UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2006
OR
For the transition period from to .
COMMISSION FILE NUMBER: 000-26489
ENCORE CAPITAL GROUP, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
8875 Aero Drive, Suite 200
San Diego, California
(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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes ¨ No x
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
INDEX TO FORM 10-Q
PART I – FINANCIAL INFORMATION
Item 1 – Consolidated Financial Statements
Unaudited Condensed Consolidated Statements of Financial Condition
Unaudited Condensed Consolidated Statements of Operations
Unaudited Condensed Consolidated Statement of Stockholders’ Equity
Unaudited Condensed Consolidated Statements of Cash Flows
Notes to Unaudited Condensed Consolidated Financial Statements
Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations
Supplemental Performance Data
Item 3 – Quantitative and Qualitative Disclosures about Market Risk
Item 4 – Controls and Procedures
PART II – OTHER INFORMATION
Item 1 – Legal Proceedings
Item 1A – Risk Factors
Item 4 – Submission of Matters to a Vote of Security Holders
Item 6 – Exhibits
SIGNATURES
Certification of Principal Executive Officer
Certification of Principal Financial Officer
Certification of the Principal Executive and Financial Officers pursuant to Section 906 of the SARBANES-OXLEY ACT of 2002
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Condensed Consolidated Statements of Financial Condition
(In Thousands, Except Par Value Amounts)
Assets
Cash and cash equivalents
Restricted cash
Accounts receivable, net
Investment in receivable portfolios, net
Property and equipment, net
Prepaid income tax
Purchased servicing asset
Forward flow asset
Other assets
Goodwill
Identifiable intangible assets, net
Total assets
Liabilities and stockholders’ equity
Liabilities:
Accounts payable and accrued liabilities
Accrued profit sharing arrangement
Deferred tax liabilities, net
Deferred revenue
Purchased servicing obligation
Debt
Total liabilities
Commitments and contingencies
Stockholders’ equity:
Convertible preferred stock, $.01 par value, 5,000 shares authorized, no shares issued and outstanding
Common stock, $.01 par value, 50,000 shares authorized, 22,777 shares and 22,651 shares issued and outstanding as of June 30, 2006 and December 31, 2005, respectively
Additional paid-in capital
Accumulated earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total liabilities and stockholders’ equity
(A) Derived from the audited consolidated financial statements as of December 31, 2005.
See accompanying notes to condensed consolidated financial statements.
2
Condensed Consolidated Statements of Operations
(In Thousands, Except Per Share Amounts)
(Unaudited)
Revenues
Revenue from receivable portfolios, net
Servicing fees and other related revenue
Total revenues
Operating expenses
Salaries and employee benefits
Stock-based compensation expense
Cost of legal collections
Other operating expenses
Collection agency commissions
General and administrative expenses
Depreciation and amortization
Total operating expenses
Income before other income (expense) and income taxes
Other income (expense)
Interest expense
Other income
Total other expense
Income before income taxes
Provision for income taxes
Net income
Basic - earnings per share computation:
Net income available to common stockholders
Weighted average shares outstanding
Earnings per share – Basic
Diluted - earnings per share computation:
Incremental shares from assumed conversion of stock options
Diluted weighted average shares outstanding
Earnings per share – Diluted
3
Condensed Consolidated Statement of Stockholders’ Equity
(Unaudited, In Thousands)
Accumulated
Earnings
Other
ComprehensiveIncome
Total
Equity
Comprehensive
Income
Balance at December 31, 2005
Other comprehensive income:
unrealized gain on non-qualified deferred compensation plan assets
Exercise of stock options
Stock-based compensation related to stock options
Tax benefit related to stock option exercises
Tax benefit from convertible note interest expense
Balance at June 30, 2006
4
Condensed Consolidated Statements of Cash Flows
Operating activities
Gross collections
Less:
Amounts collected on behalf of third parties
Amounts applied to principal on receivable portfolios
Servicing fees
Interest payments
Contingent interest payments
Decrease in restricted cash
Income taxes
Excess tax benefits from stock-based payment arrangements
Net cash provided by operating activities
Investing activities
Cash paid for Jefferson Capital acquisition
Purchases of receivable portfolios
Collections applied to principal of receivable portfolios
Proceeds from the sale of marketable securities
Proceeds from put-backs of receivable portfolios
Purchases of property and equipment
Net cash provided by (used in) investing activities
Financing activities
Proceeds from notes payable and other borrowings
Repayment of notes payable and other borrowings
Capitalized loan costs
Proceeds from exercise of common stock options and warrants
Repayment of capital lease obligations
Net cash (used in) provided by financing activities
Net increase in cash
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
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Condensed Consolidated Statements of Cash Flows (cont.)
Reconciliation of Net Income to Net Cash Provided by Operating Activities
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of loan costs
Tax benefit from stock option exercises
Deferred income tax expense (benefit)
Impairment on receivable portfolios, net
Changes in operating assets and liabilities
Decrease (increase) in other assets
Decrease in prepaid income tax
Decrease in accrued profit sharing arrangement
(Decrease) increase in accounts payable and accrued liabilities
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1: Ownership and Description of Business
Encore Capital Group, Inc. (“Encore”) together with its subsidiaries (the “Company”) is a systems-driven purchaser and manager of charged-off consumer receivable portfolios and provider of bankruptcy services to the finance industry. The Company acquires its receivable 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 the Company’s ongoing analysis of these accounts, it employs a dynamic mix of collection strategies to maximize its return on investment. The receivable portfolios the Company purchases consist primarily of unsecured, charged-off domestic consumer credit card, auto deficiency, telecom, and healthcare receivables purchased from national financial institutions, major retail credit corporations, telecom companies and resellers of such portfolios. Acquisitions of receivable portfolios are financed by operations and by borrowings from third parties. See Note 6 for further discussion of the Company’s debt.
Encore is a Delaware holding company whose principal assets are its investments in various wholly owned subsidiaries.
Note 2: Summary of Significant Accounting Policies
Significant Accounting Policies
Please refer to the Company’s annual report on Form 10-K as of and for the year ended December 31, 2005 for a summary of the Company’s significant accounting policies.
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 (“GAAP”). However, in the Company’s opinion, 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, 2006, its consolidated results of operations for the three and six months ended June 30, 2006 and 2005, and its cash flows for the six months ended June 30, 2006 and 2005. The unaudited interim condensed consolidated results of operations of the Company for the three and six months ended June 30, 2006 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, 2005, filed with the Securities and Exchange Commission on March 15, 2006.
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Effects of New Accounting Pronouncements
On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”) “Share-Based Payment,” which addresses the accounting for stock-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R is a revision of Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), “Accounting For Stock-Based Compensation.” In January 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides supplemental implementation guidance for SFAS No. 123R. SFAS No. 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees”, and instead generally requires that such transactions be accounted for using a fair-value-based method. SFAS No. 123R requires establishing assumptions and estimates of weighted-average fair value per share of options granted and performance shares issued, as well as using a valuation model to calculate the fair value of stock-based awards. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock-based awards, which is consistent with that used for pro forma disclosures under SFAS No. 123. The Company has elected the modified prospective transition method as permitted by SFAS No. 123R and accordingly prior periods have not been restated to reflect the impact of SFAS No. 123R. The modified prospective transition method requires that stock-based compensation expense be recorded for all new and unvested stock options, and restricted stock units, that are ultimately expected to vest as the requisite service is rendered beginning on January 1, 2006. Stock-based compensation expense for awards granted prior to January 1, 2006 is based on the grant date fair-value as determined under the pro forma provisions of SFAS No. 123. In accordance with SFAS No. 123R, beginning in the first quarter of 2006, the Company has presented excess tax benefits from the exercise of stock-based compensation awards as a financing activity in the Condensed Consolidated Statement of Cash Flows.
Changes in Accounting Estimate
During the quarter ended June 30, 2006, the Company revised its Unified Collection Score (“UCS”) methodology by extending the collection forecast from 60 months to 72 months. UCS is a proprietary forecasting tool that generates portfolio level expectations of liquidation for portfolios that the Company has owned and serviced for greater than 6 months. For forecasting portfolios owned and serviced less than six months, the Company uses its proprietary Behavioral Liquidation Score (“BLS”) model. The BLS methodology forecasts portfolio level expectations based on credit characteristics of the portfolio over a 54-month period. The Company has observed that receivable portfolios purchased in 2001 and prior have consistently experienced cash collections beyond 60 months from the date of purchase, in some cases 6 to 8 years from the date of purchase. When the Company first developed its cash forecasting models in 2001, limited historical collection data was available with which to accurately model projected cash flows beyond 60 months. With additional collection data accumulated over the last several years, the forecasting models have been improved and the Company believes it has enough collection history to forecast collections to 72 months. Extending the collection forecast in our UCS model from 60 months to 72 months resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios by $86.0 million or 13.6% as of June 30, 2006. The extension of the collection forecasts is being treated as a change in estimate and, in accordance with
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Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3,” (“SFAS No. 154”) is being recognized prospectively in the consolidated financial statements. This prospective treatment resulted in an increase in revenue of $0.9 million and an increase in the accrual for contingent interest of $0.4 million for the quarter ended June 30, 2006. The net impact of the change in estimate was to increase second quarter pretax income by $0.5 million, net income by $0.3 million and fully diluted earnings per share by $0.01.
New Accounting Pronouncement
On July 13, 2006, the Financial Accounting Standards Board issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN No. 48”), which is effective for fiscal years beginning after December 15, 2006. FIN No. 48 establishes recognition and measurement thresholds that must be met before a tax benefit can be recognized in the financial statements. The Company is currently analyzing the effects of the new standard and its potential impact on its financial statements.
Reclassification
Certain amounts included in the accompanying prior periods’ condensed consolidated financial statements have been reclassified to conform to the current period presentation.
Upon completion of a detailed analysis performed on its net tax assets during the quarter ended March 31, 2006, the Company determined that additional tax portfolio amortization deductions should be reflected as an increase in its prepaid income tax balance with a corresponding decrease in the net deferred tax assets. The amount reclassified on the Company’s consolidated statement of condition as of December 31, 2005 was $9.3 million. This reclassification relates to a temporary difference between GAAP and tax accounting, and accordingly has no impact to the consolidated statements of operations.
Note 3: Stock-Based Compensation
On January 1, 2006, the Company implemented SFAS No. 123R, which is a revision of SFAS No. 123. SFAS No. 123R requires establishing assumptions and estimates of the weighted-average fair value of stock options granted and restricted stock issued (“performance shares”), as well as using a valuation model to calculate the fair value of stock-based awards. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock-based awards. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. The below assumptions are used by the Company to determine the fair value of stock-based awards.
Expected Life. The expected life of options granted represents the period of time for which the options are expected to be outstanding. An independent third party performed valuation procedures, which took into account the percentage of option exercises, the percentage of options that expired unexercised, and the percentage of options outstanding. The Company used this valuation as guidance to determine the expected life of the options, which is three years.
Expected Volatility. The expected volatility is based on the historical volatility of the Company’s common stock over the weighted-average vesting term of the options, which is three years.
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Risk-Free Interest Rate. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect at the date of grant.
Dividends. The Company does not currently anticipate paying any cash dividends on its common stock. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes option valuation model.
Forfeitures. SFAS No. 123R requires the Company to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. To determine an expected forfeiture rate, the Company examined the historical employee turnover rate over the last 3 years as a proxy for forfeitures. The forfeitures are based on data specific to each employee class under the assumption that different classes of employees can act differently because of title, rank, number of options granted, and other like characteristics. For the purposes of this analysis, these classes included: (i) officers (as defined under Section 16 of the Securities Exchange Act of 1934) and (ii) all others receiving options. Based on the internal analysis, the expected forfeiture rates were determined to be 0.8% for officers and 6.6% for all others. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to January 1, 2006, the Company accounted for forfeitures as they occurred.
The fair value of options granted was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:
Weighted average fair value of options granted
Risk free interest rate
Dividend yield
Volatility factor of the expected market price of the Company’s common stock
Weighted-average expected life of options
Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant based on the Company’s historical experience and future expectations. For the three and six months ended June 30, 2006, $1.5 million and $2.8 million was recognized as stock-based compensation expense under SFAS No. 123R, respectively. Unrecognized compensation cost related to stock options and performance shares as of June 30, 2006 was $12.4 million and the weighted-average life of these outstanding stock options and performance shares is approximately 2.6 years. The fair value of options vested were $2.9 million and $3.2 million during the six months ended June 30, 2006 and 2005, respectively.
Prior to the adoption of SFAS No. 123R, the Company measured stock-based compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Company applied the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion No. 25, when the exercise price of the Company’s employee stock
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options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized.
The following table illustrates the effect on net income after taxes and net income per common share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the following periods (in thousands, except per share amounts):
Net income, as reported
Plus: Stock-based employee compensation expense included in reported net income, net of tax
Less: Total stock-based employee compensation expense determined under fair value based method, net of tax
Pro forma net income
Earnings per share:
Basic – as reported
Basic – pro forma
Diluted – as reported
Diluted – pro forma
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 not less than 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 (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.
On November 1, 2005, the Company adopted a new long-range incentive program (“Performance Shares”) for officers, executives, and other eligible employees pursuant to the 2005 Plan. The Company issued 62,550 performance share grants that could vest from 2006 to 2010, depending on whether certain performance criteria are achieved. If such performance criteria are not met, 50% of the shares will vest in 2010 and the remaining 50% will be forfeited. The performance share grants issued were valued at $16.19 per share, which is the fair market value at
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the date of grant, and in accordance with SFAS No. 123R are being amortized on a straight line basis over the expected vesting period of five years.
Performance Shares activity and related information is as follows for the six months ended June 30, 2006:
Performance Shares
Non-Vested
Shares
Beginning of period December 31, 2005
Awarded
Released
Cancelled/forfeited
End of period as of June 30, 2006
A summary of the Company’s stock option activity and related information is as follows for the six months ended June 30, 2006:
AggregateIntrinsicValue
(in thousands)
Outstanding at December 31, 2005
Granted
Exercised
Outstanding at June 30, 2006
The total intrinsic value of options exercised during the six months ended June 30, 2006 and 2005 was $1.4 million and $2.0 million, respectively.
The following table summarizes outstanding and exercisable options as of June 30, 2006:
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Note 4: Investment in Receivable Portfolios, Net
Commencing January 1, 2005, the Company began accounting for its investment in receivable portfolios in accordance with the provisions of AICPA Statement of Position 03-03 (“SOP 03-03”), “Accounting for Certain Debt Securities in a Transfer.” 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.
As permitted by 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. All portfolios with common risk characteristics purchased prior to the adoption of SOP 03-03 were aggregated by quarter of purchase.
In compliance with SOP 03-03, the Company accounts for its investments in consumer receivable portfolios, using either the interest method or the cost recovery method. The interest method applies an effective interest rate, or internal rate of return (“IRR”) to the cost basis of the pool, which is to remain level, or unchanged throughout the life of the pool unless there is an increase in subsequent expected cash flows. Subsequent increases in cash flows expected to be collected generally are recognized prospectively through an upward adjustment of the pool’s effective interest rate over its remaining life. Subsequent decreases in expected cash flows do not change the effective interest rate, but are recognized as an impairment of the cost basis of the pool, and are reflected in the consolidated statement of operations as a reduction in revenue with a corresponding valuation allowance offsetting the investment in receivable portfolios in the consolidated statement of financial condition.
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.
If the amount and timing of future cash collections on a pool of receivables are not reasonably estimable, the Company accounts for such portfolios on the cost recovery method (“Cost Recovery Portfolios”). The accounts in these portfolios have different risk characteristics than those included in other portfolios acquired during the same quarter, or the necessary information was not available to estimate future cash flows and, accordingly, they were not
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aggregated with other portfolios. Under the cost recovery method of accounting, no income is recognized until the purchase price of a Cost Recovery Portfolio has been fully recovered. At June 30, 2006, one Cost Recovery Portfolio with a book value of $3.0 million was accounted for using the cost recovery method.
During the quarter ended June 30, 2006, the Company revised its UCS methodology by extending the collection forecast from 60 months to 72 months. UCS is a proprietary forecasting tool that generates portfolio level expectations of liquidation for portfolios that the Company has owned and serviced for greater than 6 months. For forecasting portfolios owned and serviced less than six months, the Company uses its proprietary Behavioral Liquidation Score (“BLS”) model. The BLS methodology forecasts portfolio level expectations based on credit characteristics of the portfolio over a 54-month period. The Company has observed that receivable portfolios purchased in 2001 and prior have consistently experienced cash collections beyond 60 months from the date of purchase, in some cases 6 to 8 years from the date of purchase. When the Company first developed its cash forecasting models in 2001, limited historical collection data was available with which to accurately model projected cash flows beyond 60 months. With additional collection data accumulated over the last several years, the forecasting models have been improved and the Company believes that it has enough collection history to forecast collections to 72 months. Extending the collection forecast in our UCS model from 60 months to 72 months resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios by $86.0 million or 13.6% as of June 30, 2006. The extension of the collection forecasts is being treated as a change in estimate and, in accordance with SFAS No. 154 is being recognized prospectively in the financial statements. This prospective treatment resulted in an increase in revenue of $0.9 million and an increase in the accrual for contingent interest of $0.4 million for the quarter ended June 30, 2006. The net impact of the change in estimate was to increase second quarter pretax income by $0.5 million, net income by $0.3 million and fully diluted earnings per share by $0.01.
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. Total accretable yield is the difference between future estimated collections and the current cost basis of a portfolio. 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):
Beginning balance at December 31, 2005
Revenue recognized, net
(Reductions) additions on existing portfolios
Additions for current purchases
Balance at March 31, 2006
Additions on existing portfolios
Additions for 12 month curve extension
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Beginning balance at December 31, 2004
Balance at March 31, 2005
Balance at June 30, 2005
During the three months ended June 30, 2006, the Company purchased receivable portfolios with a face value of $594.2 million for $21.3 million, or a purchase cost of 3.58% of face value. The estimated collections at acquisition for these portfolios amounted to $44.2 million. During the six months ended June 30, 2006, the Company purchased receivable portfolios with a face value of $1.2 billion for $48.4 million, or a purchase cost of 4.2% of face value. The estimated collections at acquisition for these portfolios amounted to $100.0 million.
All collections realized after the net book 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, 2006 and 2005, approximately $6.7 million and $9.2 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, 2006 and 2005, approximately $13.2 million and $19.6 million, respectively, was recognized as revenue on portfolios for which the related cost basis has been fully recovered.
The following table summarizes the changes in the net balance of the investment in receivable portfolios during the six months ended June 30, 2006 (in thousands, except percentages):
Balance, beginning of period
Gross collections1
Basis adjustments
Revenue recognized1
Impairment reversals, net
Balance, end of period
Revenue as a percentage of collections
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The following table summarizes the change in the valuation allowance for investment in receivable portfolios during the six months ended June 30, 2006 (in thousands):
Provision for impairment losses
Reversal of prior allowance
The Company utilizes various business channels for the collection of its receivable portfolios. The following table summarizes collections by collection channel (in thousands):
Collection sites
Legal collections
Sales
Collection agencies
Gross collections for the period
Note 5: Other Assets
Other assets consist of the following (in thousands):
Debt issuance costs, net
Deferred court costs, net
Deferred compensation assets
Prepaid employment agreement
Note 6: Debt
The Company is obligated under borrowings as follows (in thousands):
Convertible Senior Notes
Revolving Credit Facility
Secured Financing Facility
Secured Notes
Capital Lease Obligations
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In 2005, the Company issued $100.0 million of 3.375% convertible senior notes due September 19, 2010 (the “Convertible Notes”). Interest on the Convertible Notes is payable semi-annually in arrears on March 19 and September 19 of each year, commencing March 19, 2006. The Convertible Notes rank equally with the Company’s existing and future senior indebtedness and are senior to the Company’s potential future subordinated indebtedness. The Convertible Notes are convertible prior to maturity, subject to certain conditions described below, into shares of the Company’s common stock at an initial conversion rate of 44.7678 per $1,000 principal amount of notes, which represents an initial conversion price of approximately $22.34 per share, subject to adjustment.
In October 2005, the Company obtained stockholder approval of a net-share settlement feature that allows the Company to settle conversion of the Convertible Notes through a combination of cash and stock. Based on the provisions of Emerging Issues Task Force No. 90-19, “Convertible Bonds with Issuer Option to Settle for Cash upon Conversion” (“EITF 90-19”) and Emerging Issues Task Force No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company’s Own Stock” (“EITF 00-19”), the net-settlement feature is accounted for as convertible debt and is not subject to the provisions of Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”). As a result of the net-settlement feature, the Company will be able to substantially reduce the number of shares issuable in the event of conversion of the Convertible Notes by repaying principal in cash instead of issuing shares of common stock for that amount. Additionally, the Company will not be required to include the underlying shares of common stock in the calculation of the Company’s diluted weighted average shares outstanding for earnings per share until the Company’s common stock price exceeds $22.34.
The aggregate underwriting commissions and other debt issuance costs incurred with respect to the issuance of the Convertible Notes were $3.4 million, which have been capitalized as debt issuance costs on the Company’s consolidated statement of financial condition and are being amortized on an effective interest rate method over the term of the Convertible Notes.
The Convertible Notes also contain a restricted convertibility feature that does not affect the conversion price of the Convertible Notes but, instead, places restrictions on a holder’s ability to convert their Convertible Notes into shares of the Company’s common stock. A holder may convert the Convertible Notes prior to March 19, 2010 only if one or more of the following conditions are satisfied:
Holders may also surrender their Convertible Notes for conversion anytime on or after March 19, 2010 until the close of business on the trading day immediately preceding September 19, 2010, regardless of whether any of the
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foregoing conditions have been satisfied. Upon the satisfaction of any of the foregoing conditions as of the last day of a reporting period, or during the twelve months prior to September 19, 2010, the Company would write off to expense all remaining unamortized debt issuance costs in that period.
If the Convertible Notes are converted in connection with certain fundamental changes that occur prior to March 19, 2010, the Company may be obligated to pay an additional make-whole premium with respect to the Convertible Notes converted.
Convertible Notes Hedge Strategy. Concurrent with the sale of the Convertible Notes, the Company purchased call options to purchase from the counterparties an aggregate of 4,476,780 shares of the Company’s common stock at a price of $22.34 per share. The cost of the call options totaled $27.4 million. The Company also sold warrants to the same counterparties to purchase from the Company an aggregate of 3,984,334 shares of the Company’s common stock at a price of $29.04 per share and received net proceeds from the sale of these warrants of $11.6 million. Taken together, the call option and warrant agreements have the effect of increasing the effective conversion price of the Convertible Notes to $29.04 per share. The call options and warrants must be settled in net shares. On the date of settlement, if the market price per share of the Company’s common stock is above $29.04 per share, the Company will be required to deliver shares of its common stock representing the value of the call options and warrants in excess of $29.04 per share.
The warrants have a strike price of $29.04 and are generally exercisable at anytime. The Company issued and sold the warrants in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended, because the offer and sale did not involve a public offering. There were no underwriting commissions or discounts in connection with the sale of the warrants.
In accordance with EITF No. 00-19 and Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” the Company recorded the net call options and warrants as a reduction in additional paid in capital as of December 31, 2005, and will not recognize subsequent changes in fair value of the call options and warrants in its condensed consolidated financial statements.
In May 2006, the Company amended the Revolving Credit Facility. This second amendment to the Revolving Credit Facility extended the termination date to May 2010, reduced the maximum LIBOR spread by 75 basis points, increased the expansion feature to $50.0 million from $25.0 million and eliminated and modified certain financial covenants. The amended Revolving Credit Facility bears interest at a floating rate equal to, at the Company’s option, either: (a) reserve adjusted LIBOR plus a spread that ranges from 175 to 225 basis points, depending on the Company’s leverage; or (b) the higher of the federal funds rate then in effect plus a spread of 50 basis points or the prime rate then in effect. 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. The amended Revolving 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.
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The amended Revolving Credit Facility provides for an aggregate revolving commitment of $200.0 million, subject to borrowing base availability, with $5.0 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 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, or (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 revolving credit commitments, under the expansion feature to $250.0 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 part or in full anytime without penalty.
The terms of the amended Revolving 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 that establish a minimum net worth threshold and require maintenance of specified ratios for debt to adjusted EBITDA 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 amended Revolving Credit Facility and declare all amounts outstanding to be immediately due and payable.
At June 30, 2006, of the $200.0 million commitment, our outstanding balance was $62.7 million, which bore a weighted average interest rate of 7.7%. Our aggregate borrowing base was $153.7 million, of which $91.1 million was available for future borrowings.
On December 20, 2000 MRC Receivables Corporation, a wholly owned bankruptcy-remote, special-purpose entity entered into a $75.0 million secured financing facility (the “Secured Financing Facility”) to finance the purchase of receivable portfolios. On December 31, 2004, this facility expired. Amounts outstanding under the Secured Financing Facility accrue interest at the prime rate plus 3.0% per annum, which was 11.25% at June 30, 2006. Principal payments, as defined in the agreement and accrued interest are payable weekly. Notes issued under the facility are collateralized by the charged-off receivables that were purchased with the proceeds from this financing arrangement. Unless amended, each note has a maturity date not to exceed 27 months after the borrowing date. Once an individual note is repaid (and the Company has recovered its investment in the receivable portfolio), the Company and the lender share the residual collections, net of servicing fees paid to the Company. The residual collections paid to the lender are classified as contingent interest. The sharing in residual cash flows continues for
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the entire economic life of the receivable portfolios financed using this facility, and will extend substantially beyond the expiration date of the Secured Financing Facility. Estimates of the residual cash flows to be paid to the lender are used to determine an effective interest rate and are accrued each period as contingent interest.
The following table summarizes interest expense associated with the Secured Financing Facility for the periods presented (in thousands):
Stated interest
Contingent interest
Total interest expense
The Secured Financing Facility had a balance of $14.1 million as of June 30, 2006 and was collateralized by certain charged-off receivable portfolios with an aggregate carrying amount of $40.8 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.
The Company has capital lease obligations for certain computer equipment. These lease obligations require monthly payments aggregating approximately $21,372 through November 2008 and have implicit interest rates ranging from 2.9% to 3.1%. Capital lease obligations outstanding as of June 30, 2006 were $0.6 million.
Note 7: Income Taxes
The Company recorded an income tax provision of $5.7 million, reflecting an effective rate of 43.3% of pretax income during the three months ended June 30, 2006. The effective tax rate for the three months ended June 30, 2006, 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%, the effect of permanent book versus tax differences of 0.1% and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of the Company’s 2003 income tax return of 2.5%, which the Company concluded in the three months ended June 30, 2006, was probable. For the three months ended June 30, 2005 the Company recorded an income tax provision of $5.6 million, reflecting an effective rate of 40.8% of pretax income. The effective tax rate for the three months ended June 30, 2005, 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 of 0.1%.
The Company recorded an income tax provision of $8.9 million, reflecting an effective rate of 42.3% of pretax income during the six months ended June 30, 2006. The effective tax rate for the six months ended June 30, 2006, 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%, the effect of permanent book versus tax differences of 0.1% and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of the Company’s 2003 income tax return of 1.5%, which the Company concluded in the three months ended June 30, 2006, was probable. For the six months ended June 30, 2005, the Company recorded an income tax provision of $10.6 million, reflecting an effective rate of 40.6% of pretax income. The effective tax rate for the six months ended June 30, 2005, consists
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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%, less the effect of permanent book versus tax differences of 0.1%.
Upon completion of a detailed analysis of its net tax assets, performed during the three months ended March 31, 2006, the Company determined that additional tax portfolio amortization deductions should be reflected as an increase in its prepaid income tax balance with a corresponding decrease in the net deferred tax assets. The amount reclassified on the Company’s consolidated statement of condition as of December 31, 2005 was $9.3 million. This reclassification relates to a temporary difference between GAAP and tax accounting, and accordingly has no impact to the consolidated statements of operations.
Note 8: Purchase Concentrations
The following table summarizes the concentration of our purchases by seller sorted by total aggregate costs, for the six months ended June 30, 2006 and 2005, adjusted for put-backs, account recalls and replacements (in thousands, except percentages):
Concentration of Initial
Purchase Cost by Seller
Seller 1
Seller 2
Seller 3
Seller 4
Seller 5
Seller 6
Seller 7
Seller 8
Seller 9
Seller 10
Adjustments1
Purchase, net
Note 9: Commitments and Contingencies
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
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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. On May 2, 2006, the court denied our special motion to strike pursuant to California’s anti-SLAPP statute, denied in part and granted in part our motion to dismiss, denied a variety of ex parte motions and applications filed by the plaintiff and denied the plaintiff’s motion for leave to conduct discovery or file supplemental briefing. The court granted the plaintiff 30 days in which to further amend his complaint, and on June 1, 2006, the plaintiff filed a second amended complaint in which he amended his claim for negligent infliction of emotional distress. On May 25, 2006, we filed a notice of appeal of the court’s order denying the anti-SLAPP motion and on June 16, 2006, we filed a motion to stay the case. The hearing on this motion is scheduled for August 14, 2006. 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.
On September 7, 2005, Mr. Moser filed a related action in the United States District Court for the Southern District of California against Triarc Companies, Inc. (Triarc), a significant stockholder of the Company, alleging intentional interference with contractual relations and intentional infliction of emotional distress. The case arises out of the same statements made or alleged to have been made in the Company’s Registration Statements mentioned above. On January 7, 2006, Triarc was served with an amended complaint seeking injunctive relief, an order directing Triarc to issue a statement of retraction or correction of the allegedly false statements, economic and punitive damages in an unspecified amount and attorney’s fees and costs. Triarc tendered the defense of this action to the Company, and the Company accepted the defense and will indemnify Triarc, pursuant to the indemnification provisions of the Registration Rights Agreements dated as of October 31, 2000 and February 21, 2002, and the Underwriting Agreements dated September 25, 2004 and January 20, 2005 to which Triarc is a party. 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.
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. Management is aware of a number of cases styled as class actions that have been filed against the Company. To date, a class has been certified in one 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
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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 Jefferson Capital Group in June 2005, 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 a five-year period at a fixed price. Future minimum purchase commitments at a fixed price under this agreement are as follows as of June 30, 2006(amounts in thousands):
The purchase commitment above assumes that the remaining commitment as of June 30, 2006 will be incurred ratably over the remaining term of the agreement.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
“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, 2005, 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”), for which we claim the protection of the safe harbor of the Reform Act. See Part II - Item 1A. Risk Factors for more discussion on our forward-looking statements.
Introduction
We are a systems-driven purchaser and manager of charged-off consumer receivable portfolios and a provider of bankruptcy services to the finance industry. We acquire receivable 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.
Special Committee to Consider Strategic Alternatives
On June 5, 2006, we announced the formation of a special committee of the board of directors (the “Special Committee”) to consider strategic alternatives. The Special Committee is comprised of independent members of our board of directors. The Special Committee has retained J.P. Morgan Securities Inc. and Deutsche Bank Securities Inc. as its financial advisors. The board of directors formed the Special Committee to identify and evaluate various strategic alternatives to enhance stockholder value, including the potential sale of the company. We cannot assure you that this strategic alternatives review process will result in any strategic transaction or sale of the company. We do not intend to disclose developments or provide updates on the progress or status of the strategic alternatives review process or of any strategic alternatives under consideration, unless and until the board of directors has approved a specific transaction.
Overview
Results for the three months ended June 30, 2006 as compared to the three months ended June 30, 2005 are as follows:
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Results for the six months ended June 30, 2006 as compared to the six months ended June 30, 2005 are as follows:
Although gross collections and revenue were higher for the three and six months ended June 30, 2006 compared to the three and six months ended June 30, 2005, net income was lower. The lower net income for the three months ended June 30, 2006 was primarily the result of the expensing of stock options associated with our adoption of Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”) “Share-Based Payment,” in the amount of $0.9 million on an after-tax basis, higher operating expenses associated with our higher volume of gross collections, and increased costs associated with new operating initiatives focused on increasing portfolio liquidation and lower effective accretion rates on collections from portfolios purchased in 2004, 2005, and 2006 compared to portfolios purchased in prior years due to a more competitive pricing environment in recent years, offset by after-tax net income of $0.8 million in our subsidiary, Ascension Capital Group, LP, (“Ascension”), increased accretion revenue associated with revising our Unified Collection Score (“UCS”) model by extending our collection forecast from 60 months to 72 months, and increased accretion revenue related to new operating initiatives. The lower net income for the six months ended June 30, 2006 was primarily the result of several factors including the expensing of stock options associated with our adoption of SFAS No. 123R in the amount of $1.7 million on an after-tax basis, the after-tax net loss of $0.5 million in Ascension, higher operating expenses associated with our higher volume of gross collections, and increased costs associated with new operating initiatives focused on increasing portfolio liquidation and lower effective accretion rates on collections from portfolios purchased in 2004, 2005, and 2006 compared to portfolios purchased in prior years due to a more competitive pricing environment in recent years, offset by increased accretion revenue associated with revising our UCS forecasts by extending our collection forecast from 60 months to 72 months, and increased accretion revenue during the quarter ended June 30, 2006 related to new operating initiatives implemented by the Company. The market for the purchase of unsecured charged-off consumer debt has remained competitive and we have continued to be disciplined in our approach to purchasing. During the three and six months ended June 30, 2006, we purchased $21.3 million and $48.4 million, respectively in receivable portfolios and amortized $19.8 million and $49.4 million, respectively in cost basis on our receivable portfolios. Our ability to grow revenue will be based on our ability to increase liquidation on our receivable portfolios, which would increase our internal rates of return applied to the cost basis of the portfolio, and to purchase additional receivable portfolios.
During the three and six months ended June 30, 2006, there was a significant reduction in placements of accounts at Ascension, our bankruptcy servicing business. We believe that this was the result of the large volume of bankruptcy filings in October 2005, just prior to the effective date of the new Bankruptcy Reform Act (the “Act”). We expect placement levels to return to historical levels by early 2007. Also, consistent with our revenue recognition policy, the revenue associated with the significant number of Chapter 7 account placements in October 2005 were recognized during the three months ended June 30, 2006.
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Results of Operations
Results of operations in dollars and as a percentage of revenue were as follows (in thousands, except percentages):
Revenue
Total revenue
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Comparison of Results of Operations
Our revenue is comprised primarily of accretion revenue, zero basis revenue, and servicing fee revenue. Accretion revenue represents revenue derived from pools (quarterly groupings of purchased receivable portfolios) with a cost basis that has not been fully amortized. Revenue from pools with a remaining unamortized cost basis is accrued based on each pool’s effective interest rate applied to each pool’s remaining unamortized 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. We account for our investment in receivable portfolios utilizing the interest method in accordance with the provisions of the AICPA’s Statement of Position 03-03, “Accounting for Certain Debt Securities Acquired in a Transfer” (“SOP 03-03”).
During the quarter ended June 30, 2006, we revised our UCS methodology by extending the collection forecast from 60 months to 72 months. UCS is a proprietary forecasting tool that generates portfolio level expectations of liquidation for portfolios that we have owned and serviced for greater than 6 months. For forecasting portfolios owned and serviced less than six months, we use our proprietary Behavioral Liquidation Score (“BLS”) model. The BLS methodology forecasts portfolio level expectations based on credit characteristics of the portfolio over a 54-month period. We have observed that receivable portfolios purchased in 2001 and prior have consistently experienced cash collections beyond 60 months from the date of purchase, in some cases 6 to 8 years from the date of purchase. When we first developed our cash forecasting models in 2001, we had limited historical collection data with which to accurately model projected cash flows beyond 60 months. With additional collection data accumulated over the last several years, we have improved the forecasting models and we believe that we have enough collection history to forecast collections to 72 months. Extending the collection forecast in our UCS model from 60 months to 72 months resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios by $86.0 million, or 13.6% as of June 30, 2006. The extension of the collection forecasts is being treated as a change in estimate and, in accordance with Statement of Financial Accounting Standard No. 154, (“Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3,”) is being recognized prospectively in the financial statements. This prospective treatment resulted in an increase in revenue of $0.9 million and an increase in the accrual for contingent interest of $0.4 million for the quarter ended June 30, 2006. The net impact of the change in estimate was to increase second quarter pretax income by $0.5 million, net income by $0.3 million and fully diluted earnings per share by $0.01. Also during the second quarter, we increased our total estimated remaining collections by $33.1 million, or 4.8% as of June 30, 2006, to reflect the additional collections we expect to receive from new operating initiatives we implemented. This resulted in an increase in revenue of $2.1
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million for the quarter, which was offset by $1.3 million in operating expenses incurred in connection with these initiatives.
Total revenue was $65.9 million for the three months ended June 30, 2006, an increase of $12.1 million, or 22.6%, compared to total revenue of $53.8 million for the three months ended June 30, 2005. The increase in revenue was primarily the result of revenue accreted on portfolios acquired in connection with our Jefferson Capital acquisition and other recent portfolio purchases. As discussed above, the increase was also related to the increase in the effective interest rate on certain pools of receivable portfolios in connection with our implementation of new operating initiatives, and the extension of our collection forecasts from 60 to 72 months. The increases in revenue were mitigated in part by a greater portion of our collections coming from 2004, 2005 and 2006 purchases that have lower effective accretion rates than purchases made in prior years due to a more competitive pricing environment in 2004, 2005 and 2006. Of the increase in revenue, $6.3 million related to bankruptcy servicing revenue associated with our acquisition of Ascension in August 2005. Gross collections increased $8.8 million, or 12.5%, to $79.2 million during the three months ended June 30, 2006, from $70.4 million during the three months ended June 30, 2005.
Total revenue was $126.4 million for the six months ended June 30, 2006, an increase of $22.2 million, or 21.3%, compared to total revenue of $104.2 million for the six months ended June 30, 2005. The increase in revenue was primarily the result of revenue accreted on portfolios acquired in connection with our Jefferson Capital acquisition and other recent portfolio purchases. As discussed above, the increase was also related to the increase in the effective interest rate on certain pools of receivable portfolios in connection with our implementation of new operating initiatives and the extension of our collection forecasts from 60 to 72 months. The increases in revenue were mitigated in part by a greater portion of our collections coming from 2004, 2005, and 2006 purchases that have lower effective accretion rates than purchases made in prior years due to a more competitive pricing environment in 2004, 2005 and 2006. Of the increase in revenue, $9.1 million related to bankruptcy servicing revenue associated with our acquisition of Ascension in August 2005. Gross collections increased $30.5 million, or 22.4%, to $166.8 million during the six months ended June 30, 2006, from $136.3 million during the six months ended June 30, 2005.
The following table summarizes our portfolio revenue by revenue-to-collections percentage. The accrual basis portfolios from 1999 to 2003 represent pool groups with high internal rates of return and high revenue to collection percentages (in thousands, except percentages):
For the Three Months Ended
June 30, 2005
Zero Basis Portfolios
1999 – 2003 Accrual Basis Portfolios
2004 – 2005 Accrual Basis Portfolios
2006 Accrual Basis Portfolios
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For the Six Months Ended
June 30, 2006
During the twelve months ended June 30, 2006, we invested $102.4 million for portfolios with face values aggregating $2.9 billion for an average purchase price of 3.6% of face value. This is a $106.2 million decrease, or 50.7%, in the amount invested compared with the $208.6 million invested during the twelve months ended June 30, 2005 to acquire portfolios with a face value aggregating $6.1 billion for an average purchase price of 3.4% of face value. The decrease is primarily a result of the $96.6 million allocated to the $2.8 billion of face value portfolio purchased as part of the Jefferson Capital Group acquisition in June 2005.
For revenue recognition purposes, portfolios are divided into two groups: Accrual Basis Portfolios - those that still have a remaining unamortized basis, and Zero Basis Portfolios - those portfolios for which the cost basis has been completely amortized. Zero basis revenue represents revenue derived from receivable portfolios whose cost basis has been fully amortized. When there is no remaining cost basis to amortize, each dollar collected is recognized entirely as revenue. During the three months ended June 30, 2006, $6.4 million (exclusive of $0.4 million of zero basis revenue on the retained interest) was recognized as zero basis revenue, a $2.4 million decrease from the $8.8 million (exclusive of $0.5 million of zero basis revenue on the retained interest) recognized during the three months ended June 30, 2005. During the six months ended June 30, 2006, $12.5 million (exclusive of $0.7 million of zero basis revenue on the retained interest) was recognized as zero basis revenue, a $6.1 million decrease from the $18.6 million (exclusive of $1.0 million of zero basis revenue on the retained interest) recognized during the six months ended June 30, 2005. We expect the revenue from these portfolios to decline in future quarters as collections from these portfolios diminish. For additional information on revenue see the Supplemental Performance Data below.
Operating Expenses
Total operating expenses were $45.7 million for the three months ended June 30, 2006, an increase of $13.8 million, or 43.1%, compared to total operating expenses of $31.9 million for the three months ended June 30, 2005.
Total operating expenses were $90.4 million for the six months ended June 30, 2006, an increase of $28.2 million, or 45.3%, compared to total operating expenses of $62.2 million for the six months ended June 30, 2005.
Total salaries and employee benefits increased by $3.9 million, or 31.8%, to $16.3 million during the three months ended June 30, 2006 from $12.4 million during the three months ended June 30, 2005. The increase was primarily the result of a $3.0 million or 35.2% increase in salaries, wages and payroll taxes associated with additional headcount. Of this headcount increase, approximately 100 employees representing $1.0 million in salaries, wages
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and payroll taxes related to our collection site in St. Cloud, Minnesota acquired from Jefferson Capital in June 2005 and approximately 200 employees representing $2.6 million in salaries, wages and payroll taxes related to Ascension which we acquired in August 2005.
Total salaries and employee benefits increased by $7.6 million, or 30.5%, to $32.6 million during the six months ended June 30, 2006 from $25.0 million during the six months ended June 30, 2005. The increase was primarily the result of a $6.0 million or 35.6% increase in salaries, wages and payroll taxes associated with additional headcount. Of this headcount increase, approximately 100 employees representing $2.0 million in salaries, wages and payroll taxes related to our collection site in St. Cloud, Minnesota acquired from Jefferson Capital in June 2005 and approximately 200 employees representing $5.3 million in salaries, wages and payroll taxes related to Ascension which we acquired in August 2005.
Stock-based compensation expenses
Stock-based compensation amounted to $1.5 million and $2.8 million for the three and six months ended June 30, 2006, respectively. These amounts are the result of implementing Statement of Financial Accounting Standards No. 123R, “Share-Based Payments” (“SFAS No. 123R”), effective January 1, 2006. SFAS No. 123R requires us to expense stock options, restricted stock, and any other share-based payments beginning January 1, 2006 but does not require us to expense these amounts in any prior periods. See Note 3 to the unaudited interim condensed consolidated financial statements for a further discussion of stock-based compensation.
The cost of legal collections increased $4.3 million, or 50.0% to $12.9 million during the three months ended June 30, 2006 as compared to $8.6 million during the three months ended June 30, 2005. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in the cost of legal collections was primarily the result of an increase of $6.5 million, or 28.5% in gross collections through our legal channel. Gross legal collections amounted to $29.1 million during the three months ended June 30, 2006 from $22.6 million collected during the three months ended June 30, 2005. Cost of legal collections increased as a percent of gross collections through this channel to 44.5% during the three months ended June 30, 2006, from 38.2% during the three months ended June 30, 2005, primarily as a result of upfront costs associated with new operating initiatives focused on increasing portfolio liquidation.
The cost of legal collections increased $7.2 million, or 42.6% to $24.2 million during the six months ended June 30, 2006 as compared to $17.0 million during the six months ended June 30, 2005. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in the cost of legal collections was primarily the result of an increase of $11.0 million, or 25.1% in gross collections through our legal channel. Gross legal collections amounted to $54.8 million during the six months ended June 30, 2006 from $43.8 million collected during the six months ended June 30, 2005. Cost of legal collections increased as a percent of gross collections through this channel to 44.2% during the six months ended June 30, 2006, from 38.8% during the six months ended June 30, 2005, primarily as a result of upfront costs associated with new operating initiatives focused on increasing portfolio liquidation.
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Other operating expenses increased $1.5 million, or 36.3%, to $5.7 million during the three months ended June 30, 2006 from $4.2 million during the three months ended June 30, 2005. The increase was primarily attributed to Ascension (acquired in August 2005), which contributed $1.8 million of other operating expenses relating to its bankruptcy services business, including $0.5 million of amortization expense relating to the purchased servicing asset. This increase was offset by a reduction in the cost of direct mail campaigns, which decreased $0.2 million, or 12.1%, to $1.5 million during the three months ended June 30, 2006 compared to $1.7 million during the three months ended June 30, 2005.
Other operating expenses increased $3.3 million, or 37.6%, to $12.1 million during the six months ended June 30, 2006 from $8.8 million during the six months ended June 30, 2005. This increase is the result of increases in the number of direct mail campaigns and operating costs associated with Ascension, which we acquired in August 2005. The cost of direct mail campaigns increased $0.3 million, or 6.7%, to $4.2 million during the six months ended June 30, 2006 compared to $3.9 million during the six months ended June 30, 2005. Ascension contributed $3.2 million to the overall increase, including $1.1 million of amortization expense relating to the purchased servicing asset.
During the three months ended June 30, 2006, we paid $5.0 million in commissions to third party collection agencies, or 36.1% of the related gross collections of $14.0 million compared to $3.5 million in commissions, or 42.4% of the related gross collections of $8.2 million during the three months ended June 30, 2005. The increase in commissions is consistent with the increase in collections through this channel. The decrease in the commission rate as a percentage of the related gross collections is primarily due to the mix of accounts placed with the 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).
During the six months ended June 30, 2006, we paid $9.6 million in commissions to third party collection agencies, or 35.8% of the related gross collections of $26.9 million compared to $5.5 million in commissions, or 40.1% of the related gross collections of $13.7 million during the six months ended June 30, 2005. The increase in commissions is consistent with the increase in collections through this channel. The decrease in the commission rate as a percentage of the related gross collections is primarily due to the mix of accounts placed with the 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).
General and administrative expenses increased $0.4 million, or 15.0%, to $3.3 million during the three months ended June 30, 2006, from $2.9 million during the three months ended June 30, 2005. The increase was primarily the result of a $0.6 million increase in general corporate matters and $0.5 million in increased expenses related to the
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addition of the St. Cloud site and the acquisition of Ascension in August 2005. These increases were offset by lower legal costs of $0.7 million relating to litigation defense.
General and administrative expenses increased $2.0 million, or 40.0%, to $7.0 million during the six months ended June 30, 2006, from $5.0 million during the six months ended June 30, 2005. The increase was primarily the result of a $1.2 million increase in general corporate matters and $1.1 million in increased expenses related to the addition of the St. Cloud site and the acquisition of Ascension in August 2005. These increases were offset by lower legal costs of $0.3 million relating to litigation defense.
Depreciation and amortization expense increased $0.6 million, or 132.1%, to $1.0 million during the three months ended June 30, 2006, from $0.4 million during the three months ended June 30, 2005. Amortization expense for the three months ended June 30, 2006 relating to intangible assets purchased from Ascension in the third quarter 2005 was $0.4 million. There were no amortizable intangible assets for the three months ended June 30, 2005. Depreciation expense remained relatively consistent at $0.6 million and $0.4 million during the three months ended June 30, 2006 and 2005, respectively.
Depreciation and amortization expense increased $1.0 million, or 107.8%, to $1.9 million during the six months ended June 30, 2006, from $0.9 million during the six months ended June 30, 2005. Amortization expense for the six months ended June 30, 2006 relating to intangible assets purchased from Ascension in the third quarter 2005 was $0.8 million. There were no amortizable intangible assets for the six months ended June 30, 2005. Depreciation expense remained relatively consistent at $1.1 million and $0.9 million during the six months ended June 30, 2006 and 2005, respectively.
Interest expense decreased $1.1 million, or 12.5% to $7.3 million during the three months ended June 30, 2006 from $8.4 million during the three months ended June 30, 2005.
Interest expense decreased $1.2 million, or 7.2% to $15.3 million during the six months ended June 30, 2006 from $16.5 million during the six months ended June 30, 2005.
The following table summarizes our interest expense (in thousands, except percentages):
Stated interest on debt obligations
Amortization of loan fees and other loan costs
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The decrease in interest expense is due to a decrease in contingent interest recorded under the terms of our Secured Financing Facility. Under the terms of our Secured Financing Facility, once we repay the lender for the notes associated with each purchased portfolio and collect sufficient amounts to recoup our initial cash investment in each purchased portfolio, we then share the residual collections “Contingent Interest” from the receivable portfolios, net of our servicing fees, with the lender. We make estimates with respect to the timing and amount of collections of future cash flows from these receivable portfolios. Based on these estimates, we record a portion of the estimated future profit sharing obligation as Contingent Interest Expense.
We have financed portfolio purchases subsequent to December 31, 2004 using our Revolving Credit Facility, which does not require the sharing of residual collections with the lender. See Note 6 to the unaudited interim condensed consolidated financial statements for a further discussion on our Revolving Credit Facility.
Other income and expense
During the three months ended June 30, 2006, total other income was $0.3 million, compared to $0.2 million for the three months ended June 30, 2005. During the six months ended June 30, 2006, total other income was $0.3 million, compared to $0.6 million for the six months ended June 30, 2005. For the six month ended June 30, 2006, the decrease in other income and expense was primarily the result of lower interest income due to lower balances of invested cash.
During the three months ending June 30, 2006, we recorded an income tax provision of $5.7 million, reflecting an effective rate of 43.3% of pretax income. Our effective tax rate for the three months ended June 30, 2006 differed from the federal statutory rate primarily due to the net effect of state taxes and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of our 2003 income tax return. For the three months ended June 30, 2005, we recorded an income tax provision of $5.6 million, reflecting an effective rate of 40.8% of pretax income. Our effective tax rate for the three months ended June 30, 2005 differed from the federal statutory rate primarily due to the net effect of state taxes. The increase in our effective tax rate was the result of the changing mix of permanent book versus tax differences relative to higher taxable income and the increase in tax expense related to the tax audit issue noted above.
During the six months ending June 30, 2006, we recorded an income tax provision of $8.9 million, reflecting an effective rate of 42.3% of pretax income. Our effective tax rate for the six months ended June 30, 2006 differed from the federal statutory rate primarily due to the net effect of state taxes and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of our 2003 income tax return. For the six months ended June 30, 2005, we
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recorded an income tax provision of $10.6 million, reflecting an effective rate of 40.6% of pretax income. Our effective tax rate for the six months ended June 30, 2005 differed from the federal statutory rate primarily due to the net effect of state taxes. The increase in our effective tax rate was the result of the changing mix of permanent book versus tax differences relative to higher taxable income and the increase in tax expense related to the tax audit issue noted above. See Note 7 to the unaudited interim condensed consolidated financial statements for a further discussion of income taxes.
Upon completion of a detailed analysis performed in the first quarter of 2006 on its net tax assets, we determined that additional tax portfolio amortization deductions should be reflected as an increase in our prepaid income tax balance with a corresponding decrease in the net deferred tax assets. The amount reclassified on our consolidated statement of condition as of December 31, 2005 was $9.3 million. This reclassification relates to a temporary difference between GAAP and tax accounting, and accordingly has no impact to the consolidated statements of operations.
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Cumulative Collections to Purchase Price Multiple
The following table summarizes our purchases and related resulting gross collections per year of purchase (in thousands, except multiples):
Purchase
Price1
Total Estimated Collections to Purchase Price Multiple
The following table summarizes our purchases, resulting historical gross collections, and estimated remaining gross collections by year of purchase (in thousands, except multiples):
Historical
Gross
Collections2
EstimatedRemainingGross
Collections
TotalEstimatedGross
Total Estimated Gross
Collections toPurchase Price
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Unamortized Balances of Portfolios
The following table summarizes the remaining unamortized balances of our purchased receivable portfolios by year of purchase as of June 30, 2006 (in thousands, except percentages):
Unamortized
Balance as of
Balance as a
Percentage of
Purchase Price2
Percentage of Total
Portfolio Gross Collections by Channel
During the three and six months ended June 30, 2006 and 2005, we utilized several business channels for the collection of charged-off credit card receivables and other charged-off receivables. The following tables summarize gross collections by collection channel (in thousands):
Changes in Investment in Receivable Portfolios
Revenue related to our investment in receivable portfolios is comprised of two components. First, revenue from those portfolios that have a remaining book value and are accounted for on the accrual basis (“Accrual Basis Portfolios”), and second, revenue from those portfolios that have fully recovered their cost basis for which every dollar of gross collections is recorded entirely as Zero Basis Revenue (“Zero Basis Portfolios”).
The following tables summarize the changes in the balance of the investment in receivable portfolios and the proportion of revenue recognized as a percentage of collections (in thousands, except percentages):
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Transfers of portfolios
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Analysis of Changes in Revenue
The following tables analyze the components of the increase in revenue from our receivable portfolios for the three and six months ended June 30, 2006 compared to the three and six months ended June 30, 2005(in thousands, except percentages):
Variance Component
Average portfolio balance
Weighted average effective interest rate1
Zero basis revenue
Retained interest revenue
Total variance
Purchases by Quarter
The following table summarizes the purchases we made by quarter, and the respective purchase prices (in thousands, except percentages):
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Purchases by Paper Type
The following tables summarize the types of charged-off consumer receivable portfolios we purchased for the three and six months ended June 30, 2006 and 2005 (in thousands):
Three Months Ended
June 30,
Six Months Ended
Credit card
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Liquidity and Capital Resources
Historically, we have met our cash requirements by utilizing our cash flows from operations, bank borrowings, and equity offerings. Our primary cash requirements have included the purchase of receivable portfolios, operational expenses, the payment of interest and the repayment of principal on bank borrowings, and tax payments. Our strong operating performance has resulted in an increase in stockholders’ equity to $135.3 million as of June 30, 2006 from $118.3 million as of December 31, 2005. In addition, we had an unrestricted cash balance of $10.1 million at June 30, 2006, after borrowing $4.5 million and repaying $25.1 million in principal on our debt facilities and purchasing $43.8 in receivable portfolios.
The following table summarizes our cash flows by category for the periods presented (in thousands):
On December 31, 2004 our Secured Financing Facility expired. However, Contingent Interest payments related to our residual collections sharing arrangement with the lender will extend into the future. All of our portfolio purchases are now funded with cash or financed under our $200.0 million Revolving Credit Facility. Unlike our Secured Financing Facility, the Revolving Credit Facility does not require us to share with the lender the residual collections on the portfolios financed. See Note 6 to the unaudited condensed consolidated financial statements for more discussion on our Revolving Credit Facility, Secured Financing Facility and Contingent Interest.
Operating Cash Flows
Net cash provided by operating activities was $16.1 million for the six months ended June 30, 2006, and $13.7 million for the six months ended June 30, 2005. We have been able to generate consistent operating cash flow by maintaining our gross collections performance. Gross collections for the six months ended June 30, 2006 grew $30.5 million, or 22.4%, to $166.8 million from $136.3 million for the six months ended June 30, 2005.
Total cash basis operating expenses were $81.2 million for the six months ended June 30, 2006, compared to $61.8 million for the six months ended June 30, 2005. The increase was primarily volume-related, driven by our collection growth and new operational initiatives, as well as increases in rent expense, and the cost of corporate compliance, offsets by lower litigation defense costs. Interest payments were $18.7 million for the six months ended June 30, 2006, and $19.2 million for the six months ended June 30, 2005. The decrease in interest payments was primarily the result of lower contingent interest payments related to our residual collections sharing arrangement for portfolios financed by our Secured Financing Facility and lower borrowings under the Revolving Credit Facility. See Management’s Discussion and Analysis for a detailed discussion of operating and interest expenses.
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Investing Cash Flows
Net cash provided by (used in) investing activities was $6.8 million for the six months ended June 30, 2006, and ($116.3) million for the six months ended June 30, 2005.
The cash flows provided by investing activities for the six months ended June 30, 2006 are primarily related to receivable portfolio purchases of $43.8 million offset by gross collection proceeds applied to the principal of our receivable portfolios in the amount of $49.4 million. The cash flows used in investing activities for the six months ended June 30, 2005 are primarily related to our acquisition of certain assets of Jefferson Capital for $142.9 million and receivable portfolio purchases of $44.9 million, offset by gross collection proceeds applied to the principal of our receivable portfolios in the amount of $31.7 million.
Capital expenditures for fixed assets acquired with internal cash flow were $0.8 million and $1.1 million for the six months ended June 30, 2006 and 2005, respectively.
Financing Cash Flows
Net cash (used in) provided by financing activities was ($19.9) million and $111.8 million for the six months ended June 30, 2006 and 2005, respectively.
The cash used in financing activities during the six months ended June 30, 2006, reflects $25.1 million in repayments of notes payable, amounts outstanding under our line of credit and other borrowings, offset by $4.5 million in borrowings under our line of credit agreement. Cash provided by financing activities for the six months ended June 30, 2005, reflects $167.4 million in borrowings under our line of credit agreement of which $142.9 million was used to fund the Jefferson Capital acquisition, offset by $54.0 million in repayments of notes payable, amounts outstanding under our line of credit and other borrowings.
Future Contractual Cash Obligations
The following table summarizes our future contractual cash obligations as of June 30, 2006 (in thousands):
Less Than
1 Year
1 – 3
Years
3 – 5
MoreThan
5 Years
Capital lease obligations
Operating leases
Employment agreements
3.375% Convertible Senior Notes
Contractual interest on 3.375% Convertible Senior Notes
Portfolio forward flow agreement
Total contractual cash obligations
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Repayments under our Secured Financing Facility are predicated on our cash collections from the underlying secured receivable portfolios. However, repayment of the original principal amount must be made no later than 27 months following the date of the original advance, unless amended, with respect to each advance under the Secured Financing Facility. The table reflects the repayment of the loans under the Secured Financing Facility based upon our expected cash collections, which reflects repayments earlier than the required due dates. This table does not include future interest or future contingent interest payments. Our amended Revolving Credit Facility has a remaining term of four years and to the extent that a balance is outstanding on our line of credit, it would be due in May 2010. Interest on the Revolving Credit Facility is variable and is not included in this table. The outstanding balance on our line of credit as of June 30, 2006 was $62.7 million. The portfolio forward flow agreement represents estimated payments under our five-year portfolio purchase forward flow agreement entered into on June 7, 2005. For additional information on our debt, see Note 6 to our unaudited interim condensed consolidated financial statements. For additional information on purchase commitments see Note 9 to our unaudited interim condensed consolidated financial statements.
We are in compliance with all covenants under our financing arrangements, and we have achieved eighteen consecutive quarters of positive net income. We believe that we have sufficient liquidity to fund our operations for at least the next twelve months, given our expectation of continued positive cash flows from operations, our cash and cash equivalents of $10.1 million as of June 30, 2006, and $137.3 million in borrowing capacity and borrowing base availability of $91.1 million under our Revolving Credit Facility as of June 30, 2006.
Off Balance Sheet Arrangements
We do not have any off balance sheet arrangements as defined by regulation S-K 303(a)(4).
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
For quantitative and qualitative disclosures about market risk affecting Encore, see Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005, which is incorporated herein by reference. Our exposure to market risk has not changed materially since December 31, 2005.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our periodic reports filed with the Securities and Exchange Commission (“SEC”) is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management accordingly is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Based on their most recent evaluation, which was completed as of June 30, 2006, the end of the period covered by this Quarterly Report on Form 10-Q as of and for the three months ended June 30, 2006, our Chief Executive Officer and Chief Financial Officer have concluded our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (“Exchange Act”), as amended, are effective.
Changes in Internal Control over Financial Reporting
There was no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect our internal control over financial reporting. In August 2005, the Company completed the acquisition of Ascension Capital Group, Ltd. As part of the integration process with respect to this acquisition, we are in the process of implementing our controls and procedures into the recently acquired Ascension operations and are conducting control reviews and remediation efforts pursuant to the Sarbanes-Oxley Act of 2002.
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
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. On May 2, 2006 the court denied our special motion to strike pursuant to California’s anti-SLAPP statute, denied in part and granted in part our motion to dismiss, denied a variety of ex parte motions and applications filed by the plaintiff and denied the plaintiff’s motion for leave to conduct discovery or file supplemental briefing. The court granted the plaintiff 30 days in which to further amend his complaint, and on June 1, 2006, the plaintiff filed a second amended complaint in which he amended his claim for negligent infliction of emotional distress. On May 25, 2006, we filed a notice of appeal from the court’s order denying the anti-SLAPP motion and on June 16, 2006 we filed a motion to stay the case. The hearing on this motion is scheduled for August 14, 2006. 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.
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. Management is aware of a number of cases styled as class actions that have been filed against the
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Company. To date, a class has been certified in one 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.
Item 1A. Risk Factors
You should carefully consider the factors discussed in Part I, “Item IA. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005 (the “Form 10-K”), which could materially affect our business, financial condition or future results and are incorporated herein by reference. The following risk factor is a material update to the risk factors contained in the Form 10-K:
The formation of a Special Committee by our board of directors and its consideration of the sale of our company may distract management and employees or otherwise disrupt operations, which could adversely affect our results of operations.
As discussed above, on June 5, 2006, we announced the formation of a Special Committee of our board of directors to consider strategic alternatives. While the Special Committee will look to strategic alternatives it feels may enhance stockholder value, including the potential sale of the company, the uncertainty inherent in such process could undermine company morale and may at times divert management’s attention from routine matters. For instance, the Special Committee has no exact timeline for this process and we do not intend to disclose developments or provide updates on the progress or status of the strategic alternatives review process or of any strategic alternatives under consideration until the board of directors has approved such transaction. In addition, we cannot assure you that this strategic alternatives review process ultimately will result in any strategic transaction or sale of the company, so the stockholders may never realize the potential enhancement in value that the Special Committee is seeking. Ultimately, the unpredictability associated with this process could adversely affect our results of operations in any of the ways described above or in various other ways that are unforeseen at this time.
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This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). The words “believe,” “expect,” “anticipate,” “estimate,” “project,” or the negation thereof or similar expressions constitute forward-looking statements within the meaning of the Reform Act. These statements may include, but are not limited to, projections of revenues, income or loss, estimates of capital expenditures, plans for future operations, products or services, and financing needs or plans, as well as assumptions relating to these matters. These statements include, among others, statements found under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” For all forward-looking statements, we claim the protection of the safe-harbor for forward-looking statements contained in the Reform Act.
Our actual results could differ materially from those contained in the forward-looking statements due to a number of factors, some of which are beyond our control. Factors that could affect our results of operations or financial condition and cause them to differ from those contained in the forward-looking statements include:
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Forward-looking statements speak only as of the date the statement was made. They inherently are subject to risks and uncertainties, some of which we cannot predict or quantify. Future events and actual results could differ materially from the forward-looking statements. When considering each forward-looking statement, you should keep in mind the risk factors and cautionary statements found throughout our annual report on Form 10-K as of and for the year ended December 31, 2005 filed with the Securities and Exchange Commission. We do not undertake and specifically decline any obligation to publicly release the result of any revisions to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events, whether as a result of new information, future events, or for any other reason.
In addition, it is our policy generally not to make any specific projections as to future earnings and we do not endorse projections regarding future performance that may be made by third parties.
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Item 4. Submission of Matters to a Vote of Security Holders
On June 5, 2006, we held our annual meeting of stockholders. At the annual meeting, Barry R. Barkley, J. Brandon Black, Raymond Fleming, Carl C. Gregory, III, Eric D. Kogan, Alexander Lemond, Richard A. Mandell and Peter W. May were elected to serve as directors. The votes for the election of directors are set forth below:
Name of Nominee
Barry R. Barkley
J. Brandon Black
Raymond Fleming
Carl C. Gregory, III
Eric D. Kogan
Alexander Lemond
Richard A. Mandell
Peter W. May
At the annual meeting, the stockholders also approved Proposal 2, ratifying the appointment of BDO Seidman, LLP as our independent register public accounting firm for fiscal year 2006. The votes for Proposal 2 were as follows:
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Item 6. Exhibits
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Paul Grinberg
Executive Vice-President,
Chief Financial Officer and Treasurer
(Principal Financial and Accounting Officer)
Date: August 3, 2006
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