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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE
TRANSITION PERIOD FROM __________ TO __________.
COMMISSION FILE NUMBER: 1-11416
CONSUMER PORTFOLIO SERVICES, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
California 33-0459135
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
16355 Laguna Canyon Road, Irvine, California 92618
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER: (949) 753-6800
FORMER NAME, FORMER ADDRESS AND FORMER FISCAL YEAR, IF CHANGED SINCE LAST
REPORT: N/A
Indicate by check mark whether the registrant (1) 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 by Rule 12b-2 of the Exchange Act). Yes [ ] No [X]
As of May 12, 2003 the registrant had 20,219,476 common shares outstanding.
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CONSUMER PORTFOLIO SERVICES, INC. AND SUBSIDIARIES
INDEX TO FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2003
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of March 31, 2003
and December 31, 2002............................................ 3
Condensed Consolidated Statements of Operations and
Comprehensive Income for the three-month periods ended
March 31, 2003 and 2002 .......................................... 4
Condensed Consolidated Statements of Cash Flows for the
three-month periods ended March 31, 2003 and 2002 ................ 5
Notes to Condensed Consolidated Financial Statements.............. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................... 20
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........ 32
Item 4. Controls and Procedures........................................... 33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................. 33
Item 6. Exhibits and Reports on Form 8-K.................................. 34
Signatures................................................................. 34
Certifications............................................................. 35
2
ITEM 1. FINANCIAL STATEMENTS
CONSUMER PORTFOLIO SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
MARCH 31, DECEMBER 31,
2003 2002
---------- ----------
ASSETS
Cash $ 41,456 $ 32,947
Restricted cash 17,782 18,912
Finance receivables, net 81,700 110,420
Less: Allowance for finance credit losses (19,840) (25,828)
---------- ----------
Finance receivables 61,860 84,592
Servicing fees receivable 3,729 3,407
Residual interest in securitizations 127,112 127,170
Furniture and equipment, net 1,438 1,612
Deferred financing costs 1,940 1,671
Deferred interest expense 2,026 2,695
Other assets 16,230 12,442
---------- ----------
$ 273,573 $ 285,448
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Accounts payable and accrued expenses $ 16,961 $ 18,132
Tax liabilities, net 7,009 8,800
Capital lease obligation 41 67
Notes payable 504 673
Securitization trust debt 54,165 71,630
Senior secured debt 53,308 50,072
Subordinated debt 35,996 36,000
Related party debt 17,500 17,500
---------- ----------
185,484 202,874
SHAREHOLDERS' EQUITY
Preferred stock, $1 par value;
authorized 5,000,000 shares; none issued -- --
Series A preferred stock, $1 par value;
authorized 5,000,000 shares;
3,415,000 shares issued; none outstanding -- --
Common stock, no par value; authorized
30,000,000 shares; 20,239,176 and 20,528,270
shares issued and outstanding at March 31,
2003 and December 31, 2002, respectively 63,017 63,929
Retained earnings 26,875 20,597
Comprehensive loss - minimum pension benefit
obligation, net (1,594) (1,594)
Deferred compensation (209) (358)
---------- ----------
88,089 82,574
---------- ----------
$ 273,573 $ 285,448
========== ==========
See accompanying Notes to Condensed Consolidated Financial Statements
3
CONSUMER PORTFOLIO SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS AND COMPREHENSIVE INCOME
(In thousands, except per share data)
(Unaudited)
THREE MONTHS ENDED
MARCH 31,
---------------------
2003 2002
--------- ---------
REVENUES:
Net gain on sale of contracts $ 4,555 $ 1,772
Interest income 9,328 7,744
Servicing fees 4,602 3,390
Other income 4,062 230
--------- ---------
22,547 13,136
--------- ---------
EXPENSES:
Employee costs 8,447 8,462
General and administrative 4,033 4,404
Interest 5,530 4,431
Marketing 965 1,485
Occupancy 980 841
Depreciation and amortization 238 288
--------- ---------
20,193 19,911
--------- ---------
Income (loss) before income tax benefit 2,354 (6,775)
Income tax benefit (3,924) (5,794)
--------- ---------
Income (loss) before extraordinary item 6,278 (981)
Extraordinary item, unallocated
negative goodwill -- 17,412
--------- ---------
Net income 6,278 16,431
--------- ---------
Other comprehensive income -- --
--------- ---------
Comprehensive income $ 6,278 $ 16,431
========= =========
Earnings (loss) per share before extraordinary item:
Basic $ 0.31 $ (0.05)
Diluted 0.29 (0.05)
Earnings per share, extraordinary item:
Basic $ -- $ 0.90
Diluted -- 0.90
Earnings per share after extraordinary item:
Basic $ 0.31 $ 0.85
Diluted 0.29 0.85
Number of shares used in computing earnings
(loss) per share:
Basic 20,270 19,286
Diluted 21,860 19,286
See accompanying Notes to Condensed Consolidated Financial Statements
4
CONSUMER PORTFOLIO SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
THREE MONTHS ENDED
MARCH 31,
-----------------------
2003 2002
---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 6,278 $ 16,431
Adjustments to reconcile net income to net cash
provided by operating activities:
Extraordinary gain, excess of assets acquired over purchase price -- (17,412)
Depreciation and amortization 238 288
Amortization of deferred financing costs 781 2,303
Provision for (recovery of) credit losses 66 (527)
NIR gains recognized, net (3,301) (143)
Loss on sale of furniture and equipment -- 5
Deferred compensation (140) 843
Releases of cash from Trusts to Company 8,979 16,672
Initial deposits to spread accounts (10,658) (1,273)
Net deposits to spread accounts (775) (973)
Decrease in receivables from Trusts and
investment in subordinated certificates 5,813 10,678
Changes in assets and liabilities:
Restricted cash 1,130 5,603
Purchases of contracts held for sale (87,342) (145,902)
Amortization and liquidation of contracts held for sale 110,008 155,327
Other assets (3,471) 545
Accounts payable and accrued expenses (1,171) (8,233)
Deferred tax asset/liability (1,791) 106
---------- ----------
Net cash provided by operating activities 24,644 34,338
CASH FLOWS FROM INVESTING ACTIVITIES:
Net related party receivables -- (7)
Purchase of subsidiary, net of cash acquired -- (29,467)
Purchases of furniture and equipment (35) (85)
---------- ----------
Net cash used in investing activities (35) (29,559)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of senior secured debt 25,000 46,242
Repayment of securitization trust debt (17,465) (12,011)
Repayment of senior secured debt (21,764) (789)
Repayment of subordinated debt (4) (22,500)
Repayment of capital lease obligations (26) (128)
Repayment of notes payable (169) (238)
Payment of financing costs (1,050) (1,037)
Purchase of common stock (643) --
Exercise of options and warrants 21 22
---------- ----------
Net cash provided by (used in) financing activities (16,100) 9,561
---------- ----------
Increase in cash 8,509 14,340
Cash at beginning of period 32,947 2,570
---------- ----------
Cash at end of period $ 41,456 $ 16,910
========== ==========
Supplemental disclosure of cash flow information:
Cash paid (received) during the period for:
Interest $ 4,258 $ 3,733
Income taxes (2,132) (5,683)
Supplemental disclosure of non-cash investing and financing activities:
Stock compensation (140) 843
See accompanying Notes to Condensed Consolidated Financial Statements
5
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Consumer Portfolio Services, Inc. ("CPS") was incorporated in California on
March 8, 1991. CPS and its subsidiaries (collectively, the "Company") specialize
primarily in the business of purchasing, selling and servicing retail automobile
installment sale contracts ("Contracts") originated by licensed motor vehicle
dealers ("Dealers") located throughout the United States. The Company purchases
Contracts with obligors who generally would not be expected to qualify for
traditional financing, such as that provided by commercial banks or automobile
manufacturers' captive finance companies.
MFN FINANCIAL CORPORATION ACQUISITION
On March 8, 2002, CPS acquired 100% of MFN Financial Corporation, a Delaware
corporation ("MFN") and its subsidiaries, by the merger (the "Merger") of CPS
Mergersub, Inc., a Delaware corporation ("Mergersub") and a direct wholly owned
subsidiary of CPS, with and into MFN. The Merger took place pursuant to an
Agreement and Plan of Merger, dated November 18, 2001 (the "Merger Agreement"),
among CPS, Mergersub and MFN. In the Merger, MFN became a wholly owned
subsidiary of CPS. CPS thus acquired the assets of MFN, consisting principally
of interests in automobile installment sales finance Contracts and the
facilities for originating and servicing such Contracts. The Merger was
accounted for as a purchase.
MFN, through its primary operating subsidiary, Mercury Finance Company LLC, was
in the business of purchasing automobile installment sales finance Contracts
from Dealers, and securitizing and servicing such Contracts. CPS intends to
continue to use the assets acquired in the Merger in the automobile finance
business, but a portion of such assets have been disposed of. CPS has ceased to
use the acquired assets for the purchase of automobile installment sales finance
Contracts, and does not anticipate recommencing such use. In connection with the
termination of MFN origination activities and the integration and consolidation
of certain activities, the Company has recognized certain liabilities related to
the costs to exit these activities and terminate the affected employees of MFN.
These activities include service departments such as accounting, finance, human
resources, information technology, administration, payroll and executive
management. These costs include the following:
DECEMBER 31, MARCH 31,
2002 ACTIVITY 2003 (1)
--------- --------- ---------
(IN THOUSANDS)
Severance payments and consulting contracts ........................ $ 571 $ (102) $ 469
Facilities closures ................................................ 1,995 (296) 1,699
Termination of contracts, leases, services and other obligations ... 323 (98) 225
Acquisition expenses accrued but unpaid ............................ 51 -- 51
--------- --------- ---------
Total liabilities assumed ..................................... $ 2,940 $ (496) $ 2,444
========= ========= =========
____________
(1) Approximately $2.4 million of remaining accrual is recorded in the
Condensed Consolidated Balance Sheet of the Company at March 31, 2003. The
Company believes that this amount provides adequately for anticipated remaining
6
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
costs related to exiting certain activities of MFN, and that amounts indicated
above are reasonably allocated.
The Company's Condensed Consolidated Balance Sheet and Condensed Consolidated
Statement of Operations as of and for the three months ended March 31, 2003 and
2002, include the balance sheet accounts of MFN Financial Corporation as of
March 31, 2003 and 2002 and the results of operations subsequent to March 8,
2002, the merger date.
Upon effectiveness of the Merger, each outstanding share of common stock of MFN
converted into the right to receive $10.00 per share in cash. The total Merger
consideration payable to stockholders of MFN was approximately $99.9 million.
The amount of such consideration was agreed to as the result of arms'-length
negotiations between CPS and MFN. The aggregate purchase price, including
expenses related to the transaction, was approximately $123.2 million.
Acquisition financing was provided to CPS by Westdeutsche Landesbank
Girozentrale, New York Branch ("WestLB") and Levine Leichtman Capital Partners
II, L.P ("LLCP"). CPS obtained acquisition financing from LLCP through its
issuance and sale of certain senior secured notes to LLCP in the aggregate
principal amount of $35 million.
The Company has recorded certain purchase accounting adjustments recorded on its
Condensed Consolidated Balance Sheet, which are estimates based on available
information. In addition, the Company's Condensed Consolidated Statement of
Operations for the period ended March 31, 2002 includes an extraordinary gain
related to the excess of net assets acquired over purchase price ("negative
goodwill") totaling $17.4 million.
The following table summarizes the estimated fair value of the assets acquired
and liabilities assumed at the date of acquisition.
MARCH 8,
2002
---------
(IN THOUSANDS)
Cash ............................................................ $ 93,782
Restricted cash ................................................. 25,499
Finance Contracts, net .......................................... 186,554
Residual interest in securitizations ............................ 32,485
Other assets .................................................... 12,006
---------
Total assets acquired ................................... 350,326
---------
Securitization trust debt ....................................... 156,923
Subordinated debt ............................................... 22,500
Accounts payable and other liabilities .......................... 30,242
---------
Total liabilities assumed ............................... 209,665
---------
Net assets acquired ..................................... 140,661
Less: purchase price .................................... 123,249
---------
Excess of net assets acquired over purchase price ....... $ 17,412
=========
Selected unaudited pro forma combined results of operations for the three-month
period ending March 2002, assuming the Merger occurred on January 1, 2002, are
as follows:
7
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
THREE MONTHS
ENDED
MARCH 31, 2002
-----------
(IN THOUSANDS)
Total revenue ................................................... $ 30,013
Net earnings (loss) before Merger-related expenses
and extraordinary item ................................. (10,205)
Extraordinary item .............................................. 17,412
Net earnings .................................................... 7,207
Basic net earnings (loss) per share before Merger-related
expenses and extraordinary item ........................ $ (0.53)
Extraordinary item .............................................. 0.90
Basic net earnings per share .................................... 0.37
Diluted net earnings (loss) per share before Merger-related
expenses and extraordinary item ........................ $ (0.53)
Extraordinary item .............................................. 0.90
Diluted net earnings per share .................................. 0.37
BASIS OF PRESENTATION
The unaudited Condensed Consolidated Financial Statements of the Company have
been prepared in conformity with accounting principles generally accepted in the
United States of America, with the instructions to Form 10-Q and with Article 10
of Regulation S-X of the Securities and Exchange Commission, and include all
adjustments that are, in the opinion of management, necessary for a fair
presentation of the results for the interim periods presented. All such
adjustments are, in the opinion of management, of a normal recurring nature. In
addition, certain items in prior period financial statements have been
reclassified for comparability to current period presentation. Results for the
three-month period ended March 31, 2003 are not necessarily indicative of the
operating results to be expected for the full year.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with accounting principles generally accepted
in the United States of America have been condensed or omitted. These Condensed
Consolidated Financial Statements should be read in conjunction with the
Consolidated Financial Statements and Notes to Consolidated Financial Statements
included in the Company's Annual Report on Form 10-K for the year ended December
31, 2002.
RECENT DEVELOPMENTS
On April 1, 2003, CPS announced it had signed an agreement to acquire TFC
Enterprises, Inc. ("TFC")(Nasdaq: TFCE) and its subsidiaries in a cash merger.
CPS has agreed to pay $1.87 per share for each of the approximately 11.6 million
outstanding shares of TFC stock.
The boards of both companies have approved the agreement. The transaction is
subject to approval by the stockholders of TFC and other conditions, and is
expected to be completed in May 2003.
8
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
RESIDUAL INTEREST IN SECURITIZATIONS AND GAIN ON SALE OF CONTRACTS
Gain on sale may be recognized on the disposition of Contracts outright or in
securitization transactions. In its securitization transactions, the Company, or
a wholly owned, consolidated subsidiary of the Company, retains a residual
interest in the Contracts that are sold to a wholly owned, unconsolidated
special purpose subsidiary. The Company's securitization transactions include
"term" securitizations (purchaser holds the Contracts for substantially their
entire term) and "continuous" securitizations (which finance the acquisition of
the Contracts for future sale into term securitizations).
The residual interest in term securitizations and the residual interest in the
Contracts held in "continuous" securitizations are reflected in the line item
"residual interest in securitizations" on the Company's Condensed Consolidated
Balance Sheet.
The Company's securitization structure has generally been as follows:
The Company sells Contracts it acquires to a wholly owned, unconsolidated
Special Purpose Subsidiary ("SPS"), which has been established for the limited
purpose of buying and reselling the Company's Contracts. The SPS then transfers
the same Contracts to an owner trust ("Trust"). The Trust is a qualifying
special purpose entity as defined in Statement of Financial Accounting Standards
No. 140 ("SFAS 140"), and is therefore not consolidated in the Company's
Condensed Consolidated Financial Statements. The Trust issues interest-bearing
asset backed securities (the "Notes"), generally in a principal amount equal to
the aggregate principal balance of the Contracts. The Company typically sells
these Contracts to the Trust at face value and without recourse, except that
representations and warranties similar to those provided by the Dealer to the
Company are provided by the Company to the Trust. One or more investors purchase
the Notes issued by the Trust; the proceeds from the sale of the Notes are then
used to purchase the Contracts from the Company. The Company may retain
subordinated Notes issued by the Trust. The Company purchases a financial
guaranty insurance policy, guaranteeing timely payment of principal and interest
on the senior Notes, from an insurance company (the "Note Insurers"). In
addition, the Company provides a credit enhancement for the benefit of the Note
Insurers and the investors in the form of an initial cash deposit to an account
("Spread Account") held by the Trust or in the form of subordinated Notes, or
both. The agreements governing the securitization transactions (collectively
referred to as the "Securitization Agreements") require that the initial
deposits to the Spread Accounts be supplemented by a portion of collections from
the Contracts until the Spread Accounts reach specified levels, and then
maintained at those levels. The specified levels are generally computed as a
percentage of the principal amount remaining unpaid under the related Notes. The
specified levels at which the Spread Accounts are to be maintained will vary
depending on the performance of the portfolios of Contracts held by the Trusts
and on other conditions, and may also be varied by agreement among the Company,
the SPS, the Note Insurers and the trustee. Such levels have increased and
decreased from time to time based on performance of the portfolios, and have
also varied by Securitization Agreement. The Securitization Agreements generally
9
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
grant the Company the option to repurchase the sold Contracts from the Trust
when the aggregate outstanding balance has amortized to 10% or less of the
initial aggregate balance.
The Company's continuous securitization structure is similar to the above,
except that (i) the SPS that purchases the Contracts pledges the Contracts to
secure promissory notes issued directly by the SPS, (ii) the initial purchaser
of such notes has the right, but not the obligation, to require that the Company
repurchase the Contracts, (iii) the promissory notes are in an aggregate
principal amount of not more than 72.5% to 73% of the aggregate principal
balance of the Contracts (that is, at least 27% over-collateralization), and
(iv) no Spread Account is involved. The SPS is a qualifying special purpose
entity and is therefore not consolidated in the Company's Condensed Consolidated
Financial Statements.
Upon each sale of Contracts in a securitization, whether a term securitization
or a continuous securitization, the Company removes from its Condensed
Consolidated Balance Sheet the Contracts held for sale and adds to its Condensed
Consolidated Balance Sheet (i) the cash received and (ii) the estimated fair
value of the ownership interest that the Company retains in Contracts sold in
the securitization. That retained interest (the "Residual") consists of (a) the
cash held in the Spread Account, if any, (b) over collateralization, if any, (c)
subordinated Notes retained, if any, and (d) receivables from Trust, which
include the net interest receivables ("NIRs"). NIRs represent the estimated
discounted cash flows to be received from the Trust in the future, net of
principal and interest payable with respect to the Notes, and certain expenses.
The excess of the cash received and the assets retained by the Company over the
carrying value of the Contracts sold, less transaction costs, equals the net
gain on sale of Contracts recorded by the Company.
The Company allocates its basis in the Contracts between the Notes sold and the
Residuals retained based on the relative fair values of those portions on the
date of the sale. The Company recognizes gains or losses attributable to the
change in the fair value of the Residuals, which are recorded at estimated fair
value. The Company is not aware of an active market for the purchase or sale of
interests such as the Residuals; accordingly, the Company determines the
estimated fair value of the Residuals by discounting the amount and timing of
anticipated cash flows that it estimates will be released to the Company in the
future (the cash out method), using a discount rate that the Company believes is
appropriate for the risks involved. The Company estimates the value of its
optional right to repurchase receivables pursuant to the terms of the
Securitization Agreements primarily based on its estimate of the amount and
timing of cash flows that it anticipates will be received from the repurchased
receivables following exercise of the optional right. The anticipated cash flows
include collections from both current and charged off receivables. The Company
has used an effective discount rate of approximately 14% per annum.
The Company receives periodic base servicing fees for the servicing and
collection of the Contracts. In addition, the Company is entitled to the cash
flows from the Residuals that represent collections on the Contracts in excess
of the amounts required to pay principal and interest on the Notes, the base
servicing fees, and certain other fees (such as trustee and custodial fees).
10
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Required principal payments are in most cases defined as the payments sufficient
to keep the principal balance of the Notes equal to the aggregate principal
balance of the related Contracts (excluding those Contracts that have been
charged off). Some of the Securitization Agreements require accelerated payment
of principal until the principal balance of the Notes is reduced to a specified
percentage of the aggregate principal balance of the related Contracts. Such
accelerated principal payment is said to create "over-collateralization" of the
Notes.
If the amount of cash required for payment of fees, interest and principal
exceeds the amount collected during the collection period, the shortfall is
drawn from the Spread Account, if any. If the cash collected during the period
exceeds the amount necessary for the above allocations, and there is no
shortfall in the related Spread Account, the excess is released to the Company,
or in certain cases is transferred to other Spread Accounts that may be below
their required levels. If the Spread Account balance is not at the required
credit enhancement level, then the excess cash collected is retained in the
Spread Account until the specified level is achieved. Although Spread Account
balances are held by the Trusts on behalf of the Company's SPS as the owner of
the Residuals, the cash in the Spread Accounts is restricted from use by the
Company. Cash held in the various Spread Accounts is invested in high quality,
liquid investment securities, as specified in the Securitization Agreements. The
interest rate payable on the Contracts is significantly greater than the
interest rate on the Notes. As a result, the Residuals described above are a
significant asset of the Company. In determining the value of the Residuals, the
Company must estimate the future rates of prepayments, delinquencies, defaults
and default loss severity, and the value of the Company's optional right to
repurchase receivables pursuant to the terms of the Securitization Agreements,
as all of these factors affect the amount and timing of the estimated cash
flows. The Company estimates prepayments by evaluating historical prepayment
performance of comparable Contracts. The Company has used prepayment estimates
of approximately 18.3% to 21.7% cumulatively over the lives of the related
Contracts. The Company estimates defaults and default loss severity using
available historical loss data for comparable Contracts and the specific
characteristics of the Contracts purchased by the Company. The Company estimates
recovery rates of previously charged off receivables using available historical
recovery data and projected future recovery levels. In valuing the Residuals,
the Company estimates that gross losses as a percentage of the original
principal balance will approximate 13.7% to 19.7% cumulatively over the lives of
the related Contracts, with recovery rates approximating 2.1% to 5.2% of the
original principal balance.
In future periods, the Company will recognize additional revenue from the
Residuals if the actual performance of the Contracts is better than the original
estimate, or the Company would increase the estimated fair value of the
Residuals. If the actual performance of the Contracts were worse than the
original estimate, then a downward adjustment to the carrying value of the
Residuals would be required.
The Noteholders and the related securitization Trusts have no recourse to the
Company for failure of the Contract obligors to make payments on a timely basis.
The Company's Residuals, however, are subordinate to the Notes until the
Noteholders are fully paid, and the Company is therefore at risk to that extent.
11
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
OTHER INCOME
Other income consists primarily of recoveries on previously charged off
Contracts.
STOCK BASED COMPENSATION
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," ("APB 25") and related
interpretations, in accounting for employee stock options rather than the
alternative fair value accounting allowed by Statement of Financial Accounting
Standards No. 123, "Accounting for Stock Based Compensation." ("SFAS 123"). APB
25 provides that compensation expense relative to the Company's employee stock
options is measured based on the difference between the share price and the
exercise price of stock options at the date of grant and the Company recognizes
compensation expense in its statement of operations using the straight-line
method over the vesting period for fixed awards. Under SFAS 123, the fair value
of stock options at the date of grant is recognized in earnings over the vesting
period of the options. In December 2002, the Financial Accounting Standards
Board ("FASB") issued Statement of Financial Accounting Standards No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure." ("SFAS
148"). SFAS 148 amends SFAS 123 to provide alternative methods of transition for
a voluntary change to the fair value method of accounting for stock-based
employee compensation. In addition, SFAS 148 amends the disclosure requirements
of SFAS 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method on reported results.
As of March 31, 2003 and 2002, the Company had options outstanding to acquire
4,062,149 and 3,693,439 shares, respectively, of its common stock. The following
table shows the pro forma net income (loss) as if the fair value method of SFAS
123 had been used to account for stock-based compensation expense (in thousands,
except per share amounts):
THREE MONTHS
ENDED
MARCH 31,
---------------------
2003 2002
--------- ---------
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
Net income, as reported ................................ $ 6,278 $ 16,431
Stock-based employee compensation expense, fair
value method, net of tax ............................ (263) (181)
Previously recorded stock-based employee compensation
income (expense), net of tax ........................ (81) 489
--------- ---------
Pro forma net income ................................... $ 5,934 $ 16,739
========= =========
THREE MONTHS
ENDED
MARCH 31,
---------------------
2003 2002
--------- ---------
Net income per share
Basic, as reported...................................... $ 0.31 $ 0.85
Diluted, as reported(1)................................. $ 0.29 $ 0.85
Pro forma basic......................................... $ 0.29 $ 0.87
Pro forma diluted(1).................................... $ 0.28 $ 0.87
(1) The assumed conversion of certain subordinated debt during the three month
period ended March 31, 2003, resulted in an increase to income for purposes
of the diluted earnings per share calculation of $133,400.
12
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Pro forma net income (loss) and income (loss) per share reflect only options
granted in the years ended December 31, 1996 to March 31, 2003. Therefore, the
full effect of calculating compensation cost for stock options under SFAS No.
123 is not reflected in the pro forma amounts presented above, as compensation
expense for options granted prior to 1996 is not considered.
Included in the number of options outstanding above are 1,511,200 options the
Company has conditionally granted, subject to shareholder approval in 2003 of an
increase in the number of shares available for grant under its 1997 Long-Term
Incentive Plan, at an exercise price of $1.50. Until and unless such shareholder
approval is gained, these options are not outstanding or exercisable. Excluding
such options, there would be 475,251 options available for grant.
PURCHASES OF COMPANY STOCK
During the three-month period ended March 31, 2003, the Company purchased
321,944 shares of its common stock at an average price of $2.00, or $643,888 in
total.
NEW ACCOUNTING PRONOUNCEMENTS
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others ("FIN 45")."
FIN 45 clarifies previously issued accounting guidance and disclosure
requirements for guarantees, expands the disclosures to be made by a guarantor
in its financial statements about its obligations under certain guarantees, and
requires the guarantor to recognize a liability for the fair value of an
obligation assumed under a guarantee. FIN 45 was effective as of December 31,
2002. The adoption of FIN 45 did not have a material effect on the Company.
Financial Accounting Standards Board Interpretation 46, "Consolidation of
Variable Interest Entities" ("FIN 46"), issued January 2003, requires a variable
interest entity to 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.
Prior to FIN 46, a company included another entity in its Consolidated Financial
Statements only if it controlled the entity through voting interests. FIN 46
also requires disclosures about variable interest entities that the company is
not required to consolidate but in which it has a significant variable interest.
The consolidated requirements of FIN 46 apply immediately to variable interest
entities created after January 31, 2003. The consolidated requirements apply to
older entities in the first fiscal year or interim period after June 15, 2003.
Certain disclosure requirements apply to all financial statements issued after
January 31, 2003, regardless of when the variable interest entity was
established. The adoption of FIN 46 is not expected to have a material effect on
the Company.
In April 2003, FASB issued Statement on Financial Accounting Standards No. 149,
"Amendment of Statement 133 on Derivative Instruments and Hedging Activities"
13
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
("SFAS 149"). SFAS 149 amends and clarifies financial accounting and reporting
for derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives) and for hedging
activities under FASB Statement No. 133, "Accounting for Derivative Instruments
and Hedging Activities." SFAS 149 is effective for most contracts entered into
or modified after June 30, 2003, and for hedging relationships designated after
June 30, 2003. The adoption of SFAS 149 is not expected to have a material
effect on the Company.
(2) FINANCE RECEIVABLES
The following table presents the components of Finance Receivables, net of
unearned income:
MARCH 31, 2003
--------
(IN THOUSANDS)
Finance Receivables
Automobile
Simple interest ........................................ $23,530
Precompute or "Rule of 78's", net of unearned income ... 58,170
--------
Finance Receivables, net of unearned income ................ $81,700
========
The following table presents the contractual maturities of Finance Receivables,
net of unearned income as of March 31, 2003:
AMOUNT %
---------- ----------
(DOLLARS IN THOUSANDS)
Due within one year............................... $ 14,624 18%
Due within two years.............................. 39,379 48%
Due within three years............................ 23,856 29%
Due after three years............................. 3,841 5%
---------- ----------
Total......................................... $ 81,700 100%
========== ==========
The following table presents a summary of the activity for the allowance for
credit losses, for the three-month periods ended March 31, 2003 and 2002:
MARCH 31, MARCH 31,
2003 2002
--------- ---------
(IN THOUSANDS)
Balance at beginning of period ............................ $ 25,828 $ --
Addition to allowance for credit losses due to MFN Merger.. -- 59,261
Provision for credit losses ............................... 66 --
Net charge offs ........................................... (6,054) (3,348)
--------- ---------
Balance at end of period .................................. $ 19,840 $ 55,913
========= =========
14
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(3) RESIDUAL INTEREST IN SECURITIZATIONS
The following table presents the components of the residual interest in
securitizations:
MARCH 31, DECEMBER 31,
2003 2002
--------- ---------
(IN THOUSANDS)
Cash, commercial paper, United States government
securities and other qualifying investments
(Spread Account) ............................... $ 37,120 $ 27,218
Receivables from Trusts ........................ 31,358 33,214
Over-collateralization ......................... 44,706 59,366
Investment in subordinated notes ............... 13,928 7,372
--------- ---------
Residual interest in securitizations ........... $127,112 $127,170
========= =========
The following table presents estimated remaining undiscounted credit losses
included in the estimated fair value of the residual interest in securitizations
as a percentage of the Company's servicing portfolio subject to recourse
provisions:
MARCH 31, 2003 DECEMBER 31, 2002
------------ ------------
(IN THOUSANDS)
Undiscounted estimated credit losses .......................... $ 58,785 $ 54,363
Servicing portfolio subject to recourse provisions ............ 505,614 477,038
Undiscounted estimated credit losses as percentage of
servicing portfolio subject to recourse provisions ............ 11.63% 11.40%
On March 31, 2003, CPS (through a subsidiary) sold automobile installment sales
finance Contracts to CPS Auto Receivables Trust 2003-A in a securitization
transaction, retaining a residual interest therein. In this transaction,
qualified institutional buyers purchased $138.13 million of notes backed by
automotive Contracts that CPS had purchased from Dealers. The Notes, issued by
CPS Auto Receivables Trust 2003-A, consist of two classes: $17.96 million of
1.53% Class A-1 Notes, and $120.17 million of 2.89% Class A-2 Notes. The value
of the residual was $28.8 million at March 31, 2003. The key assumptions used in
determining the value were a discount rate of 14.0% per annum, prepayment speed
of 21.69% per annum, and cumulative lifetime credit losses of 12.51%.
(4) NOTES PAYABLE TO SECURITIZATION TRUST
On June 28, 2001, MFN issued $301 million of notes secured by automobile sales
finance Contracts (the "Securitized Notes") in a private placement (the "Secured
Financing Agreement"). The issuance was completed through the MFN Auto
Receivables Trust 2001-A of MFN Securitization LLC, a wholly owned subsidiary of
Mercury Finance Company LLC. MFN Securitization LLC is a special purpose company
that holds certain automobile sales finance Contracts of the Company and
borrowed funds under the Secured Financing Agreement. MFN Securitization LLC
paid the borrowed funds to Mercury Finance Company LLC in consideration for the
transfer of certain automobile sales finance Contracts. Both classes of the
15
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Securitized Notes issued under the Secured Financing Agreement bear a fixed rate
of interest until their final distribution. While MFN Securitization LLC is
included in the Company's Condensed Consolidated Financial Statements, it is a
separate legal entity. The automobile sales finance Contracts and other assets
held by MFN Securitization LLC are legally owned by MFN Securitization LLC and
are not available to creditors of the Company or its subsidiaries. Interest
payments on the Securitized Notes are payable monthly, in arrears, based on the
respective notes' interest rates. The following table presents the Company's
Securitized Notes outstanding and their stated interest rates at March 31, 2003
(dollars in thousands):
OUTSTANDING STATED FINAL SCHEDULED
PRINCIPAL INTEREST RATE DISTRIBUTION DATE (1)
----------- ------------- ---------------------
Class A-1 Notes...................... $ -- 4.05125% July 15, 2002
Class A-2 Notes...................... 54,165 5.07000% July 15, 2007
-----------
Total principal outstanding.......... $ 54,165
===========
(1) Payment in full of the Securitized Notes could occur earlier than the final
scheduled distribution date.
Interest expense on the Securitized Notes is composed of the stated rate of
interest plus additional costs of borrowing. Additional costs of borrowing
include facility fees, insurance and amortization of deferred financing costs.
Deferred financing costs related to the Securitized Notes are amortized in
proportion to the principal distributed to the noteholders. Accordingly, the
effective cost of borrowing of the Securitized Notes is greater than the stated
rate of interest.
The Securitized Notes contain various covenants requiring certain minimum
financial ratios and results. The Company was in compliance with these covenants
as of the date of this report. The Securitized Notes also require certain funds
be held in restricted cash accounts to provide additional collateral for the
borrowings or to be applied to make payments on the Securitized Notes. As of
March 31, 2003, restricted cash under the MFN 2001-A Securitization totaled
approximately $11.4 million.
(5) SENIOR SECURED DEBT
On February 3, 2003, the Company borrowed $25 million from Levine Leichtman
Capital Partners II, L.P. ("LLCP"), net of fees and expenses of $1.05 million,.
The indebtedness, represented by the "Term D Note," was originally due in April
2003, with Company options to extend the maturity to May 2003 and January 2004,
upon payment of successive extension fees of $125,000. The Company has paid the
fee to extend the maturity to May 2003, and intends to pay the additional fee to
extend the maturity to January 2004. The Term D is bears interest monthly at
rates ranging from 4.0% to 12.0 %, depending on the ultimate term of the note.
Additionally, in a separate transaction, the Bridge Note issued to LLCP in
connection with the acquisition of MFN, in an original principal amount of $35.0
million, was due on February 28, 2003. The outstanding principal balance of
$17.0 million was paid in February 2003.
16
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(6) NET GAIN ON SALE OF CONTRACTS
The following table presents components of net gain on sale of Contracts:
THREE MONTHS
ENDED
MARCH 31,
----------------------
2003 2002
-------- --------
(IN THOUSANDS)
Gains on sale of Contracts ......................... $ 3,301 $ 1,652
Deferred acquisition fees and discounts ............ 2,291 --
Expenses related to sales .......................... (971) (407)
(Provision for) recovery of credit losses .......... (66) 527
-------- --------
Net gain on sale of Contracts ...................... $ 4,555 $ 1,772
======== ========
(7) INTEREST INCOME
The following table presents the components of interest income:
THREE MONTHS
ENDED
MARCH 31,
----------------------
2003 2002
-------- --------
(IN THOUSANDS)
Interest ....................................... $ 5,452 $ 3,909
Residual interest income, net .................. 3,741 3,821
Other interest income .......................... 135 14
-------- --------
Net interest income ............................ $ 9,328 $ 7,744
======== ========
(8) EARNINGS PER SHARE
Diluted earnings per share for the three-month periods ended March 31, 2003 and
2002, were calculated using the weighted average number of shares outstanding
for the related period. The following table reconciles the number of shares used
in the computations of basic and diluted earnings per share for the three-month
periods ended March 31, 2003 and 2002:
THREE MONTHS
ENDED
MARCH 31,
----------------
2003 2002
------- -------
(IN THOUSANDS)
Weighted average number of common shares outstanding during
the period used to compute basic earnings per share .......... 20,270 19,286
Incremental common shares attributable to exercise of
outstanding options and warrants ............................. 511 --
Incremental common shares attributable to convertible debt ... 1,079 --
------- -------
Weighted average number of common shares used to compute
diluted earnings per share ................................... 21,860 19,286
======= =======
17
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The assumed conversion of certain subordinated debt during the three-month
period ended March 31, 2003, resulted in an increase to income for purposes of
the diluted earnings per share calculation of $133,400, representing interest
attributable to convertible debt that would not have been incurred if the
convertible debt had been converted. Diluted net earnings for purposes of the
diluted earnings per share calculation totaled $6.4 million for the three months
ended March 31, 2003.
If the anti-dilutive effects of common stock equivalents were not considered,
additional shares included in the diluted earnings per share calculation for the
three-month period ended March 31, 2002 would have included an additional 2.4
million shares attributable to the exercise of options to acquire common stock
and the conversion of certain subordinated debt, for an aggregate total of
approximately 21.7 million diluted shares for the three-month period ended March
31, 2002. No such anti-dilution existed for the three-month period ended March
31, 2003.
(9) INCOME TAXES
As of December 31, 2002, the Company had a net deferred tax liability of $6.7
million, which included a valuation allowance against certain deferred tax
assets of $8.6 million. As a result of the resolution of Internal Revenue
Service examinations of tax returns previously filed by MFN Financial
Corporation, the Company recorded a tax benefit of approximately $4.9 million.
The Company has evaluated its deferred tax assets and believes that it is more
than likely that certain deferred tax assets will not be realized due to
limitations imposed by the Internal Revenue Code and expected future taxable
income. The Company, therefore, has established a valuation allowance totaling
$29.4 million.
(10) LIQUIDITY
The Company's business requires substantial cash to support its purchases of
Contracts and other operating activities. The Company's primary sources of cash
have been cash flows from operating activities, including proceeds from sales of
Contracts, amounts borrowed under various revolving credit facilities (also
sometimes known as warehouse credit facilities), servicing fees on portfolios of
Contracts previously sold, customer payments of principal and interest on
Contracts held for sale, fees for origination of Contracts, and releases of cash
from credit enhancements provided by the Company for the financial guaranty
insurers (Note Insurers) and Investors, initially made in the form of a cash
deposit to an account (Spread Account), and releases of cash from securitized
pools of Contracts in which the Company has retained a residual ownership
interest. The Company's primary uses of cash have been the purchases of
Contracts, repayment of amounts borrowed under lines of credit and otherwise,
operating expenses such as employee, interest, occupancy expenses and other
general and administrative expenses, the establishment of and further
contributions to "Spread Accounts" (cash posted to enhance credit of securitized
pools), and income taxes. There can be no assurance that internally generated
cash will be sufficient to meet the Company's cash demands. The sufficiency of
internally generated cash will depend on the performance of securitized pools
(which determines the level of releases from Spread Accounts), the rate of
18
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
expansion or contraction in the Company's servicing portfolio, and the terms
upon which the Company is able to acquire, sell, and borrow against Contracts.
Contracts are purchased from Dealers for a cash price approximating their
principal amount, and generate cash flow over a period of years. As a result,
the Company has been dependent on warehouse credit facilities to purchase
Contracts, and on the availability of cash from outside sources in order to
finance its continuing operations, as well as to fund the portion of Contract
purchase prices not financed under warehouse credit facilities. Through May
2002, the Company's Contract purchasing program consisted of both (i) purchases
for the Company's own account made on other than a flow basis, funded primarily
by advances under a revolving warehouse credit facility, and (ii) flow purchases
for immediate resale to non-affiliates. Flow purchases allowed the Company to
purchase Contracts with minimal demands on liquidity. The Company's revenues
from the resale of flow purchase Contracts, however, were materially less than
those that may be received by holding Contracts to maturity or by selling
Contracts in securitization transactions. During the three-month period ended
March 31, 2003 the Company purchased $87.3 million of Contracts for its own
account, compared to $144.9 million of Contracts on a flow basis and $1.0
million for its own account in 2002. The Company's flow purchase program ended
in May 2002.
The Company previously purchased Contracts on a flow basis, which, as compared
with purchases of Contracts for the Company's own account, involved a materially
reduced demand on the Company's cash. The Company's plan for meeting its
liquidity needs is to match its levels of Contract purchases to its availability
of cash.
The Company's ability to adjust the quantity of Contracts that it purchases and
sells will be subject to general competitive conditions and the continued
availability of warehouse credit facilities. There can be no assurance that the
desired level of Contract acquisition can be maintained or increased. Obtaining
releases of cash from the Spread Accounts is dependent on collections from the
related Trusts generating sufficient cash to maintain the Spread Accounts in
excess of the amended specified levels. There can be no assurance that
collections from the related Trusts will generate cash in excess of the amended
specified levels.
Certain of the Company's securitization transactions and the warehouse credit
facilities contain various covenants requiring certain minimum financial ratios
and results. The Company was in compliance with these covenants as of the date
of this report.
(11) LEGAL PROCEEDINGS
The Company is routinely involved in various legal proceedings resulting from
its consumer finance activities and practices, both continuing and discontinued.
The Company believes that there are substantive legal defenses to such claims,
and intends to defend them vigorously. There can be no assurance, however, as to
the outcome.
19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
GENERAL
Consumer Portfolio Services, Inc. ("CPS," and together with its subsidiaries,
the "Company") is a consumer finance company specializing in the business of
purchasing, selling and servicing automobile installment purchase contracts
("Contracts") originated by licensed automobile dealers ("Dealers") in the sale
of new and used automobiles, light trucks and passenger vans. Through its
purchases, the Company provides indirect financing to Dealer customers with
limited credit histories, low incomes or past credit problems ("Sub-Prime
Customers"). The Company serves as an alternative source of financing for
Dealers, allowing sales to customers who otherwise might not be able to obtain
financing. The Company does not lend money directly to consumers. Rather, it
purchases installment Contracts from Dealers.
CPS was incorporated and began its operations in 1991. From inception through
March 31, 2003 the Company has purchased approximately $4.7 billion of
Contracts, and as of March 31, 2003, had an outstanding servicing portfolio of
approximately $595.6 million. The Company makes the decision to purchase
Contracts exclusively from its headquarters location. The Company services
Contracts from regional centers across the United States.
CREDIT RISK RETAINED
The Company purchases Contracts with the intention of reselling them in
securitizations. In a securitization, the Company sells Contracts to a special
purpose subsidiary, which funds the purchase by sale of asset backed
interest-bearing securities. At the closing of each securitization, the Company
removes the sold Contracts from its Condensed Consolidated Balance Sheet. The
Company remains responsible for collecting payments due under the Contracts, and
retains a residual interest in the sold Contracts. The residual interest
represents the discounted value of what the Company expects will be the excess
of future collections on the Contracts over principal and interest due on the
asset backed securities. That residual interest appears on the Company's balance
sheet as "Residual interest in securitizations," and its value is dependent on
estimates of the future performance of the sold Contracts. Further, the special
purpose subsidiary may be prohibited from releasing the excess cash to the
Company if the credit performance of the sold Contracts falls short of
pre-determined standards. Such releases represent a material portion of the cash
that the Company uses to fund its operations. An unexpected deterioration in the
performance of sold Contracts could therefore have a material adverse effect on
both the Company's liquidity and its results of operations.
RESULTS OF OPERATIONS
The Company's Condensed Consolidated Balance Sheet and Condensed Consolidated
Statement of Operations as of and for the three months ended March 31, 2003 and
2002 include the results of operations of MFN Financial Corporation for the
period subsequent to March 8, 2002, the date on which the Company acquired that
corporation and its subsidiaries in a merger (the "MFN Merger"). See Note 1 of
Notes to Condensed Consolidated Financial Statements.
20
THE THREE-MONTH PERIOD ENDED MARCH 31, 2003 COMPARED TO THE THREE-MONTH PERIOD
ENDED MARCH 31, 2002
REVENUES. During the three months ended March 31, 2003, revenues were $22.5
million, an increase of $9.4 million, or 71.6%, from the prior year period
revenue amount of $13.1 million. Net gain on sale of contracts increased $2.8
million, or 157.1%, to $4.6 million in the three-month period ended March 31,
2003, compared to $1.8 million in the year earlier period, primarily as the
result of increased sales of Contracts in securitizations offset by the impact
of the termination of the flow purchase program in early May 2002. The 2003 gain
on sale amount is net of a $1.0 million pre-tax charge related to the Company's
analysis and estimate of the expected ultimate performance of the Company's
previously securitized pools in which it retains a residual interest. During the
first quarter of 2002, to prepare for the MFN Merger and related financing
requirements, the Company chose to originate Contracts almost exclusively on a
flow basis, resulting in a significantly lower gain on sale than had the
Contracts been originated for the Company's own account and securitized, as was
the case in the first quarter of 2003. In addition, as a result of revised
Company estimates resulting from analyses of the current and historical
performance of certain of the Company's previously securitized pools, the
Company recorded pre-tax charges of approximately $2.5 million related to its
residual interest in securitizations during the first quarter of 2002. Certain
of the Company's older pools related to 1998 and prior had not performed as
originally projected. Also in the first quarter of 2002, the Company recognized
a charge of approximately $500,000 related to a loss realized upon the sale of a
subordinated certificate ("B Piece") from the Company's 2002-A securitization.
Interest income for the three-month period ended March 31, 2003 increased $1.6
million, or 20.5%, to $9.3 million in 2003 from $7.7 million in 2002. Similarly,
servicing fees totaling $4.6 million in the three months ended March 31, 2003
increased $1.2 million, or 35.8%, from $3.4 million in the same period a year
earlier. The increase in interest income and servicing fees can be attributed to
the inclusion of a full quarter's results from the portfolio acquired in the MFN
Merger, compared to 23 days in the prior year period, combined with the relative
stability in the size of the Company's servicing portfolio. At March 31, 2003,
the Company was generating income and fees on a portfolio with an outstanding
principal balance approximating $595.6 million, compared to a portfolio with an
outstanding principal balance approximating $599.1 million as of March 31, 2002.
As the portfolio of Contracts acquired in the MFN Merger amortizes, the
portfolio of Contracts originated by CPS continues to expand. At March 31, 2003,
the portfolio make up was $437.3 million, or 73.4%, CPS and $158.3 million, or
26.6%, MFN, compared to $234.1 million, or 39.1%, CPS and $365.0 million, or
60.9%, MFN at March 31, 2002.
The period over period increase in other income can be attributed to recoveries
on previously charged off MFN Contracts totaling $3.7 million during the first
quarter of 2003.
EXPENSES. The Company's operating expenses consist primarily of personnel costs
and other operating expenses, which are incurred as applications and Contracts
are received, processed and serviced. Factors that affect margins and net income
include changes in the automobile and automobile finance market environments,
macroeconomic factors such as interest rates, and mix of business between
Contracts purchased on a flow basis and Contracts purchased on an other than
flow basis.
21
Personnel costs include base salaries, commissions and bonuses paid to
employees, and certain expenses related to the accounting treatment of
outstanding stock options, and are one of the Company's most significant
operating expenses. These costs (other than those relating to stock options)
generally fluctuate with the level of applications and Contracts processed and
serviced.
Other operating expenses consist primarily of facilities expenses, telephone and
other communication services, credit services, computer services (including
personnel costs associated with information technology support), professional
services, marketing and advertising expenses, and depreciation and amortization.
Total operating expenses were $20.2 million for the first quarter of 2003,
compared to $19.9 million for the first quarter of 2002.
Personnel costs were stable, $8.4 million during the three months ended March
31, 2003, representing 41.8% of total operating expenses, compared to $8.5
million for the 2002 period, or 42.5% of total operating expenses.
General and administrative expenses decreased to $4.0 million, or 20.0% of total
operating expenses, in the first quarter of 2003, from $4.4 million, or 22.1% of
total operating expenses, in the first quarter of 2002.
Interest expense for the three-month period ended March 31, 2003, increased $1.1
million, or 24.8%, to $5.5 million in 2003, compared to $4.4 million in 2002.
The increase is due to the full period inclusion of interest expense resulting
from the MFN Merger, including interest expense related to acquisition debt and
the Notes Payable to Securitization Trust, and the addition of interest expense
related to the LLCP Term D Note.
Income tax benefit of $3.9 million and $5.7 million has been provided in the
2003 and 2002 periods, respectively. The 2003 benefit is primarily the result of
the resolution of certain Internal Revenue Service examinations of previously
filed MFN tax returns, resulting in a tax benefit of $4.9 million, which has
been included in the current period tax provision. The 2002 benefit is due to
tax legislation passed in early 2002, which enabled the Company to reverse a
previously recorded valuation allowance of approximately $3.2 million, as well
as record benefit in the then current period. The Company does not expect any
comparable income tax benefit in future periods.
LIQUIDITY AND CAPITAL RESOURCES
The Company's business requires substantial cash to support its purchases of
Contracts and other operating activities. The Company's primary sources of cash
have been cash flows from operating activities, including proceeds from sales of
Contracts, amounts borrowed under various revolving credit facilities (also
sometimes known as warehouse credit facilities), servicing fees on portfolios of
Contracts previously sold, customer payments of principal and interest on
Contracts held for sale, fees for origination of Contracts, and releases of cash
from credit enhancements provided by the Company for the financial guaranty
insurers (Note Insurers) and Investors, initially made in the form of a cash
deposit to an account (Spread Account), and releases of cash from securitized
pools of Contracts in which the Company has retained a residual ownership
interest. The Company's primary uses of cash have been the purchases of
Contracts, repayment of amounts borrowed under lines of credit and otherwise,
operating expenses such as employee, interest, occupancy expenses and other
general and administrative expenses, the establishment of and further
22
contributions to "Spread Accounts" (cash posted to enhance credit of securitized
pools), and income taxes. There can be no assurance that internally generated
cash will be sufficient to meet the Company's cash demands. The sufficiency of
internally generated cash will depend on the performance of securitized pools
(which determines the level of releases from Spread Accounts), the rate of
expansion or contraction in the Company's servicing portfolio, and the terms
upon which the Company is able to acquire, sell, and borrow against Contracts.
Net cash provided by operating activities for the quarters ended March 31, 2003
and 2002, was $24.6 million and $34.3 million, respectively. Cash from operating
activities is generally provided by the net releases from the Company's
securitization Trusts and from the amortization and liquidation of Contracts.
Net cash used in investing activities for the quarters ended March 31, 2003 and
2002, was $35,000 and $29.6 million, respectively. Cash used in the MFN Merger,
net of the cash acquired in the transaction, totaled $29.5 million for the three
months ended March 31, 2002.
Net cash (used in) provided by financing activities for the quarters ended March
31, 2003 and 2002, was ($16.1) million and $9.6 million, respectively. Cash
(used in) provided by financing activities is primarily attributable to the
repayment or issuance of debt.
Contracts are purchased from Dealers for a cash price approximating their
principal amount, and generate cash flow over a period of years. As a result,
the Company has been dependent on warehouse credit facilities to purchase
Contracts, and on the availability of cash from outside sources in order to
finance its continuing operations, as well as to fund the portion of Contract
purchase prices not financed under warehouse credit facilities. The Company
currently has $200 million in warehouse credit capacity, in the form of a $125
million facility and a $75 million facility. Through May 2002, the Company's
Contract purchasing program consisted of both (i) purchases for the Company's
own account made on other than a flow basis, funded primarily by advances under
a revolving warehouse credit facility, and (ii) flow purchases for immediate
resale to non-affiliates. Flow purchases allowed the Company to purchase
Contracts with minimal demands on liquidity. The Company's revenues from the
resale of flow purchase Contracts, however, were materially less than those that
may be received by holding Contracts to maturity or by selling Contracts in
securitization transactions. During the three-month period ended March 31, 2003
the Company purchased $87.3 million of Contracts for its own account, compared
to $1.0 million for its own account and $144.9 million of Contracts on a flow
basis in 2002. The Company's flow purchase program ended in May 2002.
The $125 million warehouse facility is structured to allow CPS to fund a portion
of the purchase price of Contracts by drawing against a floating rate variable
funding note issued by CPS Warehouse Trust. This facility was established in
March 7, 2002, in the maximum amount of $100 million. Such maximum amount was
increased to $125 million in November 2002. Approximately 73% of the principal
balance of Contracts may be advanced to the Company under this facility, subject
to collateral tests and certain other conditions and covenants. Notes under this
facility bear interest at a rate of one-month commercial paper plus 1.18% per
annum. This facility was renewed on March 6, 2003 for a 364-day term.
23
The $75 million warehouse facility is similarly structured to allow CPS to fund
a portion of the purchase price of Contracts by drawing against a floating rate
variable funding note issued by CPS Funding LLC. Approximately 72.5% of the
principal balance of Contracts may be advanced to the Company under this
facility, subject to collateral tests and certain other conditions and
covenants. Notes under this facility bear interest at a rate of one-month LIBOR
plus 0.75% per annum. This facility was renewed and restated on January 9, 2003,
also for a 364-day term.
These facilities are independent of each other, and are funded and insured by
different institutions. Sales of Contracts to the facility-related special
purpose subsidiaries ("SPS") are treated as ongoing securitizations. The
Company, therefore, removes the securitized Contracts and related debt from its
Condensed Consolidated Balance Sheet and recognizes a gain on sale in the
Company's Condensed Consolidated Statement of Operations.
The Company previously purchased Contracts on a flow basis, which, as compared
with purchases of Contracts for the Company's own account, involved a materially
reduced demand on the Company's cash. The Company's plan for meeting its
liquidity needs is to match its levels of Contract purchases to its availability
of cash.
Cash used for subsequent deposits to Spread Accounts for the periods ended March
31, 2003 and 2002 was $775,000 and $1.0 million, respectively. Cash released
from Spread Accounts to the Company for the three-month periods ended March 31,
2003 and 2002, was $9.0 million and $16.7 million, respectively. Changes in
deposits to and releases from Spread Accounts are affected by the relative size,
seasoning and performance of the various pools of Contracts sold that make up
the Company's servicing portfolio to which the respective Spread Accounts are
related. During the quarter ended March 31, 2003 the Company made initial
deposits to the related Spread Accounts of $10.7 million related to its term
securitization transactions, compared to $1.3 million in the 2002 period. The
acquisition of Contracts for subsequent sale in securitization transactions, and
the need to fund Spread Accounts when those transactions take place, results in
a continuing need for capital. The amount of capital required is most heavily
dependent on the rate of the Company's Contract purchases (other than flow
purchases), the required level of initial credit enhancement in securitizations,
and the extent to which the previously established Spread Accounts either
release cash to the Company or capture cash from collections on sold Contracts.
The Company is currently limited in its ability to purchase Contracts due to
certain liquidity constraints. As of March 31, 2003, the Company had cash on
hand of $41.5 million and available Contract purchase commitments from its
warehouse credit facilities of $172.6 million. The Company's plans to manage the
need for liquidity include the completion of additional term securitizations
that would provide additional credit availability from the warehouse credit
facilities, and matching its levels of Contract purchases to its availability of
cash. There can be no assurance that the Company will be able to complete the
term securitizations on favorable economic terms or that the Company will be
able to complete term securitizations at all. If the Company is unable to
complete such securitizations, servicing fees and other portfolio related income
would decrease.
The Company's ability to adjust the quantity of Contracts that it purchases and
sells will be subject to general competitive conditions and the continued
availability of warehouse credit facilities. There can be no assurance that the
desired level of Contract acquisition can be maintained or increased. Obtaining
releases of cash from the Spread Accounts is dependent on collections from the
related Trusts generating sufficient cash to maintain the Spread Accounts in
excess of the amended specified levels. There can be no assurance that
collections from the related Trusts will generate cash in excess of the amended
specified levels.
24
Certain of the Company's securitization transactions and warehouse credit
facilities contain various covenants requiring certain minimum financial ratios
and results. The Company was in compliance with these covenants as of the date
of this report.
CRITICAL ACCOUNTING POLICIES
(a) ALLOWANCE FOR FINANCE CREDIT LOSSES
In order to estimate an appropriate allowance for losses to be incurred on
finance receivables, the Company uses a loss reserving methodology commonly
referred to as "static pooling," which stratifies its finance receivable
portfolio into separately identified pools. Using analytical and formula driven
techniques, the Company estimates an allowance for finance credit losses, which
management believes is adequate for known and inherent losses in the finance
receivable Contract portfolio. Provision for loss is charged to the Company's
Consolidated Statement of Operations. Charge offs of finance receivables are
charged to the allowance. Management evaluates the adequacy of the allowance by
examining current delinquencies, the characteristics of the portfolio and the
value of the underlying collateral. As conditions change, the Company's level of
provisioning and/or allowance may change as well.
(b) RESIDUAL INTEREST IN SECURITIZATION AND GAIN ON SALE OF CONTRACTS
Gain on sale may be recognized on the disposition of Contracts outright or in
securitization transactions. In its securitization transactions, the Company, or
a wholly owned, consolidated subsidiary of the Company, retains a residual
interest in the Contracts that are sold to a wholly owned, unconsolidated
special purpose subsidiary. The Company's securitization transactions include
"term" securitizations (purchaser holds the Contracts for substantially their
entire term) and "continuous" securitizations (which finance the acquisition of
the Contracts for future sale into term securitizations).
The residual interest in term securitizations and the residual interest in the
Contracts held in "continuous" securitizations are reflected in the line item
"residual interest in securitizations" on the Company's Condensed Consolidated
Balance Sheet.
The Company's securitization structure has generally been as follows:
The Company sells Contracts it acquires to a wholly owned, unconsolidated
Special Purpose Subsidiary ("SPS"), which has been established for the limited
purpose of buying and reselling the Company's Contracts. The SPS then transfers
the same Contracts to an owner trust ("Trust"). The Trust is a qualifying
special purpose entity as defined in Statement of Financial Accounting Standards
No. 140 ("SFAS 140"), and is therefore not consolidated in the Company's
Condensed Consolidated Financial Statements. The Trust issues interest-bearing
asset backed securities (the "Notes"), generally in a principal amount equal to
the aggregate principal balance of the Contracts. The Company typically sells
these Contracts to the Trust at face value and without recourse, except that
representations and warranties similar to those provided by the Dealer to the
Company are provided by the Company to the Trust. One or more investors purchase
the Notes issued by the Trust; the proceeds from the sale of the Notes are then
used to purchase the Contracts from the Company. The Company may retain
subordinated Notes issued by the Trust. The Company purchases a financial
guaranty insurance policy, guaranteeing timely payment of principal and interest
on the senior Notes, from an insurance company (the "Note
25
Insurers"). In addition, the Company provides a credit enhancement for the
benefit of the Note Insurers and the investors in the form of an initial cash
deposit to an account ("Spread Account") held by the Trust or in the form of
subordinated Notes, or both. The agreements governing the securitization
transactions (collectively referred to as the "Securitization Agreements")
require that the initial deposits to the Spread Accounts be supplemented by a
portion of collections from the Contracts until the Spread Accounts reach
specified levels, and then maintained at those levels. The specified levels are
generally computed as a percentage of the principal amount remaining unpaid
under the related Notes. The specified levels at which the Spread Accounts are
to be maintained will vary depending on the performance of the portfolios of
Contracts held by the Trusts and on other conditions, and may also be varied by
agreement among the Company, the SPS, the Note Insurers and the trustee. Such
levels have increased and decreased from time to time based on performance of
the portfolios, and have also varied by Securitization Agreement. The
Securitization Agreements generally grant the Company the option to repurchase
the sold Contracts from the Trust when the aggregate outstanding balance has
amortized to 10% or less of the initial aggregate balance.
The Company's continuous securitization structure is similar to the above,
except that (i) the SPS that purchases the Contracts pledges the Contracts to
secure promissory notes issued directly by the SPS, (ii) the initial purchaser
of such notes has the right, but not the obligation, to require that the Company
repurchase the Contracts, (iii) the promissory notes are in an aggregate
principal amount of not more than 72.5% to 73% of the aggregate principal
balance of the Contracts (that is, at least 27% over-collateralization), and
(iv) no Spread Account is involved. The SPS is a qualifying special purpose
entity and is therefore not consolidated in the Company's Condensed Consolidated
Financial Statements.
Upon each sale of Contracts in a securitization, whether a term securitization
or a continuous securitization, the Company removes from its Condensed
Consolidated Balance Sheet the Contracts held for sale and adds to its Condensed
Consolidated Balance Sheet (i) the cash received and (ii) the estimated fair
value of the ownership interest that the Company retains in Contracts sold in
the securitization. That retained interest (the "Residual") consists of (a) the
cash held in the Spread Account, if any, (b) over collateralization, if any, (c)
subordinated Notes retained, if any, and (d) receivables from Trust, which
include the net interest receivables ("NIRs"). NIRs represent the estimated
discounted cash flows to be received from the Trust in the future, net of
principal and interest payable with respect to the Notes, and certain expenses.
The excess of the cash received and the assets retained by the Company over the
carrying value of the Contracts sold, less transaction costs, equals the net
gain on sale of Contracts recorded by the Company.
The Company allocates its basis in the Contracts between the Notes sold and the
Residuals retained based on the relative fair values of those portions on the
date of the sale. The Company recognizes gains or losses attributable to the
change in the fair value of the Residuals, which are recorded at estimated fair
value. The Company is not aware of an active market for the purchase or sale of
interests such as the Residuals; accordingly, the Company determines the
estimated fair value of the Residuals by discounting the amount and timing of
anticipated cash flows that it estimates will be released to the Company in the
future (the cash out method), using a discount rate that the Company believes is
appropriate for the risks involved. The Company estimates the value of its
26
optional right to repurchase receivables pursuant to the terms of the
Securitization Agreements primarily based on its estimate of the amount and
timing of cash flows that it anticipates will be received from the repurchased
receivables following exercise of the optional right. The anticipated cash flows
include collections from both current and charged off receivables. The Company
has used an effective discount rate of approximately 14% per annum.
The Company receives periodic base servicing fees for the servicing and
collection of the Contracts. In addition, the Company is entitled to the cash
flows from the Residuals that represent collections on the Contracts in excess
of the amounts required to pay principal and interest on the Notes, the base
servicing fees, and certain other fees (such as trustee and custodial fees).
Required principal payments are in most cases defined as the payments sufficient
to keep the principal balance of the Notes equal to the aggregate principal
balance of the related Contracts (excluding those Contracts that have been
charged off). Some of the Securitization Agreements require accelerated payment
of principal until the principal balance of the Notes is reduced to a specified
percentage of the aggregate principal balance of the related Contracts. Such
accelerated principal payment is said to create "over-collateralization" of the
Notes.
If the amount of cash required for payment of fees, interest and principal
exceeds the amount collected during the collection period, the shortfall is
drawn from the Spread Account, if any. If the cash collected during the period
exceeds the amount necessary for the above allocations, and there is no
shortfall in the related Spread Account, the excess is released to the Company,
or in certain cases is transferred to other Spread Accounts that may be below
their required levels. If the Spread Account balance is not at the required
credit enhancement level, then the excess cash collected is retained in the
Spread Account until the specified level is achieved. Although Spread Account
balances are held by the Trusts on behalf of the Company's SPS as the owner of
the Residuals, the cash in the Spread Accounts is restricted from use by the
Company. Cash held in the various Spread Accounts is invested in high quality,
liquid investment securities, as specified in the Securitization Agreements. The
interest rate payable on the Contracts is significantly greater than the
interest rate on the Notes. As a result, the Residuals described above are a
significant asset of the Company. In determining the value of the Residuals, the
Company must estimate the future rates of prepayments, delinquencies, defaults
and default loss severity, and the value of the Company's optional right to
repurchase receivables pursuant to the terms of the Securitization Agreements,
as all of these factors affect the amount and timing of the estimated cash
flows. The Company estimates prepayments by evaluating historical prepayment
performance of comparable Contracts. The Company has used prepayment estimates
of approximately 18.3% to 21.7% cumulatively over the lives of the related
Contracts. The Company estimates defaults and default loss severity using
available historical loss data for comparable Contracts and the specific
characteristics of the Contracts purchased by the Company. The Company estimates
recovery rates of previously charged off receivables using available historical
recovery data and projected future recovery levels. In valuing the Residuals,
the Company estimates that gross losses as a percentage of the original
principal balance will approximate 13.7% to 19.7% cumulatively over the lives of
the related Contracts, with recovery rates approximating 2.1% to 5.2% of the
original principal balance.
In future periods, the Company will recognize additional revenue from the
Residuals if the actual performance of the Contracts is better than the original
estimate, or the Company would increase the estimated fair value of the
27
Residuals. If the actual performance of the Contracts were worse than the
original estimate, then a downward adjustment to the carrying value of the
Residuals would be required.
The Noteholders and the related securitization Trusts have no recourse to the
Company for failure of the Contract obligors to make payments on a timely basis.
The Company's Residuals, however, are subordinate to the Notes until the
Noteholders are fully paid, and the Company is therefore at risk to that extent.
(c) INCOME TAXES
The Company and its subsidiaries file a consolidated federal income and combined
state franchise tax returns. The Company utilizes the asset and liability method
of accounting for income taxes, under which deferred income taxes are recognized
for the future tax consequences attributable to the differences between the
financial statement values of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred taxes of a change in tax rates is recognized in income in the period
that includes the enactment date. The Company has estimated a valuation
allowance against that portion of the deferred tax asset whose utilization in
future periods is not more than likely.
In determining the possible realization of deferred tax assets, future taxable
income from the following sources are considered: (a) the reversal of taxable
temporary differences, (b) future operations exclusive of reversing temporary
differences, and (c) tax planning strategies that, if necessary, would be
implemented to accelerate taxable income into periods in which bet operating
losses might otherwise expire.
FORWARD LOOKING STATEMENTS
This report on Form 10-Q includes certain "forward-looking statements,"
including, without limitation, the statements or implications to the effect that
gross losses as a percentage of original balances will approximate 13.7% to
19.7% cumulatively over the lives of the related Contracts, with recovery rates
approximating 2.1% to 5.2% of original principal balances. Other forward-looking
statements may be identified by the use of words such as "anticipates,"
"expects," "plans," "estimates," or words of like meaning. As to the
specifically identified forward-looking statements, factors that could affect
gross losses and recovery rates include changes in the general economic climate,
which could affect the willingness or ability of obligors to pay pursuant to the
terms of Contracts, changes in laws respecting consumer finance, which could
affect the ability of the Company to enforce rights under Contracts, and changes
in the market for used vehicles, which could affect the levels of recoveries
upon sale of repossessed vehicles. Factors that could affect the Company's
revenues in the current year include the levels of cash releases from existing
pools of Contracts, which would affect the Company's ability to purchase
Contracts, the terms on which the Company is able to finance such purchases, the
willingness of Dealers to sell Contracts to the Company on the terms that it
offers, and the terms on which the Company is able to sell Contracts once
acquired. Factors that could affect the Company's expenses in the current year
include competitive conditions in the market for qualified personnel, and
interest rates (which affect the rates that the Company pays on Notes issued in
its securitizations).
28
Additional risk factors, any of which could have a material effect on the
Company's performance, are set forth below:
DEPENDENCE ON WAREHOUSE FINANCING. The Company's primary source of day-to-day
liquidity is continuous securitization of Contracts, under which it sells
Contracts to either of two special-purpose affiliated entities as often as once
a week. Such transactions function as a "warehouse," in which Contracts are
held. The Company expects to continue to effect similar transactions (or to
obtain replacement or additional financing) as current arrangements expire or
become fully utilized; however, there can be no assurance that such financing
will be obtainable on favorable terms. To the extent that the Company is unable
to maintain its existing structure or is unable to arrange new warehouse
facilities, the Company may have to curtail Contract purchasing activities,
which could have a material adverse effect on the Company's financial condition
and results of operations.
DEPENDENCE ON SECURITIZATION PROGRAM. The Company is dependent upon its ability
to continue to pool and sell Contracts in term securitizations in order to
generate cash proceeds for new purchases. Adverse changes in the market for
securitized Contract pools, or a substantial lengthening of the warehousing
period, would burden the Company's financing capabilities, could require the
Company to curtail its purchase of Contracts, and could have a material adverse
effect on the Company. In addition, as a means of reducing the percentage of
cash collateral that the Company would otherwise be required to deposit and
maintain in Spread Accounts, all of the Company's securitizations since June
1994 have utilized credit enhancement in the form of financial guaranty
insurance policies issued by monoline financial guaranty insurers. The Company
believes that financial guaranty insurance policies reduce the costs of
securitizations relative to alternative forms of credit enhancements available
to the Company. No insurer is required to insure Company-sponsored
securitizations and there can be no assurance that any will continue to do so.
Similarly, there can be no assurance that any securitization transaction will be
available on terms acceptable to the Company, or at all. The timing of any
securitization transaction is affected by a number of factors beyond the
Company's control, any of which could cause substantial delays, including,
without limitation, market conditions and the approval by all parties of the
terms of the securitization.
RISK OF GENERAL ECONOMIC DOWNTURN. The Company's business is directly related to
sales of new and used automobiles, which are affected by employment rates,
prevailing interest rates and other domestic economic conditions. Delinquencies,
foreclosures and losses generally increase during economic slowdowns or
recessions. Because of the Company's focus on Sub-Prime Customers, the actual
rates of delinquencies, repossessions and losses on such Contracts could be
higher under adverse economic conditions than those experienced in the
automobile finance industry in general. Any sustained period of economic
slowdown or recession could adversely affect the Company's ability to sell or
securitize pools of Contracts. The timing of any economic changes is uncertain,
and sluggish sales of automobiles and weakness in the economy could have an
adverse effect on the Company's business and that of the Dealers from which it
purchases Contracts.
DEPENDENCE ON PERFORMANCE OF SOLD CONTRACTS. Under the financial structures the
Company has used to date in its term securitizations, certain excess servicing
cash flows generated by the Contracts sold in the term securitizations are
retained in a Spread Account within the securitization trusts to provide
liquidity and credit enhancement. While the specific terms and mechanics of the
29
Spread Account vary among transactions, the Company's Securitization Agreements
generally provide that the Company will receive excess cash flows only if the
Spread Account balances have reached specified levels and/or the delinquency or
losses related to the Contracts in the pool are below certain predetermined
levels. In the event delinquencies and losses on the Contracts exceed such
levels, the terms of the securitization may require increased Spread Account
balances to be accumulated for the particular pool; may restrict the
distribution to the Company of excess cash flows associated with other pools;
or, in certain circumstances, may permit the insurers to require the transfer of
servicing on some or all of the Contracts to another servicer. Any of these
conditions could materially adversely affect the Company's liquidity and
financial condition.
CREDITWORTHINESS OF CONSUMERS. The Company specializes in the purchase, sale and
servicing of Contracts to finance automobile purchases by Sub-Prime Customers,
which entail a higher risk of non-performance, higher delinquencies and higher
losses than Contracts with more creditworthy customers. While the Company
believes that the underwriting criteria and collection methods it employs enable
it to control the higher risks inherent in Contracts with Sub-Prime Customers,
no assurance can be given that such criteria and methods will afford adequate
protection against such risks. The Company has experienced fluctuations in the
delinquency and charge-off performance of its Contracts. In the event that
portfolios of Contracts sold and serviced by the Company experience greater
defaults, higher delinquencies or higher losses than anticipated, the Company's
income could be negatively affected. A larger number of defaults than
anticipated could also result in adverse changes in the structure of the
Company's future securitization transactions, such as a requirement of increased
cash collateral in such transactions.
POSSIBLE INCREASE IN COST OF FUNDS. The Company's profitability is determined
by, among other things, the difference between the rate of interest charged on
the Contracts purchased by the Company and the rate of interest payable to
purchasers of Notes issued in securitizations. The Contracts purchased by the
Company generally bear finance charges close to or at the maximum permitted by
applicable state law. The interest rates payable on such Notes the Company are
fixed, based on interest rates prevailing in the market at the time of sale.
Consequently, increases in market interest rates tend to reduce the "spread" or
margin between Contract finance charges and the interest rates required by
investors and, thus, the potential operating profits to the Company from the
purchase, sale and servicing of Contracts. Operating profits expected to be
earned by the Company on portfolios of Contracts previously sold are insulated
from the adverse effects of increasing interest rates because the interest rates
on the related Notes were fixed at the time the Contracts were sold. Any future
increases in interest rates would likely increase the interest rates on Notes
issued in future term securitizations and could have a material adverse effect
on the Company's results of operations.
PREPAYMENT AND DEFAULT RISK. Gains from the sale of Contracts in the Company's
past securitization transactions have constituted a significant portion of the
net income of the Company and are likely to continue to represent a significant
portion of the Company's net income. A portion of the gains is based in part on
management's estimates of future prepayment and default rates and other
considerations in light of then-current conditions. If actual prepayments with
respect to Contracts occur more quickly than was projected at the time such
Contracts were sold, as can occur when interest rates decline, or if default
rates are greater than projected at the time such Contracts were sold, a charge
to income may be required and would be taken in the period of adjustment. If
actual prepayments occur more slowly or if default rates are lower than
30
estimated with respect to Contracts sold, total revenue would exceed previously
estimated amounts.
COMPETITION. The automobile financing business is highly competitive. The
Company competes with a number of national, local and regional finance
companies. In addition, competitors or potential competitors include other types
of financial services companies, such as commercial banks, savings and loan
associations, leasing companies, credit unions providing retail loan financing
and lease financing for new and used vehicles and captive finance companies
affiliated with major automobile manufacturers such as General Motors Acceptance
Corporation, Ford Motor Credit Corporation, Chrysler Financial Corporation and
Nissan Motors Acceptance Corporation. Many of the Company's competitors and
potential competitors possess substantially greater financial, marketing,
technical, personnel and other resources than the Company. Moreover, the
Company's future profitability will be directly related to the availability and
cost of its capital relative to that of its competitors. The Company's
competitors and potential competitors include far larger, more established
companies that have access to capital markets for unsecured commercial paper and
investment grade rated debt instruments, and to other funding sources which may
be unavailable to the Company. Many of these companies also have long-standing
relationships with Dealers and may provide other financing to Dealers, including
floor plan financing for the Dealers' purchases of automobiles from
manufacturers, which is not offered by the Company. There can be no assurance
that the Company will be able to continue to compete successfully.
LITIGATION. Because of the consumer-oriented nature of the industry in which the
Company operates and the application of certain laws and regulations, industry
participants are regularly named as defendants in class-action litigation
involving alleged violations of federal and state laws and regulations and
consumer law torts, including fraud. Many of these actions involve alleged
violations of consumer protection laws. Although the Company is not involved in
any material litigation, a significant judgment against the Company or within
the industry in connection with any such litigation could have a material
adverse effect on the Company's financial condition and results of operations.
DEPENDENCE ON DEALERS. The Company is dependent upon establishing and
maintaining relationships with unaffiliated Dealers to supply it with Contracts.
During the three-month period ended March 31, 2003, no Dealer accounted for more
than 1.0% of the Contracts purchased by the Company. The Dealer Agreements do
not require Dealers to submit a minimum number of Contracts for purchase by the
Company. The failure of Dealers to submit Contracts that meet the Company's
underwriting criteria would have a material adverse effect on the Company's
financial condition and results of operations.
GOVERNMENT REGULATIONS. The Company's business is subject to numerous federal
and state consumer protection laws and regulations, which, among other things:
(i) require the Company to obtain and maintain certain licenses and
qualifications; (ii) limit the interest rates, fees and other charges the
Company is allowed to charge; (iii) limit or prescribe certain other terms of
its Contracts; (iv) require the Company to provide specified disclosures; and
(v) regulate certain servicing and collection practices and define its rights to
repossess and sell collateral. An adverse change in existing laws or
regulations, or in the interpretation thereof, the promulgation of any
31
additional laws or regulations, or the failure to comply with such laws and
regulations could have a material adverse effect on the Company's financial
condition and results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
Although the Company utilized its floating rate variable note purchase facility
and completed a term securitization during the quarter ended March 31, 2003, the
structures did not lend themselves to some of the strategies the Company has
used in the past to minimize interest rate risk, as described below.
Specifically, the rate on the Notes issued by the floating rate variable note
purchase facility is adjustable and there is no pre-funding component to the
floating rate variable note purchase facility or term securitization. The
Company does intend to issue fixed rate Notes and to include pre-funding
structures for future term securitization transactions, whereby the amount of
asset backed securities issued exceeds the amount of Contracts initially sold to
the Trusts. In pre-funding, the proceeds from the pre-funded portion are held in
an escrow account until the Company sells the additional Contracts to the Trust
in amounts up to the balance of the pre-funded escrow account. In pre-funded
securitizations, the Company locks in the borrowing costs with respect to the
Contracts it subsequently delivers to the Trust. However, the Company incurs an
expense in pre-funded securitizations equal to the difference between the money
market yields earned on the proceeds held in escrow prior to subsequent delivery
of Contracts and the interest rate paid on the asset backed securities
outstanding, the amount as to which there can be no assurance. In addition, the
Contracts the Company does purchase and securitize have fixed rates of interest,
whereas the Company's interest expense related to the current note purchase
facility is based on a variable rate. Historically, the Company's term
securitization facilities had fixed rates of interest. Therefore, some of the
strategies the Company has used in the past to minimize interest rate risk do
not currently apply.
The Company is subject to market risks due to fluctuations in interest rates
primarily through its outstanding indebtedness and to a lesser extent its
outstanding interest earning assets, and commitments to enter into new
Contracts. The table below outlines the carrying values and estimated fair
values of such financial instruments:
MARCH 31, DECEMBER 31,
2003 2002
------------------ ------------------
CARRYING FAIR CARRYING FAIR
FINANCIAL INSTRUMENT VALUE VALUE VALUE VALUE
-------------------- -------- -------- -------- --------
(IN THOUSANDS)
Finance receivables, net ....... $61,860 $61,860 $84,592 $84,592
Notes payable .................. 504 504 673 673
Securitization trust debt ...... 54,165 54,165 71,630 71,630
Senior secured debt ............ 53,308 53,308 50,072 50,072
Subordinated debt .............. 35,996 34,656 36,000 32,800
Related party debt ............. 17,500 16,800 17,500 15,400
Much of the information used to determine fair value is highly subjective. When
applicable, readily available market information has been utilized. However, for
a significant portion of the Company's financial instruments, active markets do
32
not exist. Therefore, considerable judgments were required in estimating fair
value for certain items. The subjective factors include, among other things, the
estimated timing and amount of cash flows, risk characteristics, credit quality
and interest rates, all of which are subject to change. Since the fair value is
estimated and do not reflect amounts of which amounts outstanding could be
settled by the Company, the amounts that will actually be realized or paid at
settlement or maturity of the instruments could be significantly different.
ITEM 4. CONTROLS AND PROCEDURES
CPS maintains a system of internal controls and procedures designed to provide
reasonable assurance as to the reliability of its published financial statements
and other disclosures included in this report. Within the 90-day period prior to
filing this report, CPS evaluated the effectiveness of the design and operation
of such disclosure controls and procedures. Based upon that evaluation, the
principal executive officer (Charles E. Bradley, Jr.) and the principal
financial officer (David N. Kenneally) concluded that the disclosure controls
and procedures are effective in timely alerting them to material information
relating to CPS that is required to be included in this quarterly report on Form
10-Q. There have been no significant changes in such internal controls or in
other factors that could significantly affect internal controls subsequent to
the date that CPS carried out such evaluation.
PART II -- OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
The information provided under the caption "Legal Proceedings" in the Company's
annual report on Form 10-K for the year ended December 31, 2002, is incorporated
herein by reference. No material developments have taken place in the litigation
described therein.
The Company is the nominal defendant in a shareholder derivative lawsuit filed
in a California state court on April 1, 2003, by a purported shareholder, Robert
W. Walter. The case was removed on April 25 to the federal district court for
the central district of California. The other defendants are (i) each of the
Company's directors who held that office in 2002 (Charles Bradley, Jr., Thomas
Chrystie, John McConnaughy, Jr., John Poole, William Roberts, and Daniel Wood),
as well as two former directors (Charles Bradley, Sr., and Robert Simms). Such
individuals are alleged to have permitted the Company to have engaged in
transactions with affiliates on terms that are said to have been unfair to the
Company. The relief sought is money damages, together with costs and attorney
fees. The reader should note that (i) were there any merit to the allegations
raised in the lawsuit, any recovery would inure to the benefit of the Company,
and (ii) there will be costs to the Company incurred in relation to the lawsuit.
The Company has referred the matter to a special committee of its board of
directors, composed exclusively of individuals who are not defendants in the
lawsuit, and expects to govern itself in accordance with the determinations of
that committee.
The Company is routinely involved in various legal proceedings resulting from
its consumer finance activities and practices, both continuing and discontinued.
The Company believes that there are substantive legal defenses to such claims,
and intends to defend them vigorously. There can be no assurance, however, as to
the outcome.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are filed with this report:
99.1 Certification, by chief executive officer
99.2 Certification by chief financial officer
(b) The Company did not file any reports on Form 8-K during the quarter
ended March 31, 2003.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant duly caused this report to be signed on its behalf by the undersigned
thereunto duly authorized.
CONSUMER PORTFOLIO SERVICES, INC.
(Registrant)
Date: May 12, 2003
/s/ CHARLES E. BRADLEY, JR.
------------------------------------------------
Charles E. Bradley, Jr.
PRESIDENT AND CHIEF EXECUTIVE OFFICER
(Principal Executive Officer)
Date: May 12, 2003
/s/ DAVID N. KENNEALLY
------------------------------------------------
David N. Kenneally
SENIOR VICE PRESIDENT -- CHIEF FINANCIAL OFFICER
(Principal Financial and Accounting Officer)
34