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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 SEPTEMBER 30, 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 November 10, 2003 the registrant had 20,263,494 common shares outstanding.
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CONSUMER PORTFOLIO SERVICES, INC. AND SUBSIDIARIES
INDEX TO FORM 10-Q
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September 30,
2003 and December 31, 2002.....................................3
Condensed Consolidated Statements of Operations and
Comprehensive Income for the three-month and nine-month
periods ended September 30, 2003 and 2002 .....................4
Condensed Consolidated Statements of Cash Flows for the
nine-month periods ended September, 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.....................................23
Item 3. Quantitative and Qualitative Disclosures About Market Risk....39
Item 4. Controls and Procedures.......................................39
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.............................................40
Item 6. Exhibits and Reports on Form 8-K..............................40
Signatures....................................................................41
Certifications................................................................42
2
ITEM 1. FINANCIAL STATEMENTS
CONSUMER PORTFOLIO SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2003 2002
---------- ----------
ASSETS
Cash .......................................................... $ 27,093 $ 32,947
Restricted cash ............................................... 60,712 18,912
Finance receivables ........................................... 266,092 110,420
Less: Allowance for finance credit losses ..................... (38,017) (25,828)
---------- ----------
Finance receivables, net ...................................... 228,075 84,592
Servicing fees receivable ..................................... 3,749 3,407
Residual interest in securitizations .......................... 119,240 127,170
Furniture and equipment, net .................................. 1,068 1,612
Deferred financing costs ...................................... 1,489 1,671
Deferred interest expense ..................................... 689 2,695
Other assets .................................................. 6,733 12,442
---------- ----------
$ 448,848 $ 285,448
========== ==========
LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Accounts payable and accrued expenses ......................... $ 22,330 $ 18,132
Warehouse lines of credit ..................................... 24,255 --
Tax liabilities, net .......................................... 4,071 8,800
Capital lease obligation ...................................... 5 67
Notes payable ................................................. 3,999 673
Securitization trust debt ..................................... 202,096 71,630
Senior secured debt ........................................... 50,136 50,072
Subordinated debt ............................................. 35,966 36,000
Related party debt ............................................ 17,500 17,500
---------- ----------
360,358 202,874
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; 20,237,644 and 20,528,270 shares
issued and outstanding at September 30, 2003 and
December 31, 2002, respectively ............................ 64,525 63,929
Retained earnings ............................................. 26,665 20,597
Comprehensive loss - minimum pension benefit obligation, net... (1,594) (1,594)
Deferred compensation ......................................... (1,106) (358)
---------- ----------
88,490 82,574
---------- ----------
$ 448,848 $ 285,448
========== ==========
See accompanying Notes to Condensed Consolidated Financial Statements.
3
CONSUMER PORTFOLIO SERVICES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
-------- -------- -------- --------
REVENUES:
Net gain on sale of contracts ............................... -- 5,303 8,664 12,170
Interest income ............................................. 15,835 13,218 36,605 35,708
Servicing fees .............................................. 4,295 3,619 13,361 10,385
Other income ................................................ 5,357 3,900 13,119 8,129
-------- -------- -------- --------
25,487 26,040 71,749 66,392
-------- -------- -------- --------
EXPENSES:
Employee costs .............................................. 9,491 9,174 27,380 28,608
General and administrative .................................. 6,050 5,829 14,131 15,354
Interest .................................................... 6,427 6,334 17,044 17,982
Provision for credit losses ................................. 4,190 -- 4,190 --
Marketing ................................................... 846 1,116 2,574 3,804
Occupancy ................................................... 1,112 1,053 3,096 3,032
Depreciation and amortization ............................... 223 294 700 868
-------- -------- -------- --------
28,339 23,800 69,115 69,648
-------- -------- -------- --------
Income (loss) before income taxes (benefit) ................ (2,852) 2,240 2,634 (3,256)
Income tax expense (benefit) ................................ -- 940 (3,434) (4,314)
-------- -------- -------- --------
Income (loss) before extraordinary item ..................... (2,852) 1,300 6,068 1,058
Extraordinary item, unallocated negative goodwill............ -- -- -- 17,412
-------- -------- -------- --------
Net income (loss) ........................................... (2,852) 1,300 6,068 18,470
======== ======== ======== ========
Earnings (loss) per share before extraordinary item:
Basic .................................................... (0.14) 0.07 0.30 0.05
Diluted .................................................. (0.14) 0.06 0.28 0.05
Earnings per share, extraordinary item:
Basic .................................................... -- -- -- 0.88
Diluted .................................................. -- -- -- 0.83
Earnings (loss) per share after extraordinary item:
Basic .................................................... (0.14) 0.07 0.30 0.94
Diluted .................................................. (0.14) 0.06 0.28 0.88
Number of shares used in computing earnings (loss) per share:
Basic .................................................... 20,200 19,683 20,226 19,693
Diluted .................................................. 20,200 21,012 21,711 21,030
See accompanying Notes to Condensed Consolidated Financial Statements.
4
CONSUMER PORTFOLIO SERVICES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30
------------
2003 2002
---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ...................................................................... $ 6,068 $ 18,470
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 ................................................. 700 868
Amortization of deferred financing costs ...................................... 2,015 3,884
Provision for credit losses ................................................... 4,716 1,587
NIR gains recognized, net ..................................................... (6,676) (10,471)
Deferred compensation ......................................................... 772 951
Releases of cash from Trusts to Company ....................................... 20,227 48,963
Initial deposits to Trusts .................................................... (18,736) (6,819)
Net deposits to Trusts to increase Credit Enhancement ......................... (19,575) (13,606)
(Increase) decrease in receivables from Trusts and
investment in subordinated certificates .................................... 32,690 3,562
Changes in assets and liabilities:
Restricted cash ............................................................. (24,077) 14,492
Purchases of contracts held for sale ........................................ (182,045) (357,711)
Amortization and liquidation of contracts held for sale ..................... 249,660 434,142
Other assets ................................................................ 7,786 1,839
Accounts payable and accrued expenses ....................................... (2,568) (12,804)
Deferred tax asset/liability ................................................ (6,802) 1,108
---------- ----------
Net cash provided by operating activities ................................ 64,155 111,043
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of contracts held for investment ...................................... (92,389) --
Amortization of contracts held for investment ................................... 1,683 --
Purchase of subsidiary, net of cash acquired .................................... (10,181) (29,467)
Purchases of furniture and equipment ............................................ (68) (253)
---------- ----------
Net cash used in investing activities .................................... (100,955) (29,720)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of senior secured debt ................................... 25,000 46,242
Proceeds from issuance of securitization trust debt ............................. 83,125 --
Net proceeds from warehouse lines of credit ..................................... 21,877 --
Repayment of securitization trust debt .......................................... (68,256) (64,357)
Repayment of senior secured debt ................................................ (24,935) (15,699)
Repayment of subordinated debt .................................................. (34) (23,081)
Repayment of capital lease obligations .......................................... (80) (350)
Repayment of notes payable ...................................................... (2,994) (717)
Payment of financing costs ...................................................... (1,833) (1,037)
Purchase of common stock ........................................................ (1,195) (15)
Exercise of options and warrants ................................................ 271 309
---------- ----------
Net cash provided by (used in) financing activities ...................... 30,946 (58,705)
---------- ----------
Increase (decrease) in cash ........................................................ (5,854) 22,618
Cash at beginning of period ........................................................ 32,947 2,570
---------- ----------
Cash at end of period .............................................................. $ 27,093 $ 25,188
========== ==========
Supplemental disclosure of cash flow information:
Cash paid (received) during the period for:
Interest ................................................................... $ 12,997 $ 14,836
Income taxes ............................................................... 3,369 (5,483)
Supplemental disclosure of non-cash investing and financing activities:
Stock compensation ........................................................... 772 951
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 purchasing, selling and servicing retail automobile installment
sale contracts ("Contracts" or "finance receivables") 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.
ACQUISITION OF MFN FINANCIAL CORPORATION
On March 8, 2002, CPS acquired 100% of MFN Financial Corporation, a Delaware
corporation ("MFN") and its subsidiaries, by the merger (the "MFN Merger") of a
direct wholly-owned subsidiary of CPS with and into MFN. MFN thus became a
wholly owned subsidiary of CPS, and CPS thus acquired the assets of MFN, which
consisted principally of interests in automobile installment sales finance
Contracts and the facilities for originating and servicing such Contracts. The
MFN 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 continues to
use the assets acquired in the MFN Merger in the automobile finance business,
but has disposed of a portion of such assets. MFN has ceased to purchase
automobile installment sales finance Contracts, and does not anticipate
recommencing such purchasing. 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:
SEPTEMBER 30, DECEMBER 31,
2003 (1) ACTIVITY 2002
-------- -------- ----
(IN THOUSANDS)
Severance payments and consulting contracts ..... $ 348 $ 223 $ 571
Facilities closures ............................. 1,211 784 1,995
Termination of contracts, leases, services and
other obligations .......................... 206 117 323
Acquisition expenses accrued but unpaid ......... 51 -- 51
------- ------- -------
Total liabilities assumed .................. $1,816 $1,124 $2,940
======= ======= =======
- ------------
(1) The initial accrual amount recorded was $6.2 million on March 8, 2002 and
the remaining accrual recorded in the Condensed Consolidated Balance Sheet of
the Company is approximately $1.8 million, and $2.9 million as of September 30,
2003 and December 31, 2002, respectively. The Company believes that this amount
provides adequately for anticipated remaining costs related to exiting certain
activities of MFN, and that amounts indicated above are reasonably allocated.
6
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company's Condensed Consolidated Balance Sheet and Condensed Consolidated
Statement of Operations as of and for the three and nine months ended September
30, 2003 and 2002, include the balance sheet accounts of MFN Financial
Corporation as of September 30, 2003 and 2002 and the results of operations
subsequent to March 8, 2002, the merger date.
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
=========
ACQUISITION OF TFC ENTERPRISES, INC.
On May 20, 2003, CPS acquired TFC Enterprises, Inc., a Delaware corporation
("TFC") and its subsidiaries, by the merger (the "TFC Merger") of a direct,
wholly-owned subsidiary of CPS, with and into TFC. In the TFC Merger, TFC became
a wholly-owned subsidiary of CPS. CPS thus acquired the assets of TFC and its
subsidiaries, which consisted principally of interests in motor vehicle
installment sales finance Contracts, interests in securitized pools of such
Contracts, and the facilities for originating and servicing such Contracts. The
merger was accounted for as a purchase.
TFC, through its primary operating subsidiary, "The Finance Company," purchases
motor vehicle installment sales finance Contracts from automobile Dealers, and
securitizes and services such Contracts. CPS intends to continue to use the
assets acquired in the TFC Merger in the automobile finance business.
In connection with the integration and consolidation of certain activities
between CPS and TFC, the Company has recognized certain liabilities related to
the costs to integrate certain activities and terminate the affected employees
of TFC. These activities include service departments such as accounting,
finance, human resources, information technology, administration, payroll and
executive management. The total of these liabilities recognized by the Company
at the time of the merger were $4.5 million. These costs include the following:
7
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
SEPTEMBER 30, MAY 20,
2003 (1) ACTIVITY 2003
---------- ---------- ---------
(IN THOUSANDS)
Severance payments and consulting contracts.. $2,401 $ 282 $2,683
Facilities closures ......................... 1,380 41 1,421
Other obligations ........................... 234 206 440
------- ------- -------
Total liabilities assumed .............. $4,015 $ 529 $4,544
======= ======= =======
- ------------
(1) The Company believes that this amount provides adequately for anticipated
remaining costs related to exiting certain activities of TFC, and that amounts
indicated above are reasonably allocated.
At the closing of the TFC Merger, each outstanding share of common stock of TFC
became a right to receive $1.87 per share in cash. The total merger
consideration payable to stockholders of TFC was approximately $21.6 million.
The recipients of the total merger consideration had no material relationship
with CPS, its directors, its officers or any associates of such directors or
officers, to the best of CPS's knowledge. The merger consideration was paid with
existing cash of CPS. The aggregate purchase price, including expenses related
to the transaction, was approximately $23.7 million.
The Company's Condensed Consolidated Balance Sheet and Condensed Consolidated
Statement of Operations as of and for the three and nine months ended September
30, 2003, include the balance sheet accounts of TFC Enterprises, Inc. as of
September 30, 2003 and the results of operations subsequent to May 20, 2003, the
merger date. The Company has recorded certain purchase accounting adjustments on
its Condensed Consolidated Balance Sheet, which are estimates based on available
information.
The following table summarizes the recorded amounts of the assets acquired and
liabilities assumed at the date of acquisition.
MAY 20, 2003
------------
(IN THOUSANDS)
Cash ....................................................... $ 13,545
Restricted cash ............................................ 17,723
Finance Contracts, net ..................................... 125,108
Other assets ............................................... 502
---------
Total assets acquired .............................. 156,878
---------
Securitization trust debt .................................. 115,597
Subordinated debt .......................................... 6,321
Capital lease obligations .................................. 17
Accounts payable and other liabilities... .................. 11,217
---------
Total liabilities assumed .......................... 133,152
---------
Purchase price ..................................... $ 23,726
=========
PRO FORMA RESULTS OF OPERATIONS
Selected unaudited pro forma combined results of operations for the three-month
and nine-month periods ending September 30, 2003 and 2002, assuming the MFN
Merger and TFC Merger occurred on January 1, 2003 and 2002, are as follows:
8
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
THREE MONTHS THREE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
---- ----
(IN THOUSANDS)
Total revenue ............................................. $ 25,487 $ 32,031
Net earnings (loss) ....................................... $ (2,852) $ 2,339
Basic net earnings (loss) per share ....................... $ (0.14) $ 0.12
Diluted net earnings (loss) per share ..................... $ (0.14) $ 0.11
NINE MONTHS NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
---- ----
(IN THOUSANDS)
Total revenue ............................................. $ 78,413 $ 102,680
Net earnings (loss) before Merger-related expenses and
extraordinary item ................................... 6,497 (4,070)
Extraordinary item ........................................ -- 17,412
Net earnings .............................................. 6,497 13,342
Basic net earnings (loss) per share before Merger-related
expenses and extraordinary item ...................... $ 0.32 $ (0.21)
Extraordinary item ........................................ -- 0.88
Basic net earnings per share .............................. 0.32 0.68
Diluted net earnings (loss) per share before Merger-related
expenses and extraordinary item ...................... $ 0.30 $ (0.19)
Extraordinary item ........................................ -- 0.83
Diluted net earnings per share ............................ 0.30 0.63
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 and nine-month periods ended September 30, 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.
9
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
RECENT DEVELOPMENTS
Subsequent to June 30, 2003, the Company agreed with the other parties to its
continuous or "warehouse" securitization facilities to amend the terms of such
facilities. The effect of the amendments is to cause the use of those facilities
to be treated for financial accounting purposes as borrowings secured by pledged
Contracts, rather than as sales of such Contracts.
In addition, the Company announced in August 2003 that it would structure its
future term securitization transactions so that they will be treated for
financial accounting purposes as borrowings secured by receivables, rather than
as sales of receivables. The new structure for the warehouse facilities
described in the preceding paragraph and the intended future structure of the
Company's term securitizations has affected and will affect the way in which the
transactions are reported. The major effects are these: (i) the finance
receivables will be shown as assets of the Company on its balance sheet; (ii)
the debt issued in the transactions will be shown as indebtedness of the
Company; (iii) cash posted to enhance the credit of the securitization
transactions will be shown as "restricted cash" on the Company's balance sheet;
(iv) the servicing fee that the Company receives in connection with such
receivables will be recorded as a portion of the interest earned on such
receivables; (v) the Company will initially and periodically record as expense a
provision for estimated credit losses on the receivables; and (vi) the portion
of scheduled payments on the receivables representing interest will be recorded
as revenue as accrued.
These changes collectively represent a deferral of revenue and acceleration of
expenses, and thus a more conservative approach to accounting for the Company's
operations. The changes initially will result in the Company's reporting lower
earnings than it would report if it were to continue to structure its
securitizations to require recognition of gain on sale. As a result, reported
earnings initially will be less than they would be had the Company continued to
structure its securitizations to record a gain on sale and therefore, reported
net earnings may be negative or nominally positive for approximately the next
year. Growth in the Company's portfolio of receivables in excess of current
expectations would further delay achievement of positive net earnings. The
Company's cash availability and cash requirements should be unaffected by the
change in structure.
TREATMENT OF SECURITIZATIONS
In its securitization transactions that were treated as sales for financial
accounting purposes, the Company, or a wholly-owned, consolidated subsidiary of
the Company, retains a residual interest in the Contracts that were sold to a
wholly-owned, unconsolidated special purpose subsidiary. The Company's
securitization transactions include "term" securitizations (the purchaser holds
the Contracts for substantially their entire term) and "continuous" or
"warehouse" securitizations (which finance the acquisition of the Contracts for
future sale into term securitizations).
As of December 31, 2002 the residual interest in term and warehouse
securitizations are reflected in the line item "residual interest in
securitizations" on the Company's Condensed Consolidated Balance Sheet. As of
September 30, 2003 the line item "residual interest in securitizations" on the
Company's Condensed Consolidated Balance Sheet reflects the residual interest in
certain term securitizations but no residual interest in warehouse
securitizations. In July 2003, the warehouse securitizations were restructured
as secured financings and, therefore, are reflected in the line items "Finance
receivables" and "Warehouse lines of credit" on the Company's Condensed
Consolidated Balance Sheet.
10
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The Company's securitization structure is generally as follows:
The Company sells Contracts it acquires to a wholly-owned 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 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 (a "Note Insurer"). In addition, the Company provides
"Credit Enhancement" for the benefit of the Note Insurer and the investors in
the form of an initial cash deposit to an account ("Spread Account") held by the
Trust, in the form of overcollateralization of the Notes, where the principal
balance of the Notes issued is less than the principal balance of the Contracts,
in the form of subordinated Notes, or some combination of such Credit
Enhancements. The agreements governing the securitization transactions
(collectively referred to as the "Securitization Agreements") require that the
initial level of Credit Enhancement be supplemented by a portion of collections
from the Contracts until the level of Credit Enhancement reaches 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 Contracts. The specified levels at which the Credit Enhancements 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 a specified percentage of the initial aggregate balance.
The prior securitizations structured as sales for financial accounting purposes
differ from secured financings in that the Trust to which the SPS sells the
Contracts meets the definition of a qualified special purpose entity under
Statement of Financial Accounting Standards No. 140 ("SFAS 140"). As a result,
assets and liabilities of the Trust are not consolidated into the Company's
Condensed Consolidated Balance Sheet.
The Company's warehouse securitization structures are similar to the above,
except that (i) the SPS that purchases the Contracts pledges the Contracts to
secure promissory notes which it issues, (ii) the promissory notes are in an
aggregate principal amount of not more than 71% to 73% of the aggregate
principal balance of the Contracts (that is, at least 27%
overcollateralization), and (iii) no increase in the required amount of Credit
Enhancement is contemplated unless certain portfolio performance tests are
breached. During the quarter ended September 30, 2003 the warehouse
securitizations related to the CPS programs were amended to provide for the
transactions to be reflected as secured financings for financial accounting
purposes. The Contracts held by the warehouse SPS and the promissory notes that
it issues are therefore included in the Company's Condensed Consolidated
Financial Statements as assets and liabilities, respectively.
Upon each sale of Contracts in a securitization structured as a secured
financing, whether a term securitization or a continuous securitization, the
Company retains on its Condensed Consolidated Balance Sheet the Contracts
securitized as assets and records the Notes issued in the transaction as
indebtedness of the Company.
11
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
Under the prior securitizations structured as sales for financial accounting
purposes, the Company removed from its Condensed Consolidated Balance Sheet the
Contracts sold and added 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 or
residual interest (the "Residual") consists of (a) the cash held in the Spread
Account, if any, (b) overcollateralization, 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. Until the maturity of these transactions, the Company's
Condensed Consolidated Balance Sheet will reflect securitization transactions
structured both as sales and as secured financings.
With respect to the prior securitizations structured as sales for financial
accounting purposes, 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 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 generally 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),
or a pre-determined percentage of such balance. Where that percentage is less
than 100%, the related Securitization Agreements require accelerated payment of
principal until the principal balance of the Notes is reduced to the specified
percentage. Such accelerated principal payment is said to create
"overcollateralization" 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
withdrawn 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 (in the case of securitization transactions structured as sales
for financial accounting purposes) or the Trusts (in the case of securitization
transactions structured as secured financings for financial accounting
purposes), the cash in the Spread Accounts is restricted from use by the
12
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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,
default loss severity, and recovery rates, 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 22.2%
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
charge-offs as a percentage of the original principal balance will approximate
14.2% to 21.4% cumulatively over the lives of the related Contracts, with
recovery rates approximating 2.2% to 5.5% of the original principal balance.
Following a securitization structured as a sale for financial accounting
purposes, interest income is recognized on the balance of the Residuals at the
same rate as used for calculating the present value of the NIRs, which is equal
to 14% per annum. In addition, the Company will recognize additional revenue
from the Residuals if the actual performance of the Contracts is better than the
original estimate. 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. In a securitization structured as a secured
financing for financial accounting purposes, interest income is recognized when
accrued under the terms of the related Contracts and, therefore, presents less
potential for fluctuations in performance when compared to the approach used in
a transaction structured as a sale for financial accounting purposes.
In both securitizations structured as secured financings and securitizations
structured as sales, the related receivables are sold by the Company (through a
subsidiary) to the related securitization Trust. The difference between the two
structures is that, while the receivables have been sold by the Company, in
securitizations structured as secured financings the Company reports the assets
and liabilities of the securitization Trust on its Condensed Consolidated
Balance Sheet. Under both structures, 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.
OTHER INCOME
Other income consists primarily of recoveries on certain previously charged off
Contracts and state sales tax refunds.
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
13
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 September 30, 2003 and 2002, the Company had options outstanding to
acquire 3,849,299 and 4,051,699 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 NINE MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
---------- ---------- ---------- -----------
(IN THOUSANDS, EXCEPT (IN THOUSANDS, EXCEPT
PER SHARE DATA) PER SHARE DATA)
Net income (loss), as reported ............. $ (2,852) $ 1,300 $ 6,068 $ 18,470
Stock-based employee compensation expense,
fair value method, net of tax .............. (214) (242) (639) (596)
Previously recorded stock-based employee
compensation (income) expense, net of tax... 189 (555) 448 551
---------- ---------- ---------- -----------
Pro forma net income ....................... $ (2,877) $ 503 $ 5,877 $ 18,425
========== ========== ========== ===========
Net income per share
Basic, as reported ......................... $ (0.14) $ 0.07 $ 0.30 $ 0.94
Diluted, as reported (1) ................... $ (0.14) $ 0.06 $ 0.28 $ 0.88
Pro forma Basic ............................ $ (0.14) $ 0.03 $ 0.29 $ 0.94
Pro forma Diluted (1) ...................... $ (0.14) $ 0.02 $ 0.27 $ 0.88
(1) The assumed conversion of certain subordinated debt during the nine-month
periods ended September 30, 2003, resulted in an increase to income for purposes
of the diluted earnings per share calculation of $54,979.
Pro forma net income (loss) and income (loss) per share reflect only options
granted in the years ended December 31, 1996 to September 30, 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.
14
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
PURCHASES OF COMPANY STOCK
During the nine-month period ended September 30, 2003, the Company purchased
548,426 shares of its common stock at an average price of $2.18, or $1.2 million
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.
In April 2003, FASB issued Statement on Financial Accounting Standards No. 149,
"Amendment of Statement 133 on Derivative Instruments and Hedging Activities"
("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 did not have a material effect on the
Company.
In May 2003, the FASB issued Statement of Financial Accounting Standards No.
150, "Accounting for Certain Financial Instruments with characteristics of Both
Liabilities and Equity" ("SFAS 150"). SFAS 150 requires issuers to classify as
liabilities (or assets in some circumstances) three classes of freestanding
financial instruments that embody obligations for the issuer.
Generally, SFAS 150 is effective for financial instruments entered into or
modified after May 31, 2003, and is otherwise effective at the beginning of the
first interim period beginning after June 15, 2003. The adoption of SFAS 150 did
not have a material impact on the Company's financial statements.
In January 2003, the FASB issued Interpretation 46, "Consolidation of Variable
Interest Entities an interpretation of ARB No. 51" ("FIN 46"), which 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 September 15, 2003. Certain disclosure requirements apply in all financial
statements issued after January 31, 2003, regardless of when the variable
interest entity was established. The FASB deferred the effective date for
applying the provision of FIN 46 for interests held by public entities in
variable interest entities or potential variable interest entities created
before February 1, 2003 until the end of the first interim or annual period
after December 15, 2003. Certain disclosure requirements apply in all financial
statements issued after January 31, 2003, regardless of when the variable
interest entity was established.
15
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(2) FINANCE RECEIVABLES
The following table presents the components of Finance Receivables, net of
unearned income:
SEPTEMBER 30, DECEMBER 31,
2003 2002
--------- ---------
(IN THOUSANDS)
Finance Receivables
Automobile
Simple interest ....................................... $114,161 $ 31,359
Precompute or "Rule of 78's," net of unearned income... 151,931 79,061
--------- ---------
Finance Receivables, net of unearned income ................ $266,092 $110,420
========= =========
The following table presents the contractual maturities of Finance Receivables,
net of unearned income as of September 30, 2003:
AMOUNT %
--------- ---------
(DOLLARS IN THOUSANDS)
Due in 2003................................................. $ 3,777 1 %
Due in 2004................................................. 33,513 13 %
Due in 2005................................................. 48,207 18 %
Due in 2006................................................. 43,647 16 %
Due in 2007................................................. 41,935 16 %
Due thereafter ............................................. 95,013 36 %
--------- -----
Total................................................... $266,092 100 %
========= =====
The following table presents a summary of the activity for the allowance for
credit losses, for the nine-month periods ended September 30, 2003 and 2002:
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
--------- ---------
(IN THOUSANDS)
Balance at beginning of period ............................. $ 25,828 $ --
Addition to allowance for credit losses from acquisitions 24,271 59,261
Provision for credit losses ................................ 4,716 1,587
Net charge offs ............................................ (16,798) (26,773)
--------- ---------
Balance at end of period ................................... $ 38,017 $ 34,075
========= =========
16
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:
SEPTEMBER 30, DECEMBER 31,
2003 2002
--------- ---------
(IN THOUSANDS)
Cash, commercial paper, United States government securities...
and other qualifying investments (Spread Account) ............ $ 38,793 $ 27,218
Receivables from Trusts (NIRs) ............................... 24,303 33,214
Overcollateralization ........................................ 38,004 59,366
Investment in subordinated notes ............................. 18,140 7,372
--------- ---------
Residual interest in securitizations ......................... $119,240 $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:
SEPTEMBER 30, DECEMBER 31,
2003 2002
--------- ---------
(DOLLARS IN THOUSANDS)
Undiscounted estimated credit losses ............................. $ 53,705 $ 54,363
Servicing portfolio subject to recourse provisions ............... 477,126 477,038
Undiscounted estimated credit losses as percentage of servicing
portfolio subject to recourse provisions.......................... 11.26% 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 $30.1 million at September 30, 2003. The key assumptions
used in determining the value were a discount rate of 14.0% per annum,
cumulative lifetime prepayments of 20.43%, and cumulative lifetime credit losses
of 12.84%.
On June 30, 2003, CPS (through a subsidiary) sold automobile installment sales
finance Contracts to CPS Auto Receivables Trust 2003-B in a securitization
transaction, retaining a residual interest therein. In this transaction,
qualified institutional buyers purchased $104.5 million of notes backed by
automotive Contracts that CPS had purchased from Dealers. The Notes, issued by
CPS Auto Receivables Trust 2003-B, consist of two classes: $69.0 million of
1.43% Class A-1 Notes, and $35.5 million of 2.69% Class A-2 Notes. The value of
the residual was $23.6 million at September 30, 2003. The key assumptions used
in determining the value were a discount rate of 14.0% per annum, cumulative
lifetime prepayments of 20.99%, and cumulative lifetime credit losses of 12.41%.
17
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(4) SECURITIZATION TRUST DEBT
The Company's MFN and TFC subsidiaries have completed a number of securitization
transactions that are treated as secured borrowings for financial accounting
purposes, rather than as sales. In addition, on September 30, 2003, CPS (through
a subsidiary) sold automobile installment sales finance Contracts to CPS Auto
Receivables Trust 2003-C in a securitization transaction, which has also been
treated as a secured borrowing for financial accounting purposes. In this
transaction, qualified institutional buyers purchased $83.1 million of notes
backed by automotive Contracts that CPS had purchased from Dealers. The Notes,
issued by CPS Auto Receivables Trust 2003-C, consist of two classes: $53.7
million of 1.55% Class A-1 Notes, and $29.4 million of 3.19% Class A-2 Notes.
The debt issued in these transactions is shown on the Company's balance sheet as
"Securitization Trust Debt," and the components of such debt are summarized in
the following table:
Outstanding Principal
Series: Issue Date Initial Principal at September 30, 2003
------- ---------- ----------------- ---------------------
CPS2003-C September 30, 2003 $83.1 million $83.1 million
TFC2003-1 May 20, 2003 52.4 million 42.2 million
TFC2002-2 October 9, 2002 62.6 million 30.8 million
TFC2002-1 March 19, 2002 64.6 million 16.4 million
MFN2001-A June 28, 2001 301.0 million 29.6 million
All of the securitization trust debt was sold in private placement transactions
to qualified institutional buyers. The debt was issued through wholly-owned,
bankruptcy remote, subsidiaries of CPS, TFC or MFN, and is secured by the assets
of such subsidiaries, but not by other assets of the Company. Principal and
interest payments are guaranteed by financial guaranty insurance policies.
The terms of the various Securitization Agreements related to the issuance of
the securitization trust debt require that certain delinquency and credit loss
criteria be met with respect to the collateral pool, and require that the
Company maintain a minimum net worth, and meet other financial tests. As of
September 30, 2003, the Company was not in default of any provisions of the
agreements other than a covenant specifying maximum leverage. As of September
30, 2003, the Company had received a waiver on this covenant breach from the
controlling party. The Company is responsible for the administration and
collection of the Contracts. The Securitization Agreements 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 securitization trust
debt. As of September 30, 2003, restricted cash under the various agreements
totaled approximately $52.5 million. Interest expense on the securitization
trust debt is composed of the stated rate of interest plus amortization of
additional costs of borrowing. Additional costs of borrowing include facility
fees, insurance and amortization of deferred financing costs. Deferred financing
costs related to the securitization trust debt are amortized in proportion to
the principal distributed to the noteholders. Accordingly, the effective cost of
borrowing of the securitization trust debt is greater than the stated rate of
interest.
18
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
The wholly-owned bankruptcy remote subsidiaries of CPS, MFN and TFC were formed
to facilitate the above asset-backed financing transactions. Similar bankruptcy
remote subsidiaries issue the debt outstanding under the Company's warehouse
lines of credit. Bankruptcy remote refers to a legal structure in which it is
expected that the applicable entity would not be included in any bankruptcy
filing by its parent or affiliates. All of the assets of these subsidiaries have
been pledged as collateral for the related debt. All such transactions, treated
as secured financings for accounting and tax purposes, are treated as sales for
all other purposes, including legal and bankruptcy purposes. None of the assets
of these subsidiaries are available to pay other creditors of the Company or its
affiliates.
(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
fees to extend the maturity to January 2004. Interest on the Term D Note is
payable monthly at rates that averaged 4.79% per annum through June 30, 2003,
and 12.0% per annum thereafter.
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. In addition, the maturity of the Term B Note was extended in
October 2003 from November 2003 to January 2004. As of September 30, 2003, the
outstanding principal balances of the Term B Note and the Term C Note were $19.8
million and $5.3 million, respectively.
(6) NET GAIN ON SALE OF CONTRACTS
The following table presents components of net gain on sale of Contracts:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------- ------------------------
2003 2002 2003 2002
--------- --------- --------- ---------
(IN THOUSANDS)
Gain recognized on sale .................... $ -- $ 5,971 $ 6,676 $ 13,102
Deferred acquisition fees and discounts .... -- 1,872 4,590 3,092
Expenses related to sales .................. -- (1,193) (2,076) (2,437)
Provision for credit losses ................ -- (1,347) (526) (1,587)
--------- --------- --------- ---------
Net gain on sale of Contracts .............. -- $ 5,303 $ 8,664 $ 12,170
========= ========= ========= =========
No gain on sale is recorded in the quarter ended September 30, 2003 due to the
July 2003 decision to structure future securitizations as secured financings,
rather than as sales.
(7) INTEREST INCOME
The following table presents the components of interest income:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -----------------------
2003 2002 2003 2002
--------- -------- -------- ---------
(IN THOUSANDS)
Interest on finance receivables............. $ 11,731 $ 9,822 $ 23,841 $ 25,426
Residual interest income, net............... 3,682 3,298 12,070 10,054
Other interest income....................... 422 98 694 228
--------- -------- -------- ---------
Net interest income......................... $ 15,835 $13,218 $36,605 $ 35,708
========= ======== ======== =========
19
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(8) EARNINGS PER SHARE
Diluted earnings per share for the three-month and nine-month periods ended
September 30, 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 and the nine-month periods ended September 30, 2003
and 2002:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------- -------------------
2003 2002 2003 2002
------- ------- ------- -------
(IN THOUSANDS)
Weighted average number of common
shares outstanding during the
period used to compute basic
earnings (loss) per share ......... 20,200 19,683 20,226 19,693
Incremental common shares
attributable to exercise of
outstanding options and warrants .. -- 996 1,152 1,337
Incremental common shares
attributable to convertible debt... -- 333 333 --
------- ------- ------- -------
Number of common shares used to
compute diluted earnings (loss)
per share ......................... 20,200 21,012 21,711 21,030
======= ======= ======= =======
The assumed conversion of certain subordinated debt during the nine-month period
ended September 30, 2003, resulted in an increase to income for purposes of the
diluted earnings per share calculation of $55,000, 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 $6.1 million for the nine months
ended September 30, 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
nine-month period ended September 30, 2002 would have included an additional 1.1
million shares attributable to the conversion of certain subordinated debt. No
such anti-dilution existed for the three-month period ended September 30, 2002.
Similarly, additional shares included in the diluted earnings per share
calculation for the three-month and nine-month periods ended September 30, 2003
would have included an additional 2.8 million and 746,000 shares, respectively,
attributable to the conversion of certain subordinated debt and the exercise of
outstanding options and warrants.
20
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(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. Tax liabilities, net at September 30, 2003 included $4.1
million of current taxes payable and no net deferred taxes as net deferred tax
assets acquired were fully offset with a valuation allowance. The tax benefit
for the nine months ended September 30, 2003 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, and other state tax
matters. The tax benefit for the nine months ended September 30, 2002 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. The
Company has evaluated its deferred tax assets and believes that it is more
likely than not that certain deferred tax assets will not be realized due to
limitations imposed by the Internal Revenue Code and expected future taxable
income.
(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 securitized pools of Contracts in which the Company has retained a residual
ownership interest, and from the Spread Accounts associated with such pools. 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, 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 those pools), the rate of expansion or
contraction in the Company's managed 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. The Company
currently has $225 million in warehouse credit capacity, in the form of a $125
million facility, a $75 million facility and a $25 million facility. The first
two warehouse facilities provide funding for Contracts purchased under CPS'
programs while the third facility provides funding for Contracts purchased under
TFC's programs. Through May 2002, the Company's Contract purchasing program
consisted of both (i) flow purchases for immediate resale to non-affiliates and
(ii) purchases for the Company's own account made on other than a flow basis,
funded primarily by advances under a revolving warehouse credit facility. 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 nine-month period ended September 30, 2003 the Company purchased
$274.4 million of Contracts for its own account, compared to $176.6 million for
its own account and $181.1 million of Contracts on a flow basis in 2002. The
Company's flow purchase program ended in May 2002.
The Company's primary means of ensuring that its cash demands do not exceed its
cash resources 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 securitizes will be subject to general competitive conditions and
21
CONSUMER PORTFOLIO SERVICES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
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 Trusts and their related Spread
Accounts is dependent on collections from the related Trusts generating
sufficient cash to maintain the Spread Accounts in excess of their respective
requisite levels. There can be no assurance that collections from the related
Trusts will continue to generate sufficient cash.
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 substantially all of these
covenants as of September 30, 2003, except one related to maximum leverage. The
Company has received a waiver of such non-compliance from the controlling party.
(11) LEGAL PROCEEDINGS
The shareholder derivative lawsuit referred to in the March 2003 10-Q was
dismissed on September 5, 2003 (without prejudice).
The Company in August 2003 settled the lawsuits referred to in its annual report
as the "Mississippi Litigation," together with similar unfiled claims that might
have been asserted by a number of other Mississippi residents.
The "Stanwich Case" referred to in the Company's annual report includes both
direct claims on behalf of creditors of Stanwich Financial Services Corp. and
cross-claims on behalf of other defendants in the case. Certain cross-claims may
not be dismissed pursuant to any settlement agreements yet reached, and the
Company may need to defend against or separately settle such cross-claims.
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.
22
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 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 Contracts from Dealers.
CPS was incorporated and began its operations in 1991. In March 2002 CPS
acquired by merger (the "MFN Merger") MFN Financial Corp. and its subsidiaries.
In May 2003, CPS acquired by merger (the "TFC Merger") TFC Enterprises Inc. and
its subsidiaries. Both MFN Financial Corp and TFC Enterprises Inc., through
their respective subsidiaries, were engaged in businesses substantially similar
to that of CPS, and in each merger CPS acquired a portfolio of receivables that
had been held by the acquired company. Each merger was accounted for as a
purchase.
SECURITIZATION
GENERALLY
Throughout the periods for which information is presented in this report, the
Company has purchased Contracts with the intention of reselling them in
securitizations. All such securitizations have involved identification of
specific Contracts, sale of those Contracts (and associated rights) to a special
purpose subsidiary of the Company, and issuance of asset-backed securities to
fund the transactions. Depending on the structure of the securitization, the
transaction may be properly accounted for as a sale of the Contracts, or as a
secured financing.
When structured to be treated as a secured financing, the subsidiary is
consolidated with the Company. Accordingly, the sold Contracts and the related
securitization trust debt appear as assets and liabilities, respectively, of the
Company on its Condensed Consolidated Balance Sheet. The Company then recognizes
interest and fee income on the receivables and interest expense on the
securities issued in the securitization, and records as expense a provision for
probable credit losses on the receivables.
When structured to be treated as a sale, the subsidiary is not consolidated with
the Company. Accordingly, the securitization removes the sold Contracts from the
Company's Condensed Consolidated Balance Sheet, the asset backed securities
(debt of the non-consolidated subsidiary) do not appear as debt of the Company,
and the Company shows as an asset a retained 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.
23
CHANGE IN POLICY
During August 2003 the Company announced that it would structure its future
securitization transactions to be reflected as secured financings for financial
accounting purposes. The first term securitization so structured occurred on
September 30, 2003 when CPS (through a subsidiary) sold automobile installment
sales finance Contracts to CPS Auto Receivables Trust 2003-C. The Company had
structured all of its prior term securitization transactions related to the CPS
programs to be reflected as sales for financial accounting purposes. In the MFN
Merger and in the TFC Merger the Company acquired finance receivables that had
been previously securitized in term securitization transactions that were
reflected as secured borrowings. As of September 30, 2003, the Company's
Condensed Consolidated Balance Sheet included net finance receivables of
approximately $165.6 million and securitization trust debt of $119.0 million
related to finance receivables acquired in the two mergers, out of totals of net
finance receivables of approximately $228.1 million and securitization trust
debt of approximately $202.1 million.
CREDIT RISK RETAINED
Whether treated as a secured financing or as a sale for financial accounting
purposes, the related special purpose subsidiary may be prohibited from
releasing excess cash to the Company if the credit performance of the
securitized 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 securitized
Contracts could therefore have a material adverse effect on both the Company's
liquidity and its results of operations, regardless of whether such Contracts
are treated as having been sold or as having been financed. For estimation of
the magnitude of such risk, it may be appropriate to look to the size of the
Company's "managed portfolio," which represents both financed and sold Contracts
as to which such credit risk is retained. The Company's managed portfolio as of
September 30, 2003 was approximately $752.3 million.
RESULTS OF OPERATIONS
ACQUISITIONS
The Company's Condensed Consolidated Balance Sheet and Condensed Consolidated
Statement of Operations as of and for the three and nine months ended September
30, 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 the MFN Merger. See Note 1 of
Notes to Condensed Consolidated Financial Statements, Acquisition of MFN
Financial Corporation.
The Company's Condensed Consolidated Balance Sheet and Condensed Consolidated
Statement of Operations as of and for the three and nine months ended September
30, 2003 include the results of operations of TFC Enterprises, Inc. for the
period subsequent to May 20, 2003, the date on which the Company acquired that
corporation and its subsidiaries in the TFC Merger. See Note 1 of Notes to
Condensed Consolidated Financial Statements, Acquisition of TFC Enterprises,
Inc.
EFFECTS OF CHANGE IN SECURITIZATION STRUCTURE
The Company's July 2003 decision to structure future securitization transactions
as borrowings secured by receivables for financial accounting purposes, rather
than as sales of receivables, has affected and will affect the way in which the
transactions are reported. The major effects are these: (i) the finance
receivables will be shown as assets of the Company on its balance sheet; (ii)
the debt issued in the transactions will be shown as indebtedness of the
Company; (iii) cash posted to enhance the credit of the securitization
transactions ("Spread Accounts") will be shown as "Restricted cash" on the
Company's balance sheet; (iv) the servicing fee that the Company receives in
connection with such receivables will be recorded as a portion of the interest
earned on such receivables; (v) the Company will initially and periodically
record as expense a provision for estimated credit losses on the receivables;
and (vi) the portion of scheduled payments on the receivables representing
interest will be recorded as revenue as accrued.
24
These changes collectively represent a deferral of revenue and acceleration of
expenses, and thus a more conservative approach to accounting for the Company's
operations. The changes initially will result in the Company's reporting lower
earnings than it would report if it were to continue to structure its
securitizations to require recognition of gain on sale. As a result, reported
earnings initially will be less than they would be had the Company continued to
structure its securitizations to record a gain on sale and, therefore, reported
net earnings may be negative or nominally positive for approximately the next
year. Growth in the Company's portfolio of receivables in excess of current
expectations would further delay achievement of positive net earnings. The
Company's cash availability and cash requirements should be unaffected by the
change in structure.
The first such term transaction completed by the Company occurred on September
30, 2003 when CPS (through a subsidiary) sold automobile installment sales
finance Contracts to CPS Auto Receivables Trust 2003-C in a securitization
transaction. The Company's MFN and TFC subsidiaries completed term
securitizations structured as secured financings prior to becoming subsidiaries
of the Company. The structures of the Company's two warehouse securitization
transactions which relate to the CPS programs were amended in July 2003 to be
treated as secured financings for financial accounting purposes. The Company's
third warehouse securitization credit facility, which relates to the TFC
programs, has been structured as a secured financing for financial accounting
purposes since the date of the TFC Merger.
THE THREE-MONTH PERIOD ENDED SEPTEMBER 30, 2003 COMPARED TO THE THREE-MONTH
PERIOD ENDED SEPTEMBER 30, 2002
REVENUES. During the three months ended September 30, 2003, revenues were $25.5
million, a decrease of $553,000, or 2.1%, from the prior year period revenue
amount of $26.0 million. The primary reason for the decrease in revenues is the
elimination of net gain on sale of Contracts, as no gain on sale revenue is
recorded with securitization transactions that are structured as secured
financings for financial accounting purposes. Zero net gain on sale of contracts
was recorded in the current period, compared to $5.3 million in the year earlier
period. Given the change in the securitization structure, net gain on sale is
not expected to be a significant component of the Company's revenues in future
quarters. The Company expects that, until its portfolio of managed receivables
transitions from containing predominantly receivables securitized under a sale
structure to include significantly more receivables securitized under a secured
financing structure, its revenues will be less than they would have been had the
Company continued with the prior structure. Comparisons with prior years during
this transition period, therefore, could be misleading.
The elimination in net gain on sale revenue is offset in part by increases in
interest income and in servicing fees. Interest income for the three-month
period ended September 30, 2003 increased $2.6 million, or 19.8%, to $15.8
million in 2003 from $13.2 million in 2002. The primary reasons for the increase
in interest income are the change in securitization structure implemented during
the quarter as described above, the interest income earned on the portfolio of
Contracts acquired in the TFC Merger and an increase in residual interest
income. This increase was partially offset by the decline in the balance of the
portfolio of Contracts acquired in the MFN Merger.
25
Servicing fees of $4.3 million in the three months ended September 30, 2003
increased $676,000, or 18.7%, from $3.6 million in the same period a year
earlier. The increase in servicing fees is the result of growth in the Company's
managed portfolio held by non-consolidated subsidiaries. The Contracts in this
portfolio were securitized in structures treated as sales for financial
accounting purposes and, therefore, do not appear on the Company's Condensed
Consolidated Balance Sheet. At September 30, 2003, the Company's managed
portfolio held by non-consolidated subsidiaries had an outstanding principal
balance approximating $477.2 million, compared to $421.5 million as of September
30, 2002. At September 30, 2003, the Company's managed portfolio held by
consolidated subsidiaries had an outstanding principal balance approximating
$266.1 million, compared to $146.2 million as of September 30, 2002. As a result
of the decision to structure future securitizations as secured financings, the
Company's managed portfolio held by non-consolidated subsidiaries will decline
in future periods, and servicing fee revenue is anticipated to decline
proportionately.
The period over period increase in other income resulted primarily from the
receipt of state sales tax refunds of $2.2 million during the 2003 period. This
increase was offset in part by decreased recoveries on previously charged off
MFN Contracts. Such recoveries were $2.7 million for the three months ended
September 30, 2003, compared to $3.4 million for the same period in 2002.
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
earnings include changes in the automobile and automobile finance market
environments and macroeconomic factors such as interest rates and the
unemployment level.
Personnel costs include base salaries, commissions and bonuses paid to
employees, and certain expenses related to the accounting treatment of
outstanding warrants and 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 interest expense, provisions for
credit losses, 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 $28.3 million for the third quarter of 2003,
compared to $23.8 million for the third quarter of 2002. The increase is
primarily due to the $4.2 million expense recorded as provision for credit loss
during the 2003 period.
Personnel costs increased to $9.5 million during the three months ended
September 30, 2003, representing 33.5% of total operating expenses, from $9.2
million for the comparable 2002 period, or 38.5% of total operating expenses.
The increase is primarily the result of staff additions related to the TFC
Merger in May 2003. This increase was partially offset by staff reductions since
the MFN Merger in 2002 related to the integration and consolidation of certain
service and administrative activities and the decline in the balance of the
portfolio of Contracts acquired in the MFN Merger. The increase in personnel
costs also resulted from the increase in stock-based employee compensation
expense by $1.3 million to $325,000 in the third quarter of 2003 from a negative
$1.0 million in the comparable period in 2002.
General and administrative expenses increased to $6.1 million, or 21.3% of total
operating expenses, in the third quarter of 2003, from $5.8 million, or 24.4% of
total operating expenses, in the third quarter of 2002. The decrease as a
percentage of total operating expenses reflects continued general cost cutting
during the quarter, offset in part by legal and other corporate expenses.
26
Interest expense for the three-month period ended September 30, 2003, increased
$93,000, or 1.5%, to $6.4 million, compared to $6.3 million in the comparable
period in 2002. The small net increase is the result of changes in the amount
and composition of securitization trust debt carried on the Company's Condensed
Consolidated Balance Sheet: such debt increased as a result of the TFC Merger
and the change in securitization structure implemented beginning in July 2003,
partially offset by the decrease in the balance of the securitization trust debt
acquired in the MFN Merger. As the Company continues to structure future
securitization transactions as secured financings, securitization trust debt and
the related interest expense are expected to increase.
No income tax benefit was recorded in the 2003 period and the Company expects to
record no tax benefit for the remainder of 2003. In the 2002 period, income tax
expense of $940,000 was recorded.
THE NINE-MONTH PERIOD ENDED SEPTEMBER 30, 2003 COMPARED TO THE NINE-MONTH PERIOD
ENDED SEPTEMBER 30, 2002
REVENUES. During the nine months ended September 30, 2003, revenues were $71.7
million, an increase of $5.3 million, or 8.1%, from the prior year period
revenue of $66.4 million. With the change in securitization structure and
consequent end to recording gain on sale revenue in the third quarter of 2003,
net gain on sale of Contracts decreased $3.5 million, or 28.8%, to $8.7 million
in the nine-month period ended September 30, 2003, compared to $12.2 million in
the year earlier period. The 2003 gain on sale amount is net of a $1.8 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. The decrease for the 2003 period was also caused in
part by termination of the flow purchase program in early May 2002. 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 two quarters 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 nine-month period ended September 30, 2003 increased
$897,000, or 2.5%, to $36.6 million in 2003 from $35.7 million in 2002. The
primary reasons for the increase in interest income are the change in
securitization structure, the interest income earned on the portfolio of
Contracts acquired in the TFC Merger and an increase in residual interest
income. This increase was partially offset by the decline in the balance of the
portfolio of Contracts acquired in the MFN Merger.
Servicing fees totaling $13.4 million in the nine months ended September 30,
2003 increased $3.0 million, or 28.7%, from $10.4 million in the same period a
year earlier. The increase in servicing fees can be attributed to the growth of
the Company's managed portfolio held by non-consolidated subsidiaries related to
the CPS programs and the addition of the servicing fees generated by the
non-consolidated portfolio acquired in the MFN Merger. By comparison, in the
prior year period servicing fees were earned from the non-consolidated portfolio
acquired in the MFN Merger only for the period from March 8, 2002 to September
30, 2002. As a result of the decision to structure future securitizations as
secured financings, the Company's managed portfolio held by non-consolidated
subsidiaries will decline in future periods, and servicing fee revenue is
anticipated to decline proportionately.
27
At September 30, 2003, the Company was generating income and fees on a managed
portfolio with an outstanding principal balance approximating $752.3 million,
compared to a managed portfolio with an outstanding principal balance
approximating $575.4 million as of September 30, 2002. As the portfolio of
Contracts acquired in the MFN Merger amortizes, the portfolio of Contracts
originated under the CPS and TFC programs continues to expand. At September 30,
2003, the managed portfolio composition was as follows:
SEPTEMBER 30, 2003 SEPTEMBER 30, 2002
--------------------------- --------------------------
AMOUNT % AMOUNT %
------------ ----------- ----------- -----------
ORIGINATING ENTITY ($ IN MILLIONS)
CPS............................................. $ 517.8 68.8 % $ 327.3 56.9 %
TFC............................................ 137.9 18.3 -- --
MFN............................................ 96.6 12.8 248.1 43.1
-------- -------- -------- ---------
Total.......................................... $ 752.3 100.0 % $ 575.4 100.0 %
======== ======== ======== =========
The period over period increase in other income can be attributed in part to
the receipt of state sales tax refunds of $2.2 million during third quarter of
2003 and recoveries on previously charged off MFN Contracts totaling $9.6
million for the nine-month period ended September 30, 2003, compared to $6.8
million for the comparable period in 2002.
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 the unemployment level, and mix
of business between Contracts purchased on a flow basis and Contracts purchased
on an other than flow basis. The Company ceased to purchase Contracts on a flow
basis in May 2002.
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 interest expense, provisions for
credit losses, 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 $69.1 million for the nine-month period ended
September 30, 2003, compared to $69.6 million for the same period in 2002. Total
operating expenses for the nine-month period ended September 30, 2003 would have
been significantly lower than the 2002 period except for the $4.2 million
provision for credit loss expense recorded during the third quarter of 2003.
Such provision for credit loss is a result of the decision to structure
securitizations as financings, rather than as sales, and provisions for credit
loss expense should be anticipated for future periods.
Personnel costs decreased to $27.4 million during the nine months ended
September 30, 2003, representing 39.6% of total operating expenses, compared to
$28.6 million for the 2002 period, or 41.1% of total operating expenses. The
decrease is primarily the result of staff reductions since the MFN Merger in
2002 related to the integration and consolidation of certain service and
administrative activities and the decline in the balance of the portfolio of
Contracts acquired in the MFN Merger.
28
General and administrative expenses decreased to $14.1 million, or 20.4% of
total operating expenses, in the first three quarters of 2003, from $15.4
million, or 22.0% of total operating expenses, in the same quarters in 2002. The
decrease is a result primarily of continued general cost cutting during the
period, offset in part by legal and other corporate expenses.
Interest expense for the nine-month period ended September 30, 2003, decreased
$1.0 million, or 5.2%, to $17.0 million in 2003, compared to $18.0 million in
2002. The 5.2% decrease is the result of changes in the amount and composition
of securitization trust debt carried on the Company's Condensed Consolidated
Balance Sheet: such debt related to the MFN Merger declined as it was paid down,
partially offset by the addition of securitization trust debt associated with
the TFC Merger and the change in securitization structure implemented during the
third quarter of 2003. As the Company continues to structure future
securitization transactions as secured financings, the balance of securitization
trust debt and the related interest expense are expected to increase.
Income tax benefit of $3.4 million and $4.3 million has been recorded 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, and other
state tax matters which have 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 to record benefit the same 2002 period.
The Company expects to record no tax provision for the remainder of 2003.
EXTRAORDINARY ITEM. The nine months ended September 30, 2002 included $17.4
million of unallocated negative goodwill, which represented the difference
between the net assets acquired and the purchase price paid by the Company in
connection with the MFN Merger.
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 securitized pools of Contracts in which the Company has retained a residual
ownership interest, and from the Spread Accounts associated with such pools. 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, 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 those pools), the rate of expansion or
contraction in the Company's managed 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 nine months ended September
30, 2003 was $64.2 million. Net cash provided by operating activities for the
nine months ended September 30, 2002, was $111.0 million. 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
offset by the purchase of finance receivables.
29
Net cash used in investing activities for the nine months ended September 30,
2003 and 2002, was $101.0 million and $29.7 million, respectively. Cash used in
the TFC Merger, net of the cash acquired in the transaction, totaled $10.2
million for the nine months ended September 30, 2003.
Net cash provided by financing activities for the nine months ended September
30, 2003, was $30.9 million compared with net cash used in financing activities
of $58.7 million for the nine months ended September 30, 2002. Cash used or
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 $225 million in warehouse credit capacity, in the form of a $125
million facility, a $75 million facility and a $25 million facility. The first
two warehouse facilities provide funding for Contracts purchased under CPS'
programs while the third facility provides funding for Contracts purchased under
TFC's programs. Through May 2002, the Company's Contract purchasing program
consisted of both (i) flow purchases for immediate resale to non-affiliates and
(ii) purchases for the Company's own account made on other than a flow basis,
funded primarily by advances under a revolving warehouse credit facility. 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 nine-month period ended September 30, 2003 the Company purchased
$274.4 million of Contracts for its own account, compared to $176.6 million for
its own account and $181.1 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 on
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.
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.
The $25 million warehouse facility is similarly structured to allow TFC to fund
a portion of the purchase price of Contracts by drawing against a floating rate
variable funding note issued by TFC Warehouse I LLC. Approximately 71% of the
principal balance of Contracts may be advanced to TFC 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 1.75% per
annum. This facility was entered into as part of the TFC Merger on May 20, 2003
and has a 364-day term.
30
These facilities are independent of each other. Two different financial
institutions purchase the notes issued by these facilities, and three different
insurers insure the notes. Up through June 30, 2003, sales of Contracts to the
special purpose subsidiaries ("SPS") related to the first two facilities had
been treated as sales for financial accounting purposes. The Company, therefore,
removed these securitized Contracts and related debt from its Condensed
Consolidated Balance Sheet and recognized a gain on sale in the Company's
Condensed Consolidated Statement of Operations. Indebtedness related to
Contracts funded by the third facility, however, is on the Company's Condensed
Consolidated Balance Sheet and no gain on sale has ever been recognized in the
Company's Condensed Consolidated Statement of Operations. During July 2003, each
of the first two facilities was amended, with the effect that subsequent use of
such facilities is treated for financial accounting purposes as borrowing
secured by such receivables, rather than as a sale of receivables. The effects
of that amendment are similar to those discussed above with respect to the
change in securitization structure.
Prior to June 2002, the Company also 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 to increase Credit Enhancement amounts to required levels for the
nine-month periods ended September 30, 2003 and 2002 was $19.6 million and $13.6
million, respectively. Cash released from Trusts and their related Spread
Accounts to the Company for the nine-month periods ended September 30, 2003 and
2002, was $20.2 million and $49.0 million, respectively. Changes in the amount
of Credit Enhancement required for term securitization transactions and releases
from Trusts and their related Spread Accounts are affected by the relative size,
seasoning and performance of the various pools of Contracts securitized that
make up the Company's managed portfolio to which the respective Spread Accounts
are related. During the nine months ended September 30, 2003 the Company made
initial deposits to Spread Accounts of $18.7 million related to its term
securitization transactions, compared to $6.8 million in the 2002 period. The
acquisition of Contracts for subsequent sale in securitization transactions, and
the need to fund Spread Accounts and increase Credit Enhancement levels 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 Trusts and their related Spread Accounts either release
cash to the Company or capture cash from collections on securitized Contracts.
The Company is currently limited in its ability to purchase Contracts due to
certain liquidity constraints. As of September 30, 2003, the Company had cash on
hand of $27.1 million and available Contract purchase commitments from its
warehouse credit facilities of $200.7 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 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, interest income and other portfolio related income would
decrease.
The Company's primary means of ensuring that its cash demands do not exceed its
cash resources 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 securitizes 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 Trusts and their related Spread
Accounts is dependent on collections from the related Trusts generating
sufficient cash to maintain the Spread Accounts in excess of their respective
requisite levels. There can be no assurance that collections from the related
Trusts will continue to generate sufficient cash.
31
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 substantially all of these
covenants as of September 30, 2003, except one related to maximum leverage. The
Company has received a waiver of such non-compliance from the controlling party.
CRITICAL ACCOUNTING POLICIES
(a) ALLOWANCE FOR FINANCE CREDIT LOSSES
In order to estimate an appropriate allowance for losses incurred on finance
receivables held on the Company's Condensed Consolidated Balance Sheet, the
Company uses a loss estimation 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. Net losses incurred on 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) TREATMENT OF SECURITIZATIONS
In its securitization transactions that were treated as sales for financial
accounting purposes, the Company, or a wholly-owned, consolidated subsidiary of
the Company, retains a residual interest in the Contracts that were sold to a
wholly-owned, unconsolidated special purpose subsidiary. The Company's
securitization transactions include "term" securitizations (the purchaser holds
the Contracts for substantially their entire term) and "continuous" or
"warehouse" securitizations (which finance the acquisition of the Contracts for
future sale into term securitizations).
As of December 31, 2002 the residual interest in term and warehouse
securitizations are reflected in the line item "residual interest in
securitizations" on the Company's Condensed Consolidated Balance Sheet. As of
September 30, 2003 the line item "residual interest in securitizations" on the
Company's Condensed Consolidated Balance Sheet reflects the residual interest in
certain term securitizations but no residual interest in warehouse
securitizations. In July 2003, the warehouse securitizations were restructured
as secured financings and, therefore, are reflected in the line items "Finance
receivables" and "Warehouse lines of credit" on the Company's Condensed
Consolidated Balance Sheet.
The Company's securitization structure is generally as follows:
The Company sells Contracts it acquires to a wholly-owned 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 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 (a "Note Insurer"). In addition, the Company provides
"Credit Enhancement" for the benefit of the Note Insurer and the investors in
the form of an initial cash deposit to an account ("Spread Account") held by the
Trust, in the form of overcollateralization of the Notes, where the principal
balance of the Notes issued is less than the principal balance of the Contracts,
in the form of subordinated Notes, or some combination of such Credit
Enhancements. The agreements governing the securitization transactions
(collectively referred to as the "Securitization Agreements") require that the
32
initial level of Credit Enhancement be supplemented by a portion of collections
from the Contracts until the level of Credit Enhancement reaches 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 Contracts. The specified levels at which the Credit Enhancements 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 a specified percentage of the initial aggregate balance.
The prior securitizations structured as sales for financial accounting purposes
differ from secured financings in that the Trust to which the SPS sells the
Contracts meets the definition of a qualified special purpose entity under
Statement of Financial Accounting Standards No. 140 ("SFAS 140"). As a result,
assets and liabilities of the Trust are not consolidated into the Company's
Condensed Consolidated Balance Sheet.
The Company's warehouse securitization structures are similar to the above,
except that (i) the SPS that purchases the Contracts pledges the Contracts to
secure promissory notes which it issues, (ii) the promissory notes are in an
aggregate principal amount of not more than 71% to 73% of the aggregate
principal balance of the Contracts (that is, at least 27%
overcollateralization), and (iii) no increase in the required amount of Credit
Enhancement is contemplated unless certain portfolio performance tests are
breached. During the quarter ended September 30, 2003 the warehouse
securitizations related to the CPS programs were amended to provide for the
transactions to be reflected as secured financings for financial accounting
purposes. The Contracts held by the warehouse SPS and the promissory notes that
it issues are therefore included in the Company's Condensed Consolidated
Financial Statements as assets and liabilities, respectively.
Upon each sale of Contracts in a securitization structured as a secured
financing, whether a term securitization or a warehouse securitization, the
Company retains on its Condensed Consolidated Balance Sheet the Contracts
securitized as assets and records the Notes issued in the transaction as
indebtedness of the Company.
Under the prior securitizations structured as sales for financial accounting
purposes, the Company removed from its Condensed Consolidated Balance Sheet the
Contracts sold and added to its Condensed Consolidated Balance Sheet (i) the
cash received, if any, and (ii) the estimated fair value of the ownership
interest that the Company retains in Contracts sold in the securitization. That
retained or residual interest (the "Residual") consists of (a) the cash held in
the Spread Account, if any, (b) overcollateralization, 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. Until the maturity of these transactions, the Company's
Condensed Consolidated Balance Sheet will reflect securitization transactions
structured both as sales and as secured financings.
33
With respect to the prior securitizations structured as sales for financial
accounting purposes, 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 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 Trusts 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 generally 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),
or a pre-determined percentage of such balance. Where that percentage is less
than 100%, the related Securitization Agreements require accelerated payment of
principal until the principal balance of the Notes is reduced to the specified
percentage. Such accelerated principal payment is said to create
"overcollateralization" 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
withdrawn 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 or other form of Credit Enhancement, 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 total Credit
Enhancement amount is not at the required level, then the excess cash collected
is retained in the Trust 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 (in the case of securitization transactions structured as
sales for financial accounting purposes) or the Trusts (in the case of
securitization transactions structured as secured financings for financial
accounting purposes), 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 recovery rates, 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 22.2% 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
charge-offs as a percentage of the original principal balance will approximate
14.2% to 21.4% cumulatively over the lives of the related Contracts, with
recovery rates approximating 2.2% to 5.5% of the original principal balance.
Following a securitization structured as a sale for financial accounting
purposes, interest income is recognized on the balance of the Residuals at the
same rate as used for calculating the present value of the NIRs, which is equal
to 14% per annum. In addition, the Company will recognize additional revenue
from the Residuals if the actual performance of the Contracts is better than the
original estimate. If the actual performance of the Contracts were worse than
the original estimate, then a downward adjustment to the carrying value of the
Residuals and a related expense would be required. In a securitization
structured as a secured financing for financial accounting purposes, interest
income is recognized when accrued under the terms of the related Contracts and,
therefore, presents less potential for fluctuations in performance when compared
to the approach used in a transaction structured as a sale for financial
accounting purposes.
34
In both securitizations structured as secured financings and the securitizations
structured as sales, the related receivables are sold by the Company (through a
subsidiary) to the related securitization Trust. The difference between the two
structures is that, while the receivables have been sold by the Company, in
securitizations structured as secured financings the Company reports the assets
and liabilities of the securitization Trust on its Condensed Consolidated
Balance Sheet. Under both structures 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: (i) the reversal of taxable
temporary differences; (ii) future operations exclusive of reversing temporary
differences; and (iii) tax planning strategies that, if necessary, would be
implemented to accelerate taxable income into periods in which net 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
prepayments as a percentage of original balances will approximate 18.3% to 22.2%
cumulatively over the lives of the related Contracts, that charge-offs as a
percentage of original balances will approximate 14.2% to 21.4% cumulatively
over the lives of the related Contracts, with recovery rates approximating 2.2%
to 5.5% 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 charge-offs 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
35
Dealers to sell Contracts to the Company on the terms that it offers, and the
terms on which the Company is able to complete term securitizations once
Contracts are 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). The statements concerning the Company
structuring future securitization transactions as secured financings and the
effects of such structures on financial items and on the Company's future
profitability also are forward-looking statements. Any change to the structure
of the Company's securitization transaction could cause such forward-looking
statements not to be accurate. Both the amount of the effect of the intended
change in structure on the Company's profitability and the duration of the
period in which the Company's profitability would be affected by the intended
change in securitization structure are estimates. The accuracy of such estimates
will be affected by the rate at which the Company purchases and sells Contracts,
any changes in that rate, the credit performance of such Contracts, the
financial terms of future securitizations, any changes in such terms over time,
and other factors that generally affect the Company's profitability.
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 or
pledges Contracts, as often as once a week, to either of two special-purpose
affiliated entities in the case of CPS, or a third special-purpose affiliated
entity in the case of TFC. 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 finance pools of 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,
repossessions 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.
36
DEPENDENCE ON PERFORMANCE OF SECURITIZED CONTRACTS. Under the financial
structures the Company has used to date in its term securitizations, certain
excess cash flows generated by the Contracts sold in the term securitizations
are used to increase overcollateralization or retained in a Spread Account
within the securitization trusts to provide liquidity and credit enhancement.
While the specific terms and mechanics of each Spread Account vary among
transactions, the Company's Securitization Agreements generally provide that the
Company will receive excess cash flows only if the amount of Credit Enhancement
has 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: (i) may require increased Credit Enhancement to be accumulated
for the particular pool; (ii) may restrict the distribution to the Company of
excess cash flows associated with other pools; or (iii) 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 net 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 or other Credit Enhancement in such transactions.
PROBABLE 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 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, securitization
and servicing of Contracts. Operating profits expected to be earned by the
Company on portfolios of Contracts previously securitized 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. With interest
rates near historical lows as of the date of this report, it is probable that
interest rates will increase in the near to intermediate term. 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.
PREPAYMENTS AND CREDIT LOSSES. Gains from the sale of Contracts in the Company's
past securitization transactions structured as sales for financial accounting
purposes have constituted a significant portion of the revenue of the Company. A
portion of the gains is based in part on management's estimates of future
prepayments and credit losses and other considerations in light of then-current
conditions. If actual prepayments with respect to Contracts occur more quickly
37
than was projected at the time such Contracts were sold, as can occur when
interest rates decline, or if credit losses 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
net losses are lower than estimated with respect to Contracts sold, total
revenue would exceed previously estimated amounts. Provisions for credit losses
are recorded in connection with the origination and throughout the life of
Contracts that are held on the Company's Condensed Consolidated Balance Sheet.
Such provisions are based on management's estimates of future credit losses in
light of then-current conditions. If actual credit losses in a given period
exceed the allowance for credit losses, a bad debt expense during the period
would be required.
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 and Ford Motor Credit 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 such material consumer protection litigation, a significant judgment against
the Company or within the industry in connection with any such litigation, or an
adverse outcome in the litigation identified under the caption "Legal
Proceedings" in this report and in the Company's most recently filed report on
Form 10-K, 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 nine-month period ended September 30, 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
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.
38
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
The Company is subject to interest rate risk during the period between when
Contracts are purchased from Dealers and when such Contracts become part of a
term securitization. Specifically, the interest rates on the warehouse
facilities are adjustable while the interest rates on the Contracts are fixed.
Historically, the Company's term securitization facilities have had fixed rates
of interest. To mitigate some of this risk, the Company has in the past, and
intends to continue to, structure certain of its securitization transactions to
to include pre-funding structures, whereby the amount of Notes 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 Notes outstanding, the amount as to which there can be
no assurance.
The Company is subject to market risks due to fluctuations in interest rates
primarily as a result of its commitments to enter into new Contracts. The table
below outlines the carrying values and estimated fair values of financial
instruments:
SEPTEMBER 30, DECEMBER 31,
2003 2002
----------------------- -----------------------
CARRYING FAIR CARRYING FAIR
FINANCIAL INSTRUMENT VALUE VALUE VALUE VALUE
- -------------------- ----- ----- ----- -----
(IN THOUSANDS) (IN THOUSANDS)
Finance receivables, net... $228,075 $228,075 $ 84,592 $ 84,592
Notes payable ............. 3,999 3,999 673 673
Securitization trust debt.. 202,096 202,096 71,630 71,630
Senior secured debt ....... 50,136 50,136 50,072 50,072
Subordinated debt ......... 35,996 35,996 36,000 32,800
Related party debt ........ 17,500 17,500 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
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 as of the dates shown in the table, 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. As of the end of the period
covered by 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 (Robert E. Riedl) concluded that the disclosure
controls and procedures are effective in recording, processing, summarizing and
reporting, on a timely basis, material information relating to CPS that is
required to be included in its reports filed under the Securities Exchange Act
of 1934. There have been no significant changes in our internal controls over
financial reporting during our most recently completed fiscal quarter that
materially affected, or are reasonably likely to materially affect, our internal
control over financial reporting.
39
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 ("annual
report"), and in its quarterly report for the period ended March 31, 2003
("March 2003 10-Q"), is incorporated herein by reference.
The shareholder derivative lawsuit referred to in the March 2003 10-Q was
dismissed on September 5, 2003 (without prejudice).
The Company in August 2003 settled the lawsuits referred to in its annual report
as the "Mississippi Litigation," together with similar unfiled claims that might
have been asserted by a number of other Mississippi residents.
The "Stanwich Case" referred to in the Company's annual report includes both
direct claims on behalf of creditors of Stanwich Financial Services Corp. and
cross-claims on behalf of other defendants in the case. Certain cross-claims may
not be dismissed pursuant to any settlement agreements yet reached, and the
Company may need to defend against or separately settle such cross-claims.
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.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are filed with this report:
31.1 Rule 13a-14(a) Certification of the Chief Executive Officer of
the registrant.
31.2 Rule 13a-14(a) Certification of the Chief Financial Officer of
the registrant.
32 Section 1350 Certifications.*
* These Certifications shall not be deemed "filed" for purposes of
Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise
subject to the liability of that section. These Certifications shall not be
deemed to be incorporated by reference into any filing under the Securities
Act of 1933, as amended, or the Exchange Act, except to the extent that the
registration statement specifically states that such Certifications are
incorporated therein.
(b) The Company filed one report on Form 8-K during the quarter for which this
report is filed. Such report was dated and was filed on August 6, 2003. It
reported information under item 12 of Form 8-K, to the effect that the Company
had issued a quarterly earnings release. Pursuant to Item 7, the text of such
release was attached as an exhibit.
The Company also filed, on August 4, 2003, an amendment to a report on Form 8-K
dated May 20, 2003. The initial report disclosed, under item 2 of Form 8-K, that
the Company on May 20, 2003 had acquired TFC Enterprises, Inc. and its
subsidiaries (collectively, "TFC"). The amendment included financial statements
pursuant to Item 7, specifically, the audited consolidated balance sheets of TFC
as of December 31, 2002 and 2001, and the related consolidated statements of
operations, changes in stockholders' equity and cash flows for the years ended
December 31, 2002 and 2001, together with notes thereto and the report of
McGladrey & Pullen, LLP, independent auditors, and also included pro forma
financial information related to the acquisition of TFC.
40
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: November 13, 2003
/s/ CHARLES E. BRADLEY, JR.
-------------------------------------
Charles E. Bradley, Jr.
PRESIDENT AND CHIEF EXECUTIVE OFFICER
(Principal Executive Officer)
Date: November 13, 2003
/s/ ROBERT E. RIEDL
-------------------------------------
Robert E. Riedl
SENIOR VICE PRESIDENT AND CHIEF FINANCIAL OFFICER
(Principal Financial Officer)
41