_________________
For the transition period from ____________ to ______________.
ENCORE CAPITAL GROUP, INC. (Exact name of registrant as specified in its charter)
(877) 445 – 4581(Registrant’s telephone number, including area code)
(Not Applicable) (Former name, former address and former fiscal year, if changed since last report)_____________________________
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (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 last 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act)
Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the latest practicable date.
Class
Common Stock, $0.01 par value
22,328,507 shares
1
ENCORE CAPITAL GROUP, INC.Condensed Consolidated Statements of Financial Condition (In Thousands, Except Par Value Amounts)
(A) Derived from the audited consolidated financial statements as of December 31, 2004. See accompanying notes to condensed consolidated financial statements.
2
ENCORE CAPITAL GROUP, INC.Condensed Consolidated Statements of Operations (In Thousands, Except Per Share Amounts)(Unaudited)
See accompanying notes to condensed consolidated financial statements.
3
ENCORE CAPITAL GROUP, INC.Condensed Consolidated Statement of Stockholders' Equity (Unaudited, In Thousands)
4
ENCORE CAPITAL GROUP, INC.Condensed Consolidated Statements of Cash Flows (Unaudited, In Thousands)
5
ENCORE CAPITAL GROUP, INC.Condensed Consolidated Statements of Cash Flows (cont.) Reconciliation of Net Income to Net Cash Provided by Operating Activities(Unaudited, In Thousands)
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ENCORE CAPITAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
Encore Capital Group, Inc., together with its subsidiaries (“Encore”), is a systems-driven purchaser and manager of charged-off consumer receivable portfolios. Encore acquires these portfolios at deep discounts from their face values using its proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon Encore’s ongoing analysis of these accounts, it employs a dynamic mix of collection strategies to maximize its return on investment. The receivable portfolios Encore purchases consist primarily of unsecured, charged-off domestic consumer credit receivables purchased from national financial institutions, major retail credit corporations, and resellers of such portfolios. Acquisitions of receivable portfolios are financed by operations and by borrowings from third parties (see Note 6).
Encore is a Delaware holding company whose principal assets are its investments in various wholly-owned subsidiaries (collectively, the “Company”).
Basis of Presentation The accompanying unaudited interim condensed consolidated financial statements of the Company have been prepared in accordance with Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission and, therefore, do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America. In the Company’s opinion, however, the accompanying unaudited interim condensed consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the Company’s consolidated financial position as of June 30, 2005, and its consolidated results of operations for the three and six months ended June 30, 2005 and 2004 and its cash flows for the six months ended June 30, 2005 and 2004, respectively. The unaudited interim condensed consolidated results of operations of the Company for the three and six months ended June 30, 2005 may not be indicative of future results. These unaudited interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K as of and for the year ended December 31, 2004 filed with the Securities and Exchange Commission on March 3, 2005.
Significant Accounting Policies Please refer to the Company’s annual report on Form 10-K as of and for the year ended December 31, 2004 for a summary of the Company’s significant accounting policies.
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Forward Flow Asset In connection with the Company’s acquisition of a business in June 2005 (see Note 3), the Company entered into a forward flow agreement to purchase a minimum of $3.0 billion in face value of credit card charge-offs over the next five years at a fixed price. The Company preliminarily allocated $42.2 million of the acquisition purchase price to this agreement, which is reflected on the consolidated statement of financial condition as forward flow asset. The Company will allocate a portion of the forward flow asset to the cost basis of future receivable portfolio purchases under the forward flow agreement based on the proportion the purchase represents to the total purchase commitment, as adjusted for the time-value of money. As part of this forward flow agreement, the seller is obligated to sell a predetermined minimum amount of charged-off credit card accounts to the Company. The forward flow agreement contains penalty provisions if the seller fails to meet such minimum requirements. Any monies received pursuant to such penalty provisions would be applied to the carrying balance of the forward flow asset. The Company will routinely evaluate the forward flow asset carrying balance for impairment. The final allocation of the purchase price is pending completion of an external valuation study of the assets acquired that could change the preliminary allocation of the purchase price depending on the outcome of the valuation.
New Accounting Pronouncements In December 2003, the AICPA issued Statement of Position 03-03, “Accounting for Certain Debt Securities Acquired in a Transfer” (SOP 03-03). SOP 03-03 is effective for fiscal years beginning after December 15, 2004, and accordingly, the Company has adopted the provisions of this SOP 03-03 commencing January 1, 2005. The implementation of SOP 03-03 is discussed in Note 5.
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 123R “Share – Based Payment” (SFAS No. 123R), which is a revision of Statement of Financial Accounting Standards No. 123. SFAS No. 123R requires fair value accounting for transactions in which an entity exchanges its equity instruments for goods and services. It also addresses transactions in which an entity incurs liabilities in exchange for goods and services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions.
The Company expects to adopt the provisions of SFAS No. 123R at the required implementation date of January 1, 2006. For periods prior to implementation, the Company has retained its accounting for stock based employee compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25), and has only adopted the pro forma disclosure requirements of SFAS No. 123. The Company expects that the adoption of SFAS No. 123R will reduce its reported net income and earnings per share. The effect of adopting this statement on the Company’s historical consolidated statements of operations is reflected on a pro forma basis in Note 4, “Stock-Based Compensation”.
Reclassifications Certain amounts included in the accompanying prior periods’ condensed consolidated financial statements have been reclassified to conform to the current period presentation.
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On June 7, 2005, the Company acquired certain assets, including receivable portfolios, from Jefferson Capital Systems, LLC (Jefferson Capital), a subsidiary of CompuCredit Corporation. The acquisition was accounted for as a business combination in accordance with Statement of Financial Accounting Standards No. 141 “Business Combinations.” The results of operations of the business acquired from Jefferson Capital have been included in the consolidated financial statements from the date of acquisition. As part of the acquisition, the Company acquired a portfolio of charged-off consumer credit card debt with a face value of approximately $2.8 billion, entered into a forward flow agreement to purchase a minimum of $3.0 billion in face value of credit card charge-offs from Jefferson Capital over the next five years at a fixed price and entered into an agreement to offer employment to approximately 120 employees of Jefferson Capital at its collection site in St. Cloud, Minnesota in September 2005, after completion of a three-month transition services agreement with Jefferson Capital. In addition, the Company entered into a two year agreement to sell Chapter 13 bankruptcies to Jefferson Capital based on a pre-set pricing schedule and agreed to provide Jefferson Capital with a prescribed number of accounts on a monthly basis for its balance transfer program, also on a pre-set pricing schedule. To fund this transaction, the Company entered into a new Revolving Credit Facility that initially provided for an aggregate revolving commitment of $150 million, which was subsequently increased to $200.0 million pursuant to a recent amendment. See Note 6 for a further discussion of the Revolving Credit Facility.
The Company’s preliminary allocation of the purchase price is summarized as follows (in thousands):
The allocation to the forward flow asset represents the present value of the difference between (a) the estimated fair value of each portfolio to be acquired under the forward flow agreement and (b) the fixed purchase price of each such portfolio. The allocation to goodwill relates solely to the agreement to offer employment to the 120 employees of Jefferson Capital upon completion of the three-month transition services agreement. The final allocation of the purchase price is pending completion of an external valuation study of the assets acquired that could change the preliminary purchase price allocation depending on the outcome of the valuation. Furthermore, a portion of the purchase price could be allocated to the two-year bankruptcy servicing agreement and five-year balance transfer agreement, depending on the outcome of the valuation.
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The unaudited pro forma results of operations below presents the impact on the Company’s results of operations as if the Jefferson Capital asset acquisition had occurred at the beginning of each period presented. This pro forma information is presented for informational purposes only and is not necessarily indicative of the results of future operations. Pro forma information follows for the three and six months ended June 30, 2005 and 2004 (in thousands, except per share data):
The 1999 Equity Participation Plan (“1999 Plan”), as amended, reserved up to 3,300,000 shares for grant to employees, directors and consultants. Pursuant to the 1999 Plan, the Company could grant options at a price in excess of 85.0% of the fair market value on the date of the grant and for a term not to exceed ten years. Options generally vested ratably over a three-year period unless otherwise determined by the Compensation Committee of the Board of Directors.
On March 30, 2005, the Board of Directors of the Company adopted a new 2005 Stock Incentive Plan (the “2005 Plan”) for Board members, employees, officers, and executives of, and consultants and advisors to, the Company. The 2005 Plan was effective as of March 30, 2005, and was approved by the Company’s stockholders at the annual meeting on May 3, 2005. The 2005 Plan provides for the granting of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, performance shares, and performance-based awards to eligible individuals. Upon adoption, an aggregate of 1,500,000 shares of the Company’s common stock were available for awards under the 2005 Plan, plus ungranted shares of stock that were available for future awards under the 1999 Plan. In addition, shares subject to options granted under either the 1999 Plan or the 2005 Plan that terminate or expire without being exercised are available for grant under the 2005 Plan.
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A summary of the Company’s stock option activity and related information is as follows:
The Company has elected to follow APB No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and related interpretations in accounting for its employee stock options rather than the alternative fair value accounting provided for under SFAS No. 123. The Company also has adopted the pro forma disclosure requirements of Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure an amendment of FASB Statement No. 123 (“SFAS No. 148”). In accordance with APB No. 25, compensation cost relating to stock options granted by the Company is measured as the excess, if any, of the market price of the Company’s stock at the date of grant over the exercise price of the stock options. This expense is recognized over the vesting period of the stock options.
As required by SFAS No. 148 and SFAS No. 123, the Company provides pro forma net income and pro forma net income per common share disclosures for stock-based awards made during the periods presented as if the fair-value-based method defined in SFAS No. 123 had been applied.
The fair value for options granted during each of the periods presented was estimated at the date of grant using a Black-Scholes option-pricing model with the following assumptions:
The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not provide a reliable single measure of the fair value of its employee stock options.
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For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. The Company’s pro forma information is as follows (in thousands, except per share amounts):
In connection with the Company’s management succession plan, which is described under the heading “Executive Officers and Compensation,” in the Company’s proxy statement filed on April 5, 2005, the vesting provisions of option grants on September 11, 2002 to three executive officers have been revised by the Compensation Committee of the Company’s Board of Directors. Under the revised vesting dates, 50% of the options to purchase 208,333 shares at an exercise price of $0.51 per share granted to each of two of the executive officers vested on May 3, 2005, and the remaining 50% will vest no later than May 3, 2006. One of these officers retired on May 3, 2005, but was elected as a director of the Company at the Company’s annual meeting on the same date. One-third of the option to purchase 208,333 shares granted at an exercise price of $0.51 per share to the other executive officer vested on May 3, 2005; an additional one-third will vest no later than May 3, 2006; and the final one-third will vest no later than September 11, 2007. Under the revised vesting provisions, vesting may be accelerated upon the occurrence of an equity event as specified in the respective option agreements. As of June 30, 2005, approximately 228,000 of these options were vested and exercisable. The Compensation Committee of the Company's Board of Directors reviewed the succession plan and the new vesting provisions of the option grants and determined that the changes associated with these options are not considered a modification that renews or increases the life of the option grant and thus does not result in a new measurement of compensation cost.
Until January 1, 2006, the Company will continue to account for all of its stock options in accordance with APB No. 25 with appropriate disclosure of pro forma net income and earnings per share determined as if the fair value based method had been applied in measuring compensation cost. The Company expects to adopt the provisions of SFAS No. 123R upon its required implementation date of January 1, 2006. The adoption of SFAS 123R, will result in the recording of compensation expense in the Company’s consolidated statement of operations for the unvested option grants based on the fair value of the respective options at the date of grant.
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Prior to January 1, 2005, the Company accounted for its investment in receivable portfolios utilizing the interest method under the provisions of the AICPA’s Practice Bulletin 6, “Amortization of Discounts on Certain Acquired Loans.” Commencing January 1, 2005, the Company began accounting for its investment in receivable portfolios utilizing the interest method in accordance with the provisions of SOP 03-03. SOP 03-03 addresses accounting for differences between initial estimated cash flows expected to be collected from purchased receivables, or “pools,” and subsequent changes to those estimated cash flows. SOP 03-03 limits the revenue that may be accreted, (also known as accretable yield), to the excess of the Company’s estimate of undiscounted cash flows expected to be collected over the Company’s investment, or cost basis, in the pool. The effective interest rate applied to the cost basis of the pool would remain level, or “static” throughout its life unless there was an increase in subsequent expected cash flows. Subsequent increases in cash flows expected to be collected generally would be recognized prospectively through an upward adjustment of the pool’s effective interest rate over its remaining life. Subsequent decreases in expected cash flows would not change the effective interest rate, but would be recognized as an impairment of the cost basis of the pool, and would appear in the consolidated statement of operations with a corresponding valuation allowance offsetting the investment in receivable portfolios in the consolidated statement of financial condition. No provision for impairment losses was recorded during the six months ended June 2005 and 2004.
In accordance with SOP 03-03, static pools are established on a quarterly basis with accounts purchased during the quarter that have common risk characteristics. Discrete receivable portfolio purchases during a quarter are aggregated into pools based on these common risk characteristics. Once a static pool is established, the portfolios are permanently assigned to the pool. The discount (i.e., the difference between the cost of each static pool and the related aggregate contractual receivable balance) is not recorded because the Company expects to collect a relatively small percentage of each static pool’s contractual receivable balance. As a result, receivable portfolios are recorded at cost at the time of acquisition. Upon adoption of SOP 03-03, all portfolios with common risk characteristics purchased prior to the adoption of SOP 03-03 were aggregated by quarter of purchase.
The Company accounts for each static pool as a unit for the economic life of the pool (similar to one loan) for recognition of revenue from receivable portfolios, for collections applied to the cost basis of receivable portfolios and for provision for loss or impairment. Revenue from receivable portfolios is accrued based on each pool’s effective interest rate applied to each pool’s adjusted cost basis. The cost basis of each pool is increased by revenue earned and decreased by gross collections and impairments. The effective interest rate is the internal rate of return derived from the timing and amounts of actual cash received and anticipated future cash flow projections for each pool.
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Accretable yield represents the amount of revenue the Company expects to generate over the remaining life of its existing investment in receivable portfolios based on estimated future cash flows. The following table summarizes the Company’s accretable yield and an estimate of zero basis future cash flows at the beginning and end of the current period (in thousands):
During the three months ended June 30, 2005, the Company purchased receivable portfolios with a face value of $3.7 billion for $121.0 million, or a purchase cost of 3.29% of face value. The estimated collections at acquisition for these portfolios amounted to $262.6 million. During the six months ended June 30, 2005, the Company purchased receivable portfolios with a face value of $4.2 billion for $140.6 million, or a purchase cost of 3.34% of face value. The estimated collections at acquisition for these portfolios amounted to $306.4 million.
Collections realized after the cost basis value of a portfolio has been fully recovered (“Zero Basis Portfolios”) are recorded as revenue (“Zero Basis Revenue”). During the three months ended June 30, 2005 and 2004, approximately $9.2 million and $11.9 million, respectively, was recognized as revenue on portfolios for which the related cost basis has been fully recovered. During the six months ended June 30, 2005 and 2004, approximately $19.6 million and $24.2 million, respectively, was recognized as revenue on portfolios for which the related cost basis has been fully recovered.
If the amount and timing of future cash collections on a pool of receivable portfolios are not reasonably estimable, the Company accounts for such portfolios on the cost recovery method (“Cost Recovery Portfolios”). No revenue is accreted on Cost Recovery Portfolios. All collections are applied 100% to recover the remaining cost basis of the portfolio and thereafter are recognized as revenue. At June 30, 2005, one portfolio with a book value of $2.5 million was accounted for using the cost recovery method. This portfolio was acquired in connection with the Jefferson Capital acquisition (Note 3) and consisted primarily of bankrupt and deceased accounts. These accounts have different risk characteristics than the other portfolios acquired during the quarter and accordingly were aggregated into a separate pool. The Company has preliminarily allocated $2.5 million of the Jefferson Capital purchase price to this portfolio, which is subject to revision pending the final purchase price allocation.
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The following table summarizes the changes in the balance of the investment in receivable portfolios during the six months ended June 30, 2005 (in thousands, except percentages):
The Company historically has purchased portfolios of charged-off unsecured consumer credit cards and relatively few portfolios of charged-off unsecured consumer loans. During 2001, the Company resumed purchasing charged-off unsecured consumer loans, in 2002 it began purchasing auto loan deficiencies, and in 2004 it began purchasing charged-off consumer telecom receivables. The Company spent $3.5 million to purchase non-credit card loans for the three months ended June 30, 2005 and $6.2 million during the three months ended June 30, 2004. Gross collections related to all portfolios of charged-off unsecured consumer loans, auto loan deficiencies and telecom receivables amounted to $7.0 million for the three months ended June 30, 2005 and $5.0 million for the three months ended June 30, 2004. The Company spent $3.5 million to purchase non-credit card loans during the six months ended June 30, 2005, and $15.1 million for the six months ended June 30, 2004. Gross collections related to all portfolios of charged-off unsecured consumer loans, auto loan deficiencies and telecom receivables amounted to $13.7 million and $8.1 million for the six months ended June 30, 2005 and 2004, respectively.
The Company utilizes various business channels for the collection of its receivables. The following table summarizes collections by collection channel (in thousands):
15
During the first quarter of 2004, the Company discontinued its rewrite program and sold its portfolio of rewritten notes. The Company’s rewrite program offered debtors the ability to settle their obligation by paying a certain percentage of the amount due and executing a new “rewritten” note for the remaining negotiated balance. The notes, which were related to accounts throughout the Company’s portfolios, were sold for $4.0 million. The cash proceeds of $2.9 million from accruing portfolios and $1.1 million from zero basis portfolios were treated as additional portfolio collections for revenue recognition purposes. This is consistent with the Company’s historical accounting for collections from the rewritten notes.
The Company is obligated under borrowings as follows (in thousands):
Revolving Credit Facility On June 30, 2004, the Company entered into a $75.0 million, three-year revolving credit facility to be utilized for the purposes of purchasing receivable portfolios and for working capital needs. On June 7, 2005, the Company replaced the $75.0 million revolving credit facility with a new $150.0 million revolving facility (the “Revolving Credit Facility”) from the same financial institution. Proceeds from this new facility were used to finance the acquisition of assets from Jefferson Capital and will be utilized for the purpose of purchasing receivable portfolios and for working capital needs. See Note 3 for a further discussion of the acquisition of assets from Jefferson Capital. Effective August 1, 2005, the Company amended the Revolving Credit Facility as described in Note 10.
The new credit facility has a maturity date of June 7, 2008 and bears interest at a floating rate equal to, at the Company’s option, either: (a) reserve adjusted LIBOR plus a spread that ranges from 200 to 325 basis points, depending on the Company’s leverage; or (b) the higher of (1) the federal funds rate then in effect plus a spread of 50 basis points and (2) the prime rate then in effect plus a spread that ranges from 0 to 50 basis points. The applicable margin will be adjusted quarterly based on a pricing grid that takes into account certain financial covenants related to the Company’s consolidated statement of financial condition and results of operations. At June 30, 2005 amounts outstanding under the credit facility bore interest at 6.5%. The new credit facility is secured by all assets of the Company, except for the assets of the Company’s wholly-owned subsidiary, MRC Receivables Corporation, in which the Company’s former secured lender has a first priority security interest. The new facility also requires the Company to pay certain fees and expenses to the lender in connection with the related commitment letter and the credit facility.
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The new credit facility provides for an aggregate revolving commitment of $150.0 million, subject to borrowing base availability, with $5 million sub-limits for swingline loans and letters of credit. The Revolving Credit Facility borrowing base provides for an 85.0% initial advance rate for the purchase of qualified receivable portfolios. The borrowing base reduces for each qualifying portfolio by (i) the purchase price multiplied by (ii) 85% less 3% per month beginning after the third complete month subsequent to purchase. The aggregate borrowing base is equal to the lesser of (a) the sum of all of the borrowing bases of all qualified receivable portfolios under this facility, as defined above, and (b) 95% of the net book value of all receivable portfolios acquired on or after January 1, 2005. The Company may request an increase in the amount of the revolving credit commitments to $200.0 million upon satisfying certain conditions, including acceptance of such increase by existing or replacement lenders under the facility that agree to increase their commitments. This financing arrangement does not require the Company to share residual collections with the lender and may be pre-paid in full without penalty.
The terms of the credit facility include restrictions and covenants, which limit, among other things, the payment of dividends and the incurrence of additional indebtedness and liens. The terms also require compliance with financial covenants requiring maintenance of specified ratios of EBITDA to liabilities, tangible net worth to liabilities and EBIT to interest expense. Subject to certain exceptions, the dividend restriction referred to above generally provides that the Company will not, during any fiscal year, make distributions with respect to common stock or other equity interests in an aggregate amount in excess of 20% of consolidated net income for such period.
The credit agreement specifies a number of events of default (some of which are subject to applicable cure periods), including, among others, the failure to make payments when due, noncompliance with covenants, and defaults under other agreements or instruments of indebtedness. Upon the occurrence of an event of default, the lenders may terminate the senior credit facility and declare all amounts outstanding to be immediately due and payable.
In conjunction with establishing this new credit facility, the Company incurred loan fees and other loan costs amounting to $2.1 million. These costs, together with $0.4 million of unamortized loan fees and loan costs associated with the previous facility will be amortized over the term of the new agreement.
Secured Financing Facility On December 31, 2004, the Company’s $75.0 million secured financing facility (the “Secured Financing Facility”) expired. The Secured Financing Facility was entered into on December 20, 2000 by MRC Receivables Corporation, a wholly owned bankruptcy-remote, special-purpose entity, to finance the purchase of receivable portfolios. The facility generally provided for a 90.0% advance rate with respect to each qualified receivable portfolio purchased. Interest accrues at the prime rate plus 3.0% per annum and is payable weekly. The interest rate reduces by 1.0% on outstanding amounts in excess of $25.0 million. Amounts outstanding under the Secured Financing Facility bore interest at rates ranging from 8.25% to 9.25% at June 30, 2005. Notes issued under the facility are collateralized by the charged-off receivables that are purchased with the proceeds from this financing arrangement. Each note has a maturity date not to exceed 27 months after the borrowing date. Once the notes are repaid and the Company has recouped its investment, the Company and the lender share the residual collections from the receivable portfolios, net of servicing fees. The sharing in residual collections continues for the entire economic life of the receivable portfolios financed using this facility, and therefore will extend substantially beyond the December 31, 2004 expiration date of the Secured Financing Facility. The Company was required to give the lender the opportunity to fund all of its purchases of charged-off credit card receivables with advances on the Secured Financing Facility through December 31, 2004. Most purchases during the fourth quarter of 2004 were financed under an amendment to the Secured Financing Facility that provides for a cap, as defined, on the total amount of interest owed to the lender for such borrowings.
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The following table summarizes interest expense associated with the Secured Financing Facility for the periods presented (in thousands):
The Secured Financing Facility had a balance of $36.1 million as of June 30, 2005 and was collateralized by certain charged-off receivable portfolios with an aggregate carrying amount of $83.3 million at that time. The assets pledged under this financing facility, together with their associated cash flows, would not be available to satisfy claims of general creditors of the Company.
Secured Note On October 1, 2003, the Company entered into a loan for the purchase of certain equipment (“Secured Note”) in the amount of $0.3 million with a term of 36 months. This note is secured by the equipment, carries an interest rate of 7.24%, and had a balance of $0.1 million as of June 30, 2005.
Secured Financing On July 25, 2003, through Midland Funding NCC-1 Corporation, a wholly owned subsidiary, the Company entered into a $1.8 million secured financing arrangement (the “Secured Financing”). This financing was repaid in full on June 30, 2004. The Secured Financing provided for a 75.0% advance rate with respect to four purchased receivable portfolios of charged-off unsecured consumer loans and auto loan deficiencies. Interest accrued at 15.0% and was payable weekly. This financing arrangement did not require the Company to share residual collections with the lender.
The Company recorded an income tax provision of $10.6 million for the six months ended June 30, 2005 and $7.7 million for the six months ended June 30, 2004. The provision for income tax expense reflects tax expense at an effective rate of 40.6% for the six months ended June 30, 2005 and an effective rate of 39.8% for the six months ended June 30, 2004. For the six months ended June 30, 2005, this consists primarily of a provision for Federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%) and a provision for state taxes of 8.8%, net of a tax benefit from the effect of permanent book versus tax differences of 0.1%. For the six months ended June 30, 2004, this consists primarily of a provision for Federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%), a provision for state taxes of 8.8% and the effect of permanent book versus tax differences net of the reversal of the remaining reserve on deferred tax assets of 0.9%.
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The following table summarizes the concentration of our purchases by seller by year sorted by total aggregate costs for the six months ended June 30, 2005 and 2004, adjusted for put-backs, account recalls and replacements (in thousands, except percentages):
Litigation On October 18, 2004, Timothy W. Moser, a former officer of the Company, filed an action in the United States District Court for the Southern District of California against the Company, and certain individuals, including several of the Company’s officers and directors. On February 14, 2005 the Company was served with an amended complaint in this action alleging defamation, intentional interference with contractual relations, breach of contract, breach of the covenant of good faith and fair dealing, intentional and negligent infliction of emotional distress and civil conspiracy arising out of certain statements in the Company’s Registration Statement on Form S-1 originally filed in September 2003 and alleged to be included in the Company’s Registration Statement on Form S-3 originally filed in May 2004. The amended complaint seeks injunctive relief, economic and punitive damages in an unspecified amount plus an award of profits allegedly earned by the defendants and alleged co-conspirators as a result of the alleged conduct, in addition to attorney’s fees and costs. The Company believes the claims are without merit and will vigorously defend the action. Although the outcome of this matter cannot be predicted with certainty, management does not currently believe that this matter will have a material adverse effect on the Company’s consolidated financial position or results of operations.
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The Fair Debt Collection Practices Act (“FDCPA”) and comparable state statutes may result in class action lawsuits, which can be material to the Company due to the remedies available under these statutes, including punitive damages. The Company has recently experienced an increase in the volume of such claims, which we believe reflects the trend in our industry. Management is aware of 14 cases styled as class actions that have been filed against the Company. To date, no class has been certified in any of these cases. The Company believes that these cases are without merit and intends to vigorously defend them. However, several of these cases present novel issues on which there is no legal precedent. As a result, the Company is unable to predict the range of possible outcomes.
There are a number of other lawsuits or claims pending or threatened against the Company. In general, these lawsuits or claims have arisen in the ordinary course of business and involve claims for actual damages arising from alleged misconduct or improper reporting of credit information by the Company or its employees. Although litigation is inherently uncertain, based on past experience, the information currently available and the possible availability of insurance and/or indemnification from originating institutions in some cases, management of the Company does not believe that the currently pending and threatened litigation or claims will have a material adverse effect on the Company’s consolidated financial position or results of operations. However, future events or circumstances, currently unknown to management, will determine whether the resolution of pending or threatened litigation or claims will ultimately have a material effect on the Company’s consolidated financial position, liquidity or results of operations in any future reporting periods.
Purchase Commitments In connection with the Company’s acquisition of assets in June 2005 (see Note 3), the Company entered into a forward flow agreement to purchase a minimum of $3.0 billion in face value of credit card charge-offs over the next five years at a fixed price. Future minimum purchase commitments under this agreement are as follows as of June 30, 2005 (amounts in thousands):
Effective August 1, 2005, the Company amended the Revolving Credit Facility. The amendment contained several provisions including an increase of the facility to $200 million, changes to certain financial covenants, the ability to increase the facility to $225 million, a reduction on the interest spreads and the ability to incur certain additional indebtedness.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K as of and for the year ended December 31, 2004, filed with the Securities and Exchange Commission. The Form 10-K contains a general description of our industry and a discussion of recent trends affecting the industry. Certain statements herein may constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). Forward-looking statements involve risks, uncertainties and other factors that may cause our actual results, performance, or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. The Company claims the protection of the safe harbor of the reform act for forward-looking statements. See Part II — Other Information for more information regarding forward-looking statements.
We are a systems-driven purchaser and manager of charged-off consumer receivable portfolios. We acquire these portfolios at deep discounts from their face values using our proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon the ongoing analysis of these accounts, we employ a dynamic mix of collection strategies to maximize our return on investment.
Overview Our business and financial results improved during the three and six months ended June 30, 2005 as compared to the corresponding periods of the prior year. Highlights for the three months ended June 30, 2005 as compared to the three months ended June 30, 2004 are as follows:
Highlights for the six months ended June 30, 2005 as compared to the six months ended June 30, 2004 are as follows:
Our stockholders’ equity increased $17.1 million from $96.0 million as of December 31, 2004 to $113.1 million as of June 30, 2005. Our operating performance during the six months ended June 30, 2005 resulted in unrestricted cash of $18.9 million as of June 30, 2005, after borrowing $167.4 million and repaying $54.0 million in principal on our debt facilities and purchasing $140.6 million in receivable portfolios, which includes $95.7 million of receivable portfolios acquired from Jefferson Capital.
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Jefferson Capital Acquisition On June 7, 2005, we acquired certain assets, including receivable portfolios, from Jefferson Capital Systems, LLC (“Jefferson Capital”), a subsidiary of CompuCredit Corporation for consideration totaling $142.9 million. As part of the acquisition, we acquired a portfolio of charged-off consumer credit card debt with a face value of approximately $2.8 billion, entered into a forward flow agreement to purchase a minimum of $3.0 billion in face value of credit card charge-offs from Jefferson Capital over the next five years at a fixed price and entered into an agreement to offer employment to approximately 120 employees of Jefferson Capital at its collection site in St. Cloud, Minnesota in September 2005, after completion of a three month transition services agreement with Jefferson Capital. In addition, the Company entered into a two year agreement to sell Chapter 13 bankruptcies to Jefferson Capital based on a pre-set pricing schedule and agreed to provide Jefferson Capital with a prescribed number of accounts on a monthly basis for its balance transfer program, also based on a pre-set pricing schedule. To fund this transaction and to provide a source of capital for future portfolio purchases and working capital needs, we entered into a new senior secured revolving credit facility that initially provided for an aggregate revolving commitment of $150 million, which was subsequently increased to $200 million pursuant to a recent amendment. See Note 6 to the unaudited interim condensed consolidated financial statements for a further discussion of our new Revolving Credit Facility and Note 3 for a further discussion of the acquisition of certain assets from Jefferson Capital.
Purchasing Market Outlook The current portfolio purchasing market remains challenging. In general, the increased competition in the purchasing market results in portfolio purchases at higher prices than we have paid historically, which reduces the profitability of our business. Our recent purchase from Jefferson Capital and the five year forward flow agreement that we entered into concurrently with the purchase, largely satisfies our purchasing goals for the remainder of 2005 and will represent a meaningful portion of our purchases in 2006 and beyond, thereby reducing the volatility of our quarterly purchases. Furthermore, we believe that our consumer level analytics and multi-disciplined approach to purchasing will allow us to continue to purchase profitable portfolios in this challenging environment.
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Results of operations in dollars and as a percentage of revenue were as follows (in thousands, except percentages):
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Total revenue was $53.8 million for the three months ended June 30, 2005, an increase of $10.2 million, or 23.3%, compared to total revenue of $43.6 million for the three months ended June 30, 2004. The increase in revenue was primarily the result of continued strong performance on older portfolios and increased portfolio purchases during the quarter, including our Jefferson Capital acquisition. These increases were offset in part by lower effective interest rates resulting from a more competitive pricing environment. Revenue and collections on portfolios acquired from Jefferson Capital amounted to $3.5 million and $3.0 million, respectively. Gross collections increased $13.0 million, or 22.7%, to $70.4 million during the three months ended June 30, 2005, from $57.4 million during the three months ended June 30, 2004. Revenue as a percentage of collections for the three months ended June 30, 2005 was 76.4% compared to 75.9% for the three months ended June 30, 2004.
Total revenue was $104.2 million for the six months ended June 30, 2005, an increase of $18.3 million, or 21.2%, compared to total revenue of $86.0 million for the six months ended June 30, 2004. The increase in revenue was primarily the result of continued strong performance on older portfolios and increased portfolio purchases during the quarter, including our Jefferson Capital acquisition. These increases were offset in part by lower effective interest rates resulting from a more competitive pricing environment. Revenue and collections on portfolios acquired from Jefferson Capital amounted to $3.5 million and $3.0 million, respectively. Gross collections increased $14.9 million, or 12.3%, to $136.3 million during the six months ended June 30, 2005, from $121.4 million during the six months ended June 30, 2004. Revenue as a percentage of collections for the six months ended June 30, 2005 was 76.5% compared to 70.8% for the six months ended June 30, 2004.
During the twelve months prior to June 30, 2005, we invested $207.7 million for portfolios with face values aggregating $6.1 billion for an average purchase price of 3.4% of face value. This is a $126.7 million increase, or 156.4%, in the amount invested compared with the $81.0 million invested during the twelve months prior to June 30, 2004 to acquire portfolios with a face value aggregating $3.1 billion for an average purchase price of 2.6% of face value. For additional information on revenue see the Supplemental Performance Data below.
Total operating expenses were $31.9 million for the three months ended June 30, 2005, an increase of $6.5 million, or 25.4%, compared to total operating expenses of $25.4 million for the three months ended June 30, 2004.
Total operating expenses were $62.2 million for the six months ended June 30, 2005, an increase of $13.4 million, or 27.6%, compared to total operating expenses of $48.8 million for the six months ended June 30, 2004.
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Salaries and employee benefits Total salaries and benefits increased by $0.5 million, or 4.4%, to $12.4 million during the three months ended June 30, 2005, from $11.9 million during the three months ended June 30, 2004. The increase was primarily the result of increases in incentive compensation resulting from our strong operating performance. Total salaries and employee benefits as a percentage of gross collections during the three months ended June 30, 2005 were 17.6% compared to 20.6% for the three months ended June 30, 2004. During the three months ended June 30, 2005 we averaged 703 employees whose average monthly gross collections were $33,400. During the three months ended June 30, 2004 we averaged 759 employees whose average monthly gross collections were $25,200.
Total salaries and benefits increased by $1.5 million, or 6.4%, to $25.0 million during the six months ended June 30, 2005 from $23.5 million during the six months ended June 30, 2004. The increase was primarily the result of a $0.8 million increase in incentive compensation resulting from our strong operating performance and a $0.4 million increase in salaries and wages and associated payroll taxes. Total salaries and benefits as a percentage of gross collections during the six months ended June 30, 2005 were 18.3% compared to 19.3% for the six months ended June 30, 2004. During the six months ended June 30, 2005, we averaged 700 employees whose average monthly gross collections were $32,400. During the six months ended June 30, 2004 we averaged 743 employees whose average monthly gross collections were $27,200.
Other operating expenses Other operating expenses increased $0.8 million, or 22.5%, to $4.2 million during the three months ended June 30, 2005, from $3.4 million during the three months ended June 30, 2004. The increase during the three months ended June 30, 2005 primarily reflects an increase in data acquisition fees and an increase in the cost of direct mail campaigns. Data acquisition fees increased approximately $0.4 million primarily as a result of our analysis of receivable portfolios acquired from Jefferson Capital. The cost of direct mail campaigns increased approximately $0.4 million primarily as a result of increased mail volume.
Other operating expenses increased $2.0 million, or 29.1%, to $8.8 million during the six months ended June 30, 2005 from $6.8 million during the six months ended June 30, 2004. The increase during the six months ended June 30, 2005 primarily reflects increases in the cost of direct mail campaigns and an increase in data acquisition fees. The cost of direct mail campaigns increased $1.2 million, or 42.0%, to $3.9 million during the six months ended June 30, 2005 compared to $2.7 million during the six months ended June 30, 2004, primarily as a result of increased mail volume. Data acquisition fees increased approximately $0.4 million primarily as a result of our analysis of receivable portfolios acquired from Jefferson Capital.
Collection agency commissions These expenses are commissions we pay to third party collection agencies. Commissions as a percentage of collections in this channel vary from period to period depending on, among other things, the time from charge-off of the accounts placed with an agency (freshly charged-off accounts have a lower commission rate).
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During the three months ended June 30, 2005, we incurred $3.5 million in commissions to third party collection agencies, or 42.4% of the related gross collections of $8.2 million, compared to $0.9 million in commissions, or 32.9% of the related gross collections of $2.6 million during the three months ended June 30, 2004. The increase in commissions is consistent with the increase in collections through this channel, of which approximately $1.3 million of the commissions increase and $3.0 million of the collections increase relates to collections on the portfolio acquired from Jefferson Capital. All collections on the portfolio acquired from Jefferson Capital have been reflected as collections from third party collection agencies. When the transition services agreement with Jefferson Capital expires on September 5, 2005 and the employees of Jefferson Capital become employees of the Company, a portion of collections on the portfolio acquired from Jefferson Capital will be reflected in the collection site channel. The increase in the commission rate as a percentage of the related gross collections reflects a shift in the mix of accounts collected by third party collection agencies from a greater proportion of freshly charged-off accounts during the three months ended June 30, 2004 to a lesser proportion of freshly charged-off accounts during the three months ended June 30, 2005.
During the six months ended June 30, 2005, we incurred $5.5 million in commissions to third party collection agencies, or 40.1% of the related gross collections of $13.7 million compared to $1.5 million in commissions, or 32.8% of the related gross collections of $4.7 million during the six months ended June 30, 2004. The increase in commissions is consistent with the increase in collections through this channel, of which approximately $1.3 million of the commissions increase and $3.0 million of the collections increase relates to collections on the portfolio acquired from Jefferson Capital. All collections on the portfolio acquired from Jefferson Capital have been reflected as collections from third party collection agencies. When the transition services agreement with Jefferson Capital expires on September 5, 2005 and the employees of Jefferson Capital become employees of the Company, a portion of collections on the portfolio acquired from Jefferson Capital will be reflected in the collection site channel. The increase in the commission rate as a percentage of the related gross collections reflects a shift in the mix of accounts collected by third party collection agencies from a greater proportion of freshly charged-off accounts during the six months ended June 30, 2004 to a lesser proportion of freshly charged-off accounts during the six months ended June 30, 2005.