million.
-7-
2. ACCOUNTING POLICIES (CONTINUED):
Income Taxes:
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes," referred to as SFAS No. 109, which requires that
deferred tax assets and liabilities be recognized using enacted tax rates for
the effect of temporary differences between the book and tax bases of recorded
assets and liabilities. SFAS No. 109 also requires that deferred tax assets be
reduced by a valuation allowance, if it is more likely than not that some
portion or all of the deferred tax asset will not be realized. Deferred taxes
have not been provided on the cumulative undistributed earnings of foreign
subsidiaries because such amounts are expected to be reinvested indefinitely.
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 the 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 and any impairment. 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 5).
Derivative Financial Instruments:
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities",
referred to as SFAS No. 133, requires companies to recognize all of their
derivative instruments as either assets or liabilities in the balance sheet at
fair value. The Company has certain nonrecourse notes payable that have
derivative instruments embedded within them. The embedded derivatives are not
hedge instruments and, accordingly, changes in their estimated fair value are
reported as other income (expense) in the accompanying statements of income. The
embedded derivatives are included in long-term debt on the accompanying balance
sheets as they are not separable from the notes payable and they have the same
counterparty.
The Company is exposed to foreign currency fluctuations relating to its
operations in Canada, the United Kingdom and the Philippines. In order to
partially hedge cash flow exposure, the Company periodically enters into forward
exchange contracts in order to minimize the impact of currency fluctuations on
transactions, cash flows and firm commitments. These contracts are recorded at
fair value on the accompanying balance sheets, and changes in fair value are
recorded in other comprehensive income (see note 10).
Reclassifications:
Certain amounts for the six months ended June 30, 2003 have been reclassified
for comparative purposes.
-8-
3. 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 and
other costs related to the acquisition.
On March 26, 2004, the Company completed the merger of NCO Portfolio Management,
Inc., referred to as NCO Portfolio, with a wholly owned subsidiary of the
Company. The Company owned approximately 63.3 percent of the outstanding stock
of NCO Portfolio prior to the merger and, pursuant to the merger, acquired all
NCO Portfolio shares that it did not own for 1.8 million shares of NCO common
stock valued at $39.8 million. The value of the stock issued was based on the
average closing price of the Company's common stock for the period beginning two
days before and ending two days after the announcement of the merger on December
15, 2003. The Company recorded goodwill of $15.8 million, most of which is not
deductible for tax purposes. The allocation of the fair market value to the
acquired assets and liabilities of NCO Portfolio was based on preliminary
estimates and may be subject to change. During the three months ended June 30,
2004, the Company revised the estimated allocation of the fair market value that
resulted in an increase in goodwill of $1.1 million. As a result of the
acquisition, the Company expects to expand its portfolio base and reduce the
cost of operations through economies of scale. Therefore, the Company believes
the allocation of a portion of the purchase price to goodwill is appropriate.
The following is a preliminary allocation of the purchase price of the minority
interest of NCO Portfolio (amounts in thousands):
Purchase price $ 39,891
Transaction costs 1,902
Fair value adjustment to:
Purchased accounts receivable 2,324
Other assets (526)
Liabilities (299)
Minority interest (27,454)
--------
Goodwill $ 15,838
========
On April 2, 2004, the Company completed the acquisition of RMH Teleservices,
Inc., referred to as RMH, a provider of CRM services. The Company issued 3.4
million shares of NCO common stock for all of the outstanding shares of RMH and
assumed 339,000 warrants and 248,000 stock options. The total value of the
consideration was $88.8 million. The Company also repaid $11.4 million of RMH's
pre-acquisition debt. The values of the stock, warrants and stock options were
based on the average closing price of the Company's common stock for the period
beginning two days before and ending two days after the announcement of the
first amendment to the agreement on January 22, 2004. The Company allocated
$25.0 million of the purchase price to the customer relationships and recorded
goodwill of $64.5 million, most of which is not deductible for tax purposes. As
part of the purchase accounting, the Company recorded accruals for acquisition
related expenses including termination costs related to certain redundant
personnel that were scheduled to be eliminated upon completion of the
acquisition and certain future rental obligations attributable to facilities
which are scheduled to be closed. The allocation of the fair market value to the
acquired assets and liabilities of RMH was based on preliminary estimates and
may be subject to change. As a result of the acquisition, the Company expects to
expand RMH's current customer base, strengthen its relationship with certain
existing customers, and reduce the cost of providing services to the acquired
customers through economies of scale. Therefore, the Company believes the
allocation of a portion of the purchase price to goodwill is appropriate. The
following is a preliminary allocation of the purchase price to the assets
acquired and liabilities assumed of RMH (amounts in thousands):
Purchase price $ 88,808
Accounts receivable (23,824)
Customer relationship (25,000)
Property and equipment (37,235)
Deferred tax asset (26,597)
Other assets (6,180)
Long-term debt 29,233
Other assumed liabilities 29,907
Accrued acquisition costs:
Lease obligations for office closures 18,493
Severance 4,210
Other 12,914
Foreign currency translation of
goodwill (239)
--------
Goodwill $ 64,490
========
-9-
3. BUSINESS COMBINATIONS (CONTINUED):
The following summarizes the unaudited pro forma results of operations, assuming
the NCO Portfolio and RMH acquisitions occurred as of the beginning of the
respective periods. The pro forma information is provided for informational
purposes only. It is based on historical information, and does not necessarily
reflect the actual results that would have occurred, nor is it indicative of
future results of operations of the consolidated entities (amounts in thousands,
except per share data):
For the Six Months
Ended June 30,
--------------------
2004 2003
-------- --------
Revenue $523,694 $520,041
Net income $ 26,065 $ 17,965
Earnings per share - basic $0.76 $0.58
Earnings per share - diluted $0.73 $0.56
4. 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,
----------------- ------------------
2004 2003 2004 2003
------- ------- ------------------
Net income $14,419 $10,277 $26,402 $21,469
Other comprehensive income (expense):
Foreign currency translation adjustment (1,231) 4,087 (1,602) 6,956
Change in fair value of foreign currency
hedge 337 - 337 -
Unrealized gain on interest rate swap - 183 - 351
------- ------- -------- -------
Comprehensive income $13,525 $14,547 $25,137 $28,776
======= ======= ======== =======
The foreign currency translation adjustment was attributable to changes in the
exchange rates used to translate the financial statements of the Canadian,
United Kingdom and Philippines subsidiaries into U.S. dollars.
-10-
5. PURCHASED ACCOUNTS RECEIVABLE:
The Company's Portfolio Management and ARM International divisions purchase
defaulted consumer accounts receivable at a discount from the actual principal
balance. On certain international portfolios, Portfolio Management and ARM
International jointly purchase defaulted consumer accounts receivable. The
following summarizes the change in purchased accounts receivable (amounts in
thousands):
For the Six
Months Ended For the Year Ended
June 30, 2004 December 31, 2003
------------- ------------------
Balance at beginning of period $152,613 $152,448
Purchases of accounts receivable 26,235 74,299
Collections on purchased accounts receivable (91,433) (154,121)
Revenue recognized 46,124 76,735
Impairment of purchased accounts receivable (449) (1,751)
Residual purchased accounts receivable from
previously unconsolidated subsidiary - 4,515
Fair value purchase accounting adjustment (2,324) -
Foreign currency translation adjustment 64 488
-------- ---------
Balance at end of period $130,830 $152,613
======== =========
Included in collections for the three and six months ended June 30, 2004 was
$4.2 million of proceeds from portfolio sales. Included in collections for the
three and six months ended June 30, 2003 was $80,000 and $1.5 million,
respectively, of proceeds from the sale of accounts.
During the three months ended June 30, 2004 and 2003, impairment charges of
$61,000 and $632,000, respectively, were recorded from portfolios where the
carrying values exceeded the expected future undiscounted cash flows. During the
six months ended June 30, 2004 and 2003, impairment charges of $449,000 and
$962,000, respectively, were recorded. As of June 30, 2004 and December 31,
2003, the combined carrying values on all impaired portfolios aggregated $4.9
million and $11.4 million, respectively, or 3.8 percent and 7.5 percent of total
purchased accounts receivable, respectively, representing their net realizable
value.
As of June 30, 2004 and December 31, 2003, one portfolio with a carrying value
of $2.0 million and $4.2 million, respectively, which was acquired in connection
with the dissolution of an off-balance sheet securitization, was also being
accounted for under the cost recovery method.
6. 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 $67.2 million and $59.3 million as
of June 30, 2004 and December 31, 2003, respectively, have been shown net of
their offsetting liability for financial statement presentation.
-11-
7. INTANGIBLE ASSETS:
Goodwill:
SFAS 142 requires goodwill to be allocated and tested at the reporting unit
level. The Company's reporting units under SFAS 142 are ARM U.S., CRM, Portfolio
Management and ARM International, and had the following goodwill (amounts in
thousands):
June 30, 2004 December 31, 2003
------------- -----------------
ARM U.S. $471,558 $471,558
CRM 64,490 -
Portfolio Management 15,838 -
ARM International 33,640 34,812
-------- --------
Total $585,526 $506,370
======== ========
CRM's goodwill resulted from the acquisition of RMH (see note 3). Portfolio
Management's goodwill resulted from the purchase of the minority interest of NCO
Portfolio (see note 3). The change in ARM International's goodwill balance from
December 31, 2003 to June 30, 2004, was due to changes in the exchange rates
used for the foreign currency translation.
Other Intangible Assets:
Other intangible assets consist primarily of deferred financing costs and
customer relationships. The following represents the other intangible assets
(amounts in thousands):
June 30, 2004 December 31, 2003
------------------------------ ------------------------------
Gross Carrying Accumulated Gross Carrying Accumulated
Amount Amortization Amount Amortization
-------------- ------------ -------------- ------------
Deferred financing costs $15,335 $10,967 $15,321 $ 9,687
Customer relationships 33,761 4,230 8,761 2,104
Other intangible assets 975 891 900 816
------- ------- ------- -------
Total $50,071 $16,088 $24,982 $12,607
======= ======= ======= =======
The Company recorded amortization expense for all other intangible assets of
$2.4 million and $1.2 million during the three months ended June 30, 2004 and
2003, respectively, and $3.5 million and $2.4 million during the six months
ended June 30, 2004 and 2003, respectively. The following represents the
Company's estimated amortization expense from these other intangible assets over
the next five years (amounts in thousands):
For the Years Ended Estimated
December 31, Amortization Expense
----------------------- -----------------------
2004 $8,170
2005 9,294
2006 7,350
2007 6,401
2008 5,000
-12-
8. LONG-TERM DEBT:
Long-term debt consisted of the following (amounts in thousands):
June 30, 2004 December 31, 2003
------------- -----------------
Credit facility $110,000 $132,500
Convertible notes 125,000 125,000
Securitized nonrecourse debt 27,857 33,210
Other nonrecourse debt 14,461 17,591
Capital leases and other 23,965 7,186
Less current portion (72,235) (66,523)
-------- --------
$229,048 $248,964
======== ========
Credit Facility:
On August 13, 2003, the Company amended its credit agreement with Citizens Bank
of Pennsylvania, referred to as 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, referred to as 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 on the term loan until the Maturity Date. The
remaining balance outstanding under the term loan and the balance under the
revolving credit facility will become due on the Maturity Date. The availability
of the revolving credit facility is reduced by any unused letters of credit. As
of June 30, 2004, the Company had unused letters of credit of $2.8 million and
$47.2 million remaining availability under the revolving credit facility.
Prior to February 28, 2004, all borrowings carried interest at a rate equal to
either, at the option of the Company, Citizens Bank's prime rate plus a margin
of 1.25 percent, or the London InterBank Offered Rate, referred to as LIBOR,
plus a margin of 3.00 percent. After February 28, 2004, all borrowings carried
interest at a rate equal to either, at the option of the Company, Citizens
Bank's prime rate (Citizens Bank's prime rate was 4.25 percent at June 30, 2004)
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, referred to as EBITDA, ratio, or LIBOR
(LIBOR was 1.36 percent at June 30, 2004) plus a margin of 2.25 percent to 3.00
percent depending on the Company's consolidated funded debt to EBITDA ratio. The
Company is charged a fee on the unused portion of the credit facility of 0.50
percent until February 28, 2004, and ranging from 0.38 percent to 0.50 percent
depending on the Company's consolidated funded debt to EBITDA ratio after
February 28, 2004. The effective interest rate on credit facility was
approximately 3.60 percent and 4.31 percent for the three months ended June 30,
2004 and 2003, respectively, and 3.82 percent and 4.38 percent for the six
months ended June 30, 2004 and 2003, respectively.
Borrowings under the credit agreement are collateralized by substantially all
the assets of the Company. 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, the incurrence
of additional debt, the issuance of equity and distributions to shareholders. If
an event of default, such as failure to comply with covenants, material adverse
change, or change of control, were to occur under the credit agreement, the
lenders would be entitled to declare all amounts outstanding under it
immediately due and payable and foreclose on the pledged assets. As of June 30,
2004, the Company was in compliance with all required financial covenants and
the Company was not aware of any events of default.
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,
referred to as 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.
-13-
8. LONG-TERM DEBT (CONTINUED):
Securitized Nonrecourse Debt:
NCO Portfolio has two securitized nonrecourse notes payable that were originally
established to fund the purchase of accounts receivable. Each of the notes
payable is nonrecourse to the Company, is secured by a portfolio of purchased
accounts receivable, and is bound by an indenture and servicing agreement. The
Company is servicer for each portfolio of purchased accounts receivable within
these securitized notes. These are term notes without the ability to re-borrow.
Monthly principal payments on the notes equal all collections after servicing
fees, collection costs, interest expense, and administrative fees.
The first securitized note was established in September 1998 through a special
purpose finance subsidiary. This note carries a floating interest rate of LIBOR
plus 0.65 percent per annum. The final due date of all payments under the
facility is the earlier of March 2005, or satisfaction of the note from
collections. A liquidity reserve of $900,000 and $5.4 million was included in
restricted cash as of June 30, 2004 and December 31, 2003, respectively. As of
June 30, 2004 and December 31, 2003, the amount outstanding on the facility was
$8.8 million and $13.9 million, respectively. The note issuer was guaranteed
against loss by NCO Portfolio for up to $4.5 million. In December 2003, the $4.5
million guarantee was funded using $3.3 million of restricted cash from another
securitization and $1.2 million of operating cash. In January 2004, the $4.5
million from the guarantee was used to pay down a portion of the securitized
note.
The second securitized note was established in August 1999 and carries interest
at 15.00 percent per annum. The final due date of all payments under the
facility is the earlier of December 2004, or satisfaction of the note from
collections. As of June 30, 2004 and December 31, 2003, the amount outstanding
on the facility was $19.1 million and $19.3 million, respectively.
Other Nonrecourse Debt:
In August 2002, NCO Portfolio entered into a four-year exclusivity agreement
with CFSC Capital Corp. XXXIV, referred to as Cargill. The agreement stipulates
that all purchases of accounts receivable by NCO Portfolio with a purchase price
in excess of $4.0 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 August 2004 for a cost
of $125,000 per month for each remaining month. If Cargill chooses to
participate in the financing of a portfolio of accounts receivable, the
financing will be at 90 percent of the purchase price, unless otherwise
negotiated, with floating interest at the prime rate plus 3.25 percent (prime
rate was 4.25 percent at June 30, 2004). Each borrowing is due two years after
the loan is made. Debt service payments equal collections less servicing fees
and interest expense. As additional return, 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.
The effective interest rate on these notes, including the residual interest
component, was approximately 33.6 percent and 29.06 percent for the three months
ended June 30, 2004 and 2003, respectively, and 34.2 percent and 26.84 percent
for the six months ended June 30, 2004 and 2003, respectively. Borrowings under
this financing agreement are nonrecourse to the Company, 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. Total
debt outstanding under this facility was $14.5 million and $17.6 million as of
June 30, 2004 and December 31, 2003, respectively, which included $5.8 million
and $4.7 million of accrued residual interest, respectively. As of June 30,
2004, NCO Portfolio was in compliance with all required covenants.
Upon full satisfaction of the notes payable and the return of members' capital
as it relates to each purchase of accounts receivable, the Company is obligated
to pay Cargill a contingent payment amount equal to 50 percent of collections
received, unless otherwise negotiated, net of servicing fees and other related
charges. The contingent payment has been accounted for as an embedded derivative
in accordance with SFAS 133. At issuance, the proceeds received were allocated
to the note payable and the embedded derivative. The resulting original issue
discount on the note payable is amortized to interest expense through maturity
using the effective interest method. At June 30, 2004 and December 31, 2003, the
estimated fair value of the embedded derivative was $5.8 million and $4.7
million respectively.
-14-
8. LONG-TERM DEBT (CONTINUED):
Capital Leases:
The Company leases certain equipment under agreements that are classified as
capital leases. The equipment leases have original terms ranging from 24 to 60
months and have purchase options at the end of the original lease term.
9. EARNINGS PER SHARE:
Basic earnings per share, referred to as EPS, was computed by dividing the net
income for the three and six months ended June 30, 2004 and 2003, by the
weighted average number of common shares outstanding. Diluted EPS was computed
by dividing the adjusted net income for the three and six months ended June 30,
2004 and 2003, by the weighted average number of common shares outstanding plus
all common equivalent shares. Net income is adjusted to add-back interest
expense on the convertible debt, net of taxes, if the convertible debt is
dilutive. The interest expense on the convertible debt, net of taxes, included
in the diluted EPS calculation was $913,000 and $920,000 for the three months
ended June 30, 2004 and 2003, respectively, and $1.8 million for the six months
ended June 30, 2004 and 2003. Outstanding options, warrants, and convertible
securities have been utilized in calculating diluted amounts 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 June 30, Ended June 30,
------------------ -----------------
2004 2003 2004 2003
------ ------ ------ ------
Basic 31,502 25,908 28,814 25,908
Dilutive effect of convertible debt 3,797 3,797 3,797 3,797
Dilutive effect of options 314 63 313 38
Dilutive effect of warrants 110 - 55 -
------ ------ ------ ------
Diluted 35,723 29,768 32,979 29,743
======= ====== ====== ======
10. DERIVATIVE FINANCIAL INSTRUMENTS:
The Company selectively uses derivative financial instruments to manage interest
costs and minimize currency exchange risk. The Company does not hold derivatives
for trading purposes. While these derivative financial instruments are subject
to fluctuations in value, these fluctuations are generally offset by the value
of the underlying exposures being hedged. The Company minimizes the risk of
credit loss by entering into these agreements with major financial institutions
that have high credit ratings.
A portion of the Company's business is performed in Canada for clients in the
United States, which exposes the Company's earnings, cash flows, and financial
position to risk from foreign currency denominated transactions. The Company
also has operations in the Philippines for clients in the United States, which
creates exposure from foreign currency denominated transactions that will
increase as these operations grow. Due to the growth of the Canadian operations,
a policy was established to minimize cash flow exposure to adverse changes in
currency exchange rates by identifying and evaluating the risk that cash flows
would be affected due to changes in exchange rates and by determining the
appropriate strategies necessary to manage such exposures. The Company's
objective is to maintain economically balanced currency risk management
strategies that provide adequate downside protection.
-15-
10. DERIVATIVE FINANCIAL INSTRUMENTS (CONTINUED):
In order to partially hedge cash flow economic exposure in Canada, the Company
entered into forward exchange contracts to minimize the impact of currency
fluctuations on transactions, cash flows and firm commitments. The Company had
forward exchange contracts for the purchase of $15.8 million of Canadian dollars
outstanding at June 30, 2004, which mature within 90 days, with a fair market
value of $336,593.
11. SUPPLEMENTAL CASH FLOW INFORMATION:
The following are supplemental disclosures of cash flow information (amounts in
thousands):
For the Six Months Ended
June 30,
------------------
2004 2003
-------- ------
Noncash investing and financing activities:
Common stock issued for acquisitions $128,699 $ -
Fair value of assets acquired 213,517 -
Liabilities assumed from acquisitions 84,925 -
Deferred portion of purchased accounts receivable 3,288 2,383
Deferred compensation from restricted stock 677 -
12. COMMITMENTS AND CONTINGENCIES:
Purchase Commitments:
The Company enters into noncancelable agreements with various telecommunications
and other vendors that require minimum purchase commitments. These agreements
expire between 2004 and 2007. The following represents the future minimum
payments, by year and in the aggregate, under noncancelable purchase commitments
(amounts in thousands):
2004 $23,043
2005 21,030
2006 14,453
2007 6,500
-------
$65,026
=======
The Company incurred $8.6 million and $3.5 million of expense in connection with
these purchase commitments for the three months ended June 30, 2004 and 2003,
respectively, and $15.8 million and $6.6 million for the six months ended June
30, 2004 and 2003, respectively.
Long-Term Collection Contract:
The Company has a long-term collection contract with a large client to provide
collection services that includes guaranteed collections, subject to limits. The
Company is required to pay the client the difference between actual collections
and the guaranteed collections on May 31, 2004 and May 31, 2005, subject to
limits of $6.0 million and $13.5 million, respectively. Any guarantees in excess
of the limits will only be satisfied with future collections. The Company is
entitled to recoup at least 90 percent of any such guarantee payments from
subsequent collections in excess of any remaining guarantees. On May 31, 2004,
the actual collections were $7.5 million below the guaranteed collections, or
$1.5 million in excess of the $6.0 million limit. Since the Company prepaid the
client $5.5 million from prior bonuses, it was only required to pay
approximately $528,000 as of May 31, 2004. Almost all of the remaining $1.5
million of guaranteed collections was paid to the client from bonuses earned
during June 2004.
-16-
12. COMMITMENTS AND CONTINGENCIES (CONTINUED):
Termination Fee:
The Company has a contract with a client to perform CRM services that includes a
termination clause. This contract expires on October 31, 2007.
In the event the client terminates the services agreement due to the Company's
material breach or a transaction in which a competitor of the client acquired
control of the Company or in the event the Company terminates the services
agreement for convenience after October 1, 2004, the Company is required to pay
a minimum termination fee of $153,000 for each month remaining in the agreement
(or $6.1 million at June 30, 2004). In most other instances (as defined in the
services agreement) in which either party terminates the services agreement, the
Company is required to pay a termination fee of $77,000 for each month remaining
in the services agreement (or $3.1 million at June 30, 2004).
Forward-Flow Agreement:
NCO Portfolio was party to a fixed price agreement that ended in May 2004,
referred to as forward-flow, with a major financial institution that obligated
NCO Portfolio to purchase, on a monthly basis, portfolios of charged-off
accounts receivable meeting certain criteria. A portion of the purchase price is
deferred for 24 months, including a nominal rate of interest. The deferred
purchase price payable is included in long-term debt and as of June 30, 2004 and
December 31, 2003, was $9.0 million and $6.5 million, respectively.
Litigation and Investigations:
The Company is party, from time to time, to various legal proceedings,
regulatory investigations and tax examinations incidental to its business. The
Company continually monitors these legal proceedings, regulatory investigations
and tax examinations to determine the impact and any required accruals.
FTC:
In October 2003, the Company was notified by the Federal Trade Commission,
referred to as the FTC, that it intended to pursue a claim against the Company
for violations of the Fair Credit Reporting Act relating to certain aspects of
the Company's credit reporting practices during 1999 and 2000.
The allegations related primarily to a large group of consumer accounts from one
client that were transitioned to the Company for servicing during 1999. The
Company received incorrect information from the prior service provider at the
time of transition. The Company became aware of the incorrect information during
2000 and ultimately removed the incorrect information from the consumers' credit
files. During the first quarter of 2004, the Company made a settlement offer for
this matter to the FTC. The FTC accepted the offer during the second quarter of
2004. The Company is asserting certain claims for indemnification from the
owners of the consumer accounts. In connection with the proposed settlement
offer made in the first quarter of 2004, the Company recorded its expected
exposure to this claim.
-17-
12. COMMITMENTS AND CONTINGENCIES (CONTINUED):
Litigation and Investigations (continued):
FTC (continued):
The Company is also a party to a class action litigation regarding this group of
consumer accounts. The class action litigation was settled and was covered by
insurance, subject to applicable deductibles.
The FTC is also alleging that certain reporting violations occurred on a small
subset of the Company's purchased accounts receivable.
The Company believes that the resolution of the above matters will not have a
material adverse effect on its financial position, results of operations or
business.
Fort Washington Flood:
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. The landlord and the former landlord filed counter-claims
against the Company. 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 and
alleging, among other things, that they breached their fiduciary duties to the
Company.
In January 2004, the Court, in ruling on the preliminary objections, allowed the
former landlord defendants' suit to proceed, but struck from the complaint the
breach of fiduciary duty allegations asserting violations of duties owed by
individual officers to the Company.
Other:
The Company is involved in other legal proceedings, regulatory investigations
and tax examinations from time to time in the ordinary course of its business.
Management believes that none of these other legal proceedings, regulatory
investigations or tax examinations will have a materially adverse effect on the
financial condition or results of operations of the Company.
13. SEGMENT REPORTING:
As of June 30, 2004, the Company's business consisted of four operating
divisions: ARM U.S., formerly known as U.S. Operations, CRM, Portfolio
Management and ARM International, formerly known as International Operations.
The accounting policies of the segments are the same as those described in note
2, "Accounting Policies."
Effective July 1, 2004, the Company will combine the Canadian portion of ARM
International with ARM U.S., and this division will be referred to as ARM
North America. The United Kingdom subsidiary will continue to operate as ARM
International. The information presented below does not reflect this
reorganization.
-18-
13. SEGMENT REPORTING (CONTINUED):
ARM U.S. provides accounts receivable management services to consumer and
commercial accounts for all market sectors including financial services,
healthcare, retail and commercial, telecommunications, utilities, education, and
government. ARM U.S. serves clients of all sizes in local, regional, and
national markets. In addition to traditional accounts receivable collections,
these services include developing the client relationship beyond bad debt
recovery and delinquency management, and delivering cost-effective accounts
receivable and customer relationship management solutions to all market sectors.
ARM U.S. had total assets, net of any intercompany balances, of $728.7 million
and $714.2 million at June 30, 2004 and December 31, 2003, respectively. ARM
U.S. had capital expenditures of $11.9 million and $8.9 million for the six
months ended June 30, 2004 and 2003, respectively. ARM U.S. also provides
accounts receivable management services to Portfolio Management. ARM U.S.
recorded revenue of $16.7 million and $12.1 million for these services for the
three months ended June 30, 2004 and 2003, respectively, and $31.8 million and
$24.4 million for the six months ended June 30, 2004 and 2003, respectively. The
accounting policies used to record the revenue from Portfolio Management are the
same as those described in note 2, "Accounting Policies."
With the April 2004 acquisition of RMH, the CRM division was formed. The CRM
division provides customer relationship management services to clients in the
United States through offices in the United States, Canada, the Philippines and
Panama. CRM had total assets, net of any intercompany balances, of $171.3
million at June 30, 2004. CRM had capital expenditures of $1.5 million for the
six months ended June 30, 2004. The accounting policies used to record the
revenue from CRM are the same as those described in note 2, "Accounting
Policies."
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 $148.0 million and $170.4 million
at June 30, 2004 and December 31, 2003, respectively.
ARM International provides accounts receivable management services across Canada
and the United Kingdom. ARM International had total assets, net of any
intercompany balances, of $62.2 million and $61.5 million at June 30, 2004 and
December 31, 2003, respectively. ARM International had capital expenditures of
$1.1 million and $1.3 million for the six months ended June 30, 2004 and 2003,
respectively. ARM International also provides accounts receivable management
services to ARM U.S. ARM International recorded revenue of $10.6 million and
$6.8 million for these services for the three months ended June 30, 2004 and
2003, respectively, and $20.3 million and $12.5 million for the six months ended
June 30, 2004 and 2003, respectively. The accounting policies used to record the
revenue from ARM U.S. are the same as those described in note 2, "Accounting
Policies."
The following tables represent the revenue, payroll and related expenses,
selling, general, and administrative expenses, and 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, 2004
(amounts in thousands)
---------------------------------------------------
Payroll and Selling, General
Related and Admin.
Revenue Expenses Expenses EBITDA
-------- -------- --------------- -------
ARM U.S. $177,712 $ 87,579 $68,612 $21,521
CRM 59,445 42,476 10,147 6,822
Portfolio Management 24,132 485 17,012 6,635
ARM International 21,329 12,903 4,724 3,702
Eliminations (27,363) (10,620) (16,743) -
-------- -------- -------- -------
Total $255,255 $132,823 $83,752 $38,680
======== ======== ======== =======
-19-
13. SEGMENT REPORTING (CONTINUED):
For the Three Months Ended June 30, 2003
(amounts in thousands)
---------------------------------------------------
Payroll and Selling, General
Related and Admin.
Revenue Expenses Expenses EBITDA
-------- -------- ---------------- -------
ARM U.S. $172,011 $84,411 $65,214 $22,386
Portfolio Management 18,086 563 13,382 4,141
ARM International 17,361 10,128 4,234 2,999
Eliminations (18,884) (6,772) (12,112) -
-------- -------- -------- -------
Total $188,574 $88,330 $70,718 $29,526
======== ======== ======== =======
For the Six Months Ended June 30, 2004
(amounts in thousands)
---------------------------------------------------
Payroll and Selling, General
Related and Admin.
Revenue Expenses Expenses EBITDA
-------- -------- ---------------- -------
ARM U.S. $361,131 $175,358 $139,839 $45,934
CRM 59,445 42,476 10,147 6,822
Portfolio Management 45,734 1,132 33,103 11,499
ARM International 42,340 25,237 9,131 7,972
Eliminations (52,164) (20,341) (31,823) -
-------- -------- -------- -------
Total $456,486 $223,862 $160,397 $72,227
======== ======== ======== =======
For the Six Months Ended June 30, 2003
(amounts in thousands)
---------------------------------------------------
Payroll and Selling, General
Related and Admin.
Revenue Expenses Expenses EBITDA
-------- ----------- ---------------- -------
ARM U.S. $345,116 $168,912 $129,601 $46,603
Portfolio Management 36,318 1,043 26,503 8,772
ARM International 33,115 19,212 7,991 5,912
Eliminations (36,958) (12,539) (24,419) -
-------- -------- -------- -------
Total $377,591 $176,628 $139,676 $61,287
======== ======== ======== =======
14. INVESTMENT IN UNCONSOLIDATED SUBSIDIARY:
NCO Portfolio has a 50 percent ownership interest in a joint venture,
InoVision-MEDCLR NCOP Ventures, LLC, referred to as the Joint Venture, with IMNV
Holdings, LLC, referred to as IMNV. The Joint Venture was established in 2001 to
purchase utility, medical and various other small balance accounts receivable
and is accounted for using the equity method of accounting. Included in "other
assets" on the Balance Sheets were NCO Portfolio's investment in the Joint
Venture of $4.1 million and $4.0 million as of June 30, 2004 and December 31,
2003, respectively. Included in the Statements of Income, as "interest and
investment income," was, $442,000 and $479,000 for the three months ended June
30, 2004 and 2003, respectively, representing NCO Portfolio's 50 percent share
of net income from this unconsolidated subsidiary. Income of $1.0 million and
$952,000 was recorded from this unconsolidated subsidiary for the six months
ended June 30, 2004 and 2003, respectively. NCO Portfolio received distributions
of $1.4 million and $72,000 during the six months ended June 30, 2004 and June
30, 2003, respectively. NCO Portfolio's 50 percent share of the Joint Venture's
retained earnings was $1.0 million and $1.3 million as of June 30, 2004 and
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14. INVESTMENT IN UNCONSOLIDATED SUBSIDIARY (CONTINUED):
December 31, 2003, respectively. The Company performs collection services for
the Joint Venture and recorded service fee revenue of $1.8 million and $1.4
million for the three months ended June 30, 2004 and 2003, respectively, and
$3.7 million and $3.0 million for the six months ended June 30, 2004 and 2003,
respectively. The Company had receivables of $1.4 million and $269,000 on its
balance sheets as of June 30, 2004 and December 31, 2003, respectively, for
these service fees. The Company also performs collection services for an
affiliate of IMNV and recorded service fee revenue of $2.6 million and $2.9
million for the three months ended June 30, 2004 and 2003, respectively, and
$5.5 million for the six months ended June 30, 2004 and 2003.
The following tables summarize the financial information of the Joint Venture
(amounts in thousands):
As of
--------------------------------------------
June 30, 2004 December 31, 2003
-------------------- ---------------------
Total assets $13,648 $15,344
Total liabilities 6,397 7,415
For the Six Months Ended
June 30,
--------------------------
2004 2003
------------ -----------
Revenue $7,987 $6,440
Net income 2,150 1,903
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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, fluctuations in
quarterly operating results, the integration of acquisitions, the long-term
collection contract, the final outcome of the environmental liability, the final
outcome of 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 proceedings, regulatory
investigation or tax examinations, 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 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 related to possible impairments of goodwill and other
intangible assets, risks associated with technology, risks related to the ERP
implementation, risks related to the final outcome of the environmental
liability, risks related to the final outcome of the Company's litigation with
its former landlord, risks relating to the Company's litigation, regulatory
investigations and tax examinations, risks related to past or possible future
terrorist attacks, risks related to the threat or outbreak of war or
hostilities, risks related to the domestic and international economy, risks
related to the Company's international operations, 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 for the year
ended December 31, 2003, 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 2003, 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, 2004, COMPARED TO THREE MONTHS ENDED JUNE 30,
2003
Revenue. Revenue increased $66.7 million, or 35.4 percent, to $255.3
million for the three months ended June 30, 2004, from $188.6 million for the
three months ended June 30, 2003.
Our operations are organized into four market specific divisions that
include: ARM U.S., CRM, Portfolio Management, and ARM International. For the
three months ended June 30, 2004, these divisions accounted for $177.7 million,
$59.4 million, $24.1 million, and $21.3 million of revenue, respectively.
Included in ARM U.S.'s revenue was $16.7 million of intercompany revenue from
Portfolio Management, which was eliminated upon consolidation and included in
ARM International's revenue was $10.6 million of intercompany revenue from ARM
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U.S., which was eliminated upon consolidation. For the three months ended June
30, 2003, the ARM U.S., Portfolio Management and ARM International divisions
accounted for $172.0 million, $18.1 million and $17.4 million of revenue,
respectively. Included in ARM U.S.'s revenue was $12.1 million of intercompany
revenue from Portfolio Management that was eliminated upon consolidation and
included in ARM International's revenue was $6.8 million of intercompany revenue
from ARM U.S. that was eliminated upon consolidation. The CRM division was
formed in the second quarter of 2004 with the acquisition of RMH Teleservices,
Inc., referred to as RMH, on April 2, 2004 and, accordingly, is not included in
the results for 2003.
ARM U.S.'s revenue increased $5.7 million, or 3.3 percent, to $177.7
million for the three months ended June 30, 2004, from $172.0 million for the
three months ended June 30, 2003. The increase in ARM U.S. revenue was partially
attributable to an increase in fees from collection services performed for
Portfolio Management, growth in business from existing clients and the addition
of new clients. ARM U.S.'s revenue for the three months ended June 30, 2004 and
2003 included revenue recorded from the 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, subject to limits. During the three months ended June 30, 2004, ARM
U.S. earned $956,000 of revenue from bonuses and recovery of penalties,
compared to an additional deferral of revenue of $1.7 million for the three
months ended June 30, 2003.
Portfolio Management's revenue increased $6.0 million, or 33.4 percent, to
$24.1 million for the three months ended June 30, 2004, from $18.1 million for
the three months ended June 30, 2003. Portfolio Management's collections
increased $11.0 million, or 30.7 percent, to $46.6 million for the three months
ended June 30, 2004, from $35.6 million for the three months ended June 30,
2003. Portfolio Management's revenue represented 52 percent of collections for
the three months ended June 30, 2004, as compared to 51 percent of collections
for the three months ended June 30, 2003. Revenue increased due to the increase
in collections from new purchases of receivables and higher collections due to a
better collection environment, especially on certain large portfolios that
continued to outperform expectations. Collections for the three months ended
June 30, 2004 and 2003, included proceeds from portfolio sales of $4.2 million
and $80,000, respectively.
ARM International's revenue increased $4.0 million, or 22.9 percent, to
$21.3 million for the three months ended June 30, 2004, from $17.4 million for
the three months ended June 30, 2003. The increase in ARM International's
revenue was primarily attributable to an increase in the services provided to
ARM U.S. In addition, a portion of the increase was attributable to the addition
of new clients, growth in business from existing clients and favorable changes
in the foreign currency exchange rates used to translate ARM International's
results of operations into U.S. dollars.
Payroll and related expenses. Payroll and related expenses increased $44.5
million to $132.8 million for the three months ended June 30, 2004, from $88.3
million for the three months ended June 30, 2003, and increased as a percentage
of revenue to 52.0 percent from 46.8 percent. The increase in payroll and
related expenses as a percentage of revenue was primarily attributable to the
CRM division, which was formed with the acquisition of RMH in April 2004. The
CRM division has a more significant amount of payroll and related expenses as
compared to the ARM business.
ARM U.S.'s payroll and related expenses increased $3.2 million to $87.6
million for the three months ended June 30, 2004, from $84.4 million for the
three months ended June 30, 2003, and increased slightly as a percentage of
revenue to 49.3 percent from 49.1 percent.
Portfolio Management's payroll and related expenses decreased $78,000 to
$485,000 for the three months ended June 30, 2004, from $563,000 for the three
months ended June 30, 2003, and decreased as a percentage of revenue to 2.0
percent from 3.1 percent. Portfolio Management outsources all of the collection
services to ARM U.S. and, therefore, has a relatively small fixed payroll cost
structure. The decrease in payroll and related expenses as a percentage of
revenue was due to the absorption of the fixed payroll costs over a larger
revenue base.
ARM International's payroll and related expenses increased $2.8 million to
$12.9 million for the three months ended June 30, 2004, from $10.1 million for
the three months ended June 30, 2003, and increased as a percentage of revenue
to 60.5 percent from 58.3 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 ARM
-23-
International's business. However, 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 effect of 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 $13.1 million to $83.8 million for the three
months ended June 30, 2004, from $70.7 million for the three months ended June
30, 2003, but decreased as a percentage of revenue to 32.8 percent from 37.5
percent. The decrease in selling, general and administrative expenses as a
percentage of revenue was primarily attributable to the CRM division, which was
formed with the acquisition of RMH on April 2, 2004. The CRM division has a more
significant portion of their expense structure in payroll and related expenses
as compared to the ARM business.
Depreciation and amortization. Depreciation and amortization increased to
$11.1 million for the three months ended June 30, 2004, from $8.0 million for
the three months ended June 30, 2003. The increase was attributable to the
amortization of the fair value assigned to the customer relationships acquired
in connection with the RMH acquisition and the depreciation of property and
equipment acquired in connection with the RMH acquisition.
Other income (expense). Interest and investment income included investment
income of $442,000 for the three months ended June 30, 2004, as compared to
$479,000 for the three months ended June 30, 2003, from the 50 percent ownership
interest in a joint venture that purchases utility, medical and other various
small balance accounts receivable. Interest expense decreased to $5.3 million
for the three months ended June 30, 2004, from $5.9 million for the three months
ended June 30, 2003. The decrease was attributable to lower principal balances
as a result of debt repayments made in excess of borrowings against the credit
facility during 2004 and 2003, and lower interest rates. The decrease was
partially offset by Portfolio Management's additional nonrecourse borrowings
from CFSC Capital Corp. XXXIV, referred to as Cargill, to purchase accounts
receivable. Other income for the three months ended June 30, 2004, included a
$621,000 gain related to a benefit from a deferred compensation plan assumed as
part of the acquisition of FCA International Ltd. in May 1998. 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 and $250,000
of income from a partial recovery from a third party of an environmental
liability.
Income tax expense. Income tax expense for the three months ended June 30,
2004, increased to $9.1 million, or 38.6 percent of income before income tax
expense, from $6.5 million, or 37.9 percent of income before income tax expense,
for the three months ended June 30, 2003. The increase in the effective tax rate
was primarily attributable to changes in state income taxes.
SIX MONTHS ENDED JUNE 30, 2004, COMPARED TO SIX MONTHS ENDED JUNE 30, 2003
Revenue. Revenue increased $78.9 million, or 20.9 percent, to $456.5
million for the six months ended June 30, 2004, from $377.6 million for the six
months ended June 30, 2003.
For the six months ended June 30, 2004, our ARM U.S., CRM, Portfolio
Management, and ARM International divisions accounted for $361.1 million, $59.5
million, $45.7 million, and $42.3 million of revenue, respectively. Included in
ARM U.S.'s revenue was $31.8 million of intercompany revenue from Portfolio
Management, which was eliminated upon consolidation and included in ARM
International's revenue was $20.3 million of intercompany revenue from ARM U.S.,
which was eliminated upon consolidation. For the six months ended June 30, 2003,
the ARM U.S., Portfolio Management and ARM International divisions accounted for
$345.1 million, $36.3 million and $33.1 million of revenue, respectively.
Included in ARM U.S.'s revenue was $24.4 million of intercompany revenue from
Portfolio Management that was eliminated upon consolidation and included in ARM
International's revenue was $12.5 million of intercompany revenue from ARM U.S.
that was eliminated upon consolidation. The CRM division was formed in the
second quarter of 2004 in connection with the acquisition of RMH on April 2,
2004 and, accordingly, is not included in the results for 2003.
ARM U.S.'s revenue increased $16.0 million, or 4.6 percent, to $361.1
million for the six months ended June 30, 2004, from $345.1 million for the six
months ended June 30, 2003. The increase in ARM U.S.'s revenue was partially
attributable to an increase in fees from collection services performed for
Portfolio Management, growth in business from existing clients and the addition
of new clients. ARM U.S.'s revenue for the six months ended June 30, 2004 and
2003 included revenue recorded from the long-term collection contract. The
-24-
method of recognizing revenue for this long-term collection contract defers
certain revenues into future periods until collections exceed collection
guarantees, subject to limits. During the six months ended June 30, 2004, ARM
U.S. earned $2.6 million of revenue from bonuses and recovery of penalties,
compared to an additional deferral of revenue of $2.7 million for the six months
ended June 30, 2003.
Portfolio Management's revenue increased $9.4 million, or 25.9 percent, to
$45.7 million for the six months ended June 30, 2004, from $36.3 million for the
six months ended June 30, 2003. Portfolio Management's collections increased
$17.7 million, or 24.5 percent, to $90.1 million for the six months ended June
30, 2004, from $72.4 million for the six months ended June 30, 2003. Portfolio
Management's revenue represented 51 percent of collections for the six months
ended June 30, 2004, as compared to 50 percent of collections for the six months
ended June 30, 2003. Revenue increased due to the increase in collections from
new purchases of receivables and higher collections due to a better collection
environment, especially on certain large portfolios that continued to outperform
expectations. Collections for the six months ended June 30, 2004 and 2003,
included proceeds from portfolio sales of $4.2 million and $1.5 million,
respectively.
ARM International's revenue increased $9.2 million, or 27.9 percent, to
$42.3 million for the six months ended June 30, 2004, from $33.1 million for the
six months ended June 30, 2003. The increase in ARM International's revenue was
primarily attributable to an increase in the services provided to ARM U.S. In
addition, a portion of the increase was attributable to the addition of new
clients, growth in business from existing clients and favorable changes in the
foreign currency exchange rates used to translate ARM International's results of
operations into U.S. dollars.
Payroll and related expenses. Payroll and related expenses increased $47.2
million to $223.9 million for the six months ended June 30, 2004, from $176.6
million for the six months ended June 30, 2003, and increased as a percentage of
revenue to 49.0 percent from 46.6 percent. The increase in payroll and related
expenses as a percentage of revenue was primarily attributable to the CRM
division, which was formed with the acquisition of RMH on April 2, 2004. The CRM
division has a more significant amount of payroll and related expenses as
compared to the ARM business.
ARM U.S.'s payroll and related expenses increased $6.5 million to $175.4
million for the six months ended June 30, 2004, from $168.9 million for the six
months ended June 30, 2003, and decreased slightly as a percentage of revenue to
48.6 percent from 48.9 percent. The decrease in the payroll and related expenses
as a percentage of revenue was attributable to the deferral of $2.7 million of
revenue from the long-term contract recorded for the six months ended June 30,
2003.
Portfolio Management's payroll and related expenses increased $89,000 to
$1.1 million for the six months ended June 30, 2004, from $1.0 million for the
six months ended June 30, 2003, but decreased as a percentage of revenue to 2.5
percent from 2.9 percent. Portfolio Management outsources all of the collection
services to ARM U.S. and, therefore, has a relatively small fixed payroll cost
structure. The decrease in payroll and related expenses as a percentage of
revenue was due to the absorption of the fixed payroll costs over a larger
revenue base.
ARM International's payroll and related expenses increased $6.0 million to
$25.2 million for the six months ended June 30, 2004, from $19.2 million for the
six months ended June 30, 2003, and increased as a percentage of revenue to 59.6
percent from 58.0 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 ARM
International's business. However, 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 effect of 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 $20.7 million to $160.4 million for the six
months ended June 30, 2004, from $139.7 million for the six months ended June
30, 2003, but decreased as a percentage of revenue to 35.1 percent from 37.0
percent. The decrease in selling, general and administrative expenses as a
percentage of revenue was primarily attributable to the CRM division, which was
formed with the acquisition of RMH on April 2, 2004. The CRM division has a more
significant portion of their expense structure in payroll and related expenses
as compared to the ARM business.
-25-
Depreciation and amortization. Depreciation and amortization increased to
$18.9 million for the six months ended June 30, 2004, from $15.9 million for the
six months ended June 30, 2003. The increase was attributable to the
amortization of the customer relationships and property and equipment acquired
in the RMH acquisition on April 2, 2004.
Other income (expense). Interest and investment income included investment
income of $1.0 million for the six months ended June 30, 2004, as compared to
$952,000 for the six months ended June 30, 2003, from the 50 percent ownership
interest in a joint venture that purchases utility, medical and other various
small balance accounts receivable. Interest expense decreased to $10.5 million
for the six months ended June 30, 2004, from $11.7 million for the six months
ended June 30, 2003. The decrease was attributable to lower principal balances
as a result of debt repayments made in excess of borrowings against the credit
facility during 2004 and 2003, and lower interest rates. The decrease was
partially offset by Portfolio Management's additional nonrecourse borrowings
from Cargill to purchase accounts receivable. Other income for the six months
ended June 30, 2004, included a $621,000 gain related to a benefit from a
deferred compensation plan assumed as part of the acquisition of FCA
International Ltd. in May 1998. Other income 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 and $250,000 of income from a partial recovery
from a third party of an environmental liability.
Income tax expense. Income tax expense for the six months ended June 30,
2004, increased to $18.0 million, or 39.9 percent of income before income tax
expense, from $13.7 million, or 37.9 percent of income before income tax
expense, for the six months ended June 30, 2003. The increase in the effective
tax rate was primarily attributable to the liability recorded related to the
proposed settlement offer we made during the three months ended June 30, 2004
related to the Federal Trade Commission's claim against us for alleged
violations of the Fair Credit Reporting Act relating to certain aspects of our
credit reporting practices during 1999 and 2000. We received incorrect
information from the prior service provider at the time of transition and we
believe that we may assert certain claims for indemnification from the owners of
the consumer accounts. The expense recorded for the claim is not deductible for
taxes purposes. However, the reimbursement from the indemnification, if any, may
be taxable. The nondeductible expense results in an increase in the effective
rate for the first six months of 2004. The increase was also attributable to
changes in state income taxes.
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.
We believe that funds generated from operations, together with existing
cash and available borrowings under our credit agreement, will be sufficient to
finance our current operations, planned capital expenditure requirements, and
internal growth at least through the next twelve months. However, we could
require additional debt or equity financing if we were to make any significant
acquisitions for cash during that period.
The cash flow from our contingency collection business and our purchased
portfolio business is dependent upon our ability to collect from consumers and
businesses. Many factors, including the economy and our ability to hire and
retain qualified collectors and managers, are essential to our ability to
generate cash flows. Fluctuations in these trends that cause a negative impact
on our business could have a material impact on our expected future cash flows.
Cash Flows from Operating Activities. Cash provided by operating activities
was $55.3 million for the six months ended June 30, 2004, compared to $35.7
million for the six months ended June 30, 2003. The increase in cash provided by
operations was partially attributable to increases in net income and non-cash
expenses, and a $2.1 million increase in accounts payable and accrued expenses
for the six months ended June 30, 2004, as compared to a $4.3 million decrease
for the same period in the prior year. A portion of the increase was also
attributable to the transfer of $4.5 million out of restricted cash during the
first quarter of 2004 to repay a portion of the securitized nonrecourse debt.
The increase was partially offset by a larger increase in trade accounts
receivable during the six months ended June 30, 2004.
-26-
Cash Flows from Investing Activities. Cash used in investing activities was
$2.4 million for the six months ended June 30, 2004, compared to $2.3 million
for the six months ended June 30, 2003. The increase in cash used in investing
activities was primarily attributable to the cash paid for RMH related
acquisition costs and higher purchases of property and equipment during the six
months ended June 30, 2004. These increases were partially offset by lower
purchases of accounts receivable and higher collections applied to purchased
accounts receivable during the six months ended June 30, 2004.
Cash Flows from Financing Activities. Cash used in financing activities was
$39.7 million for the six months ended June 30, 2004, compared to $29.8 million
for the six months ended June 30, 2003. The increase in cash used in financing
activities in the first quarter of 2004 resulted from the repayment of a note
payable assumed in connection with the RMH acquisition and higher repayments of
borrowings under nonrecourse debt used to purchase large accounts receivable
portfolios. These increases were partially offset from the issuance of common
stock in connection with stock option exercises.
Credit Facility. On August 13, 2003, we amended our credit agreement with
Citizens Bank of Pennsylvania, referred to as 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, referred to as the Maturity
Date. The amended credit facility is structured as a $150.0 million term loan
and a $50.0 million revolving credit facility. We are required to make quarterly
repayments of $6.3 million on the term loan until the Maturity Date. The
remaining balance outstanding under the term loan and the balance under the
revolving credit facility will become due on the Maturity Date. As of June 30,
2004, there was $47.2 million available under the revolving credit facility.
The credit agreement contains certain financial and other covenants, such
as maintaining net worth and funded debt to earnings before interest, taxes,
depreciation, and amortization, referred to as EBITDA, requirements, and
includes restrictions on, among other things, acquisitions, the incurrence of
additional debt, the issuance of equity, and distributions to shareholders. If
an event of default, such as failure to comply with covenants, material adverse
change, or change of control, were to occur under the credit agreement, the
lenders would be entitled to declare all amounts outstanding under it
immediately due and payable. As of June 30, 2004, we were in compliance with all
required financial covenants and we were not aware of any events of default.
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, referred to as the 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. We used the
$121.3 million of net proceeds from this offering to repay debt under our credit
agreement.
Nonrecourse Debt. In August 2002, NCO Portfolio entered into a four-year
financing agreement with Cargill to provide financing for larger purchases of
accounts receivable at 90 percent of the purchase price, unless otherwise
negotiated. Cargill, at its sole discretion, has the right to finance any
purchase of $4.0 million or more. Cargill may or may not choose to finance a
transaction. This agreement gives NCO Portfolio the financing to purchase larger
portfolios that it may not otherwise be able to purchase, and has no minimum or
maximum credit authorization. Borrowings carry interest at the prime rate plus
3.25 percent (prime rate was 4.25 percent at June 30, 2004) and are nonrecourse
to NCO Portfolio and us, except for the assets financed through Cargill. Debt
service payments equal total collections less servicing fees and expenses until
each individual borrowing is fully repaid and NCO Portfolio's original
investment is returned, including interest. Thereafter, Cargill is paid a
residual of 40 percent of collections, less servicing costs, unless otherwise
negotiated. Individual loans are required to be repaid based on collections, but
not more than two years from the date of borrowing. Total debt outstanding under
this facility as of June 30, 2004, was $14.5 million, including $5.8 million of
accrued residual interest. As of June 30, 2004, NCO Portfolio was in compliance
with all of the financial covenants.
Contractual Obligations. On April 2, 2004, in connection with the
acquisition of RMH, we assumed purchase obligations of $4.8 million and capital
lease commitments of $12.2 million.
-27-
OFF-BALANCE SHEET ARRANGEMENTS
NCO Portfolio has a 50 percent ownership interest in a joint venture,
InoVision-MEDCLR-NCOP Ventures, LLC, referred to as the Joint Venture, with IMNV
Holdings, LLC, referred to as IMNV. The Joint Venture was established in 2001 to
purchase utility, medical and other various small balance accounts receivable
and is accounted for using the equity method of accounting. Included in "other
assets" on the balance sheets was NCO Portfolio's investment in the Joint
Venture of $4.1 million and $4.0 million as of June 30, 2004 and December 31,
2003, respectively. Included in the Statements of Income, as "interest and
investment income," was, $442,000 and $479,000 for the three months ended June
30, 2004 and 2003, respectively, representing NCO Portfolio's 50 percent share
of operating income from this unconsolidated subsidiary. Income of $1.0 million
and $952,000 was recorded from this unconsolidated subsidiary for the six months
ended June 30, 2004 and 2003, respectively.
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. A 10 percent change in the foreign currency exchange rates
could have a material impact on our business. 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: goodwill, customer relationships, revenue
recognition for purchased accounts receivable, allowance for doubtful accounts,
notes receivable 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 2003 financial statements contained in our Annual
Report on Form 10-K for the year ended December 31, 2003. During the six months
ended June 30, 2004, we did not make any material changes to our estimates or
methods by which estimates are derived with regard to our critical accounting
policies except for recording the goodwill and customer relationships from the
acquisition of RMH.
Customer Relationships. As a result of one acquisition made during 2004 and
two acquisitions made during 2002, the recorded value of customer relationships
as of June 30, 2004 was $29.5 million. We made significant assumptions to
estimate the future revenue and cash flows used to determine the fair value of
the customer relationships. These assumptions included expected life, attrition
rates, discount factors, future tax rates, and other factors. If the expected
revenue and cash flows are not realized impairment losses may be recorded in the
future.
IMPACT OF RECENTLY ISSUED AND PROPOSED ACCOUNTING PRONOUNCEMENTS
SOP 03-3 Accounting for Certain Loans or Debt Securities Acquired in a
Transfer. We currently follow the accounting guidance in Practice Bulletin #6
for the accounting for purchased accounts receivable portfolios. Practice
Bulletin #6 has been superceded by SOP 03-3 - Accounting for Certain Loans or
Debt Securities Acquired in a Transfer, referred to as SOP 03-3. SOP 03-3 is
effective for loans acquired in fiscal years beginning after December 15, 2004,
although early adoption is permitted. SOP 03-3 applies 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. SOP 03-3
addresses accounting for differences between contractual and expected cash flows
from an investor's initial investment in certain loans when such differences are
attributable, in part, to credit quality. SOP 03-3 also addresses such loans
acquired in purchased business combinations.
SOP 03-3 limits the revenue that may be accrued to the excess of the
estimate of expected cash flows over a portfolio's initial cost of accounts
receivable acquired. SOP 03-3 requires that the excess of the contractual cash
flows over expected cash flows not be recognized as an adjustment of revenue,
expense, or on the balance sheet. SOP 03-3 freezes the internal rate of return,
referred to as the 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 is written down to maintain the original IRR. Increases in expected
cash flows are to be recognized prospectively through adjustment of the IRR over
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a portfolio's remaining life up to the limit of the initial cost of the accounts
receivable acquired. Loans acquired in the same fiscal quarter with common risk
characteristics may be aggregated for the purpose of applying SOP 03-3. We are
in the process of determining the effect SOP 03-3 will have on our financial
position and results of operations.
FASB Interpretation No. 46, "Consolidation of Variable Interest Entities".
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of
Variable Interest Entities," referred to as FIN 46. 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
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. On
January 1, 2004, we adopted FIN 46. We have a $10.8 million note receivable and
a $5.5 million note receivable included in our balance sheet under current and
long-term other assets as of June 30, 2004. These notes receivable are from two
separate companies that comprised our Market Strategy division that were sold
during 2000. Under FIN 46, the companies that issued these notes receivable are
considered variable interest entities. Based on our evaluation of these variable
interest entities, we are not required to consolidate theses entities under FIN
46.
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
Our management, with participation of our chief executive officer and chief
financial officer, conducted an evaluation as of the end of the period covered
by this report, of the effectiveness of our disclosure controls and procedures,
as defined in Exchange Act Rule 13a-15(e). Based on that evaluation, our chief
executive officer and chief financial officer concluded that our disclosure
controls and procedures were effective in reaching a reasonable level of
assurance that management is timely alerted to material information relating to
us during the period when our periodic reports are being prepared.
During the quarter ended June 30, 2004, there has not occurred any change
in our internal control over financial reporting, as defined in Exchange Act
Rule 13a-15(f), that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
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.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
-----------------
FTC:
In October 2003, the Company was notified by the Federal Trade
Commission, referred to as the FTC, that it intends to pursue a claim
against the Company for violations of the Fair Credit Reporting Act,
relating to certain aspects of the Company's credit reporting practices
during 1999 and 2000.
The allegations relate primarily to a large group of consumer accounts
from one client that were transitioned to the Company for servicing during
1999. The Company received incorrect information from the prior service
provider at the time of transition. The Company became aware of the
incorrect information during 2000 and ultimately removed the incorrect
information from the consumers' credit files. During the first quarter of
2004, the Company made a settlement offer for this matter to the FTC. The
FTC accepted the offer during the second quarter of 2004. The Company is
asserting certain claims for indemnification from the owners of the
consumer accounts. In connection with the proposed settlement offer made in
the first quarter of 2004, the Company recorded its expected exposure to
this claim.
The Company is also a party to a class action litigation regarding
this group of consumer accounts. The class action litigation was settled
and was covered by insurance, subject to applicable deductibles.
The FTC is also alleging that certain reporting violations occurred on
a small subset of the Company's purchased accounts receivable.
The Company believes that the resolution of the above matters will not
have a material adverse effect on its financial position, results of
operations or business.
Fort Washington Flood:
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.
The landlord and the former landlord filed counter-claims against the
Company. 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 and alleging, among other things, that they
breached their fiduciary duties to the Company.
In January 2004, the Court, in ruling on the preliminary objections,
allowed the former landlord defendants' suit to proceed, but struck from
the complaint the breach of fiduciary duty allegations asserting violations
of duties owed by individual officers to the Company.
Other:
The Company is involved in other legal proceedings and regulatory
investigations from time to time in the ordinary course of its business.
Management believes that none of these other legal proceedings or
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regulatory investigations will have a materially adverse effect on the
financial condition or results of operations of the Company.
Item 2. Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity
----------------------------------------------------------------------
Securities
----------
None - not applicable
Item 3. Defaults Upon Senior Securities
-------------------------------
None - not applicable
Item 4. Submission of Matters to a Vote of Shareholders
-----------------------------------------------
The Annual Meeting of Shareholders of the Company was held on May 17,
2004. At the Annual Meeting, the shareholders elected William C.
Dunkelberg, Ph. D. and Allen F. Wise as directors to serve for a term of
three years as described below:
Number of Votes
---------------
Withhold
Name For Authority
---- --- ---------
William C. Dunkelberg, Ph. D. 24,092,091 1,656,674
Allen F. Wise 16,320,390 9,428,375
In addition, the terms of the following directors continued after the
Annual Meeting: Michael J. Barrist, Charles C. Piola, Jr., Leo J. Pound,
and Eric S. Siegel.
At the Annual Meeting, the shareholders also approved the 2004 Equity
Incentive Plan as follows:
For Against Abstain Broker Non-Vote
--- ------- ------- ---------------
17,226,240 5,661,302 27,413 2,833,810
Item 5. Other Information
-----------------
None - not applicable
Item 6. Exhibits and Reports on Form 8-K
--------------------------------
(a) Exhibits
3.4 Amended and Restated Bylaws.
10.1 2004 Equity Incentive Plan (compensatory plan).
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a) promulgated under the Exchange Act.
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a) promulgated under the Exchange Act.
32.1 Certification of the Company's Chief Executive Officer and
Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
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(b) Reports on Form 8-K
Date of
-------
Filing / Furnishing Item Reported
------------------- -------------
5/19/04 Item 7, Item 9 and Item 12 - Conference call
transcript from the earnings release for the
first quarter of 2004.
5/13/04 Item 7 and Item 9 - Press release announcing the
settlement of FTC claim.
5/4/04 Item 7, Item 9 and Item 12 - Press release
announcing the earnings for the first
quarter of 2004.
4/2/04 Item 5 and Item 7 - Press release announcing
completion of the acquisition of RMH
Teleservices, Inc.
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SIGNATURES
Pursuant to the requirements 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 9, 2004 By: Michael J. Barrist
--------------------------------
Michael J. Barrist
Chairman of the Board, President
and Chief Executive Officer
(principal executive officer)
Date: August 9, 2004 By: 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)
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Exhibit Index
-------------
Exhibit No. Description
- ----------- -----------
3.4 Amended and Restated Bylaws
10.1 2004 Equity Incentive Plan (compensatory plan).
31.1 Certification of Chief Executive Officer pursuant to Rule
13a-14(a) promulgated under the Exchange Act.
31.2 Certification of Chief Financial Officer pursuant to Rule
13a-14(a) promulgated under the Exchange Act.
32.1 Certification of the Company's Chief Executive Officer and
Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
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