UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
Portfolio Recovery Associates, Inc.
(888) 772-7326
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
YES [X] NO [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
YES [ ] NO [X]
The number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
PORTFOLIO RECOVERY ASSOCIATES, INC.
INDEX
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PORTFOLIO RECOVERY ASSOCIATES, INC.CONSOLIDATED STATEMENTS OF FINANCIAL POSITIONSeptember 30, 2003 and December 31, 2002(unaudited)
The accompanying notes are an integral part of these consolidated financial statements.
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PORTFOLIO RECOVERY ASSOCIATES, INC.CONSOLIDATED STATEMENTS OPERATIONSFor the Three and Nine Months Ended September 30, 2003 and 2002(unaudited)
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PORTFOLIO RECOVERY ASSOCIATES, INC.CONSOLIDATED STATEMENTS OF CASH FLOWSFor the Nine Months Ended September 30, 2003 and 2002(unaudited)
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PORTFOLIO RECOVERY ASSOCIATES, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(unaudited)
1. Organization and Business:
Portfolio Recovery Associates, LLC (“PRA”) was formed March 20, 1996. Portfolio Recovery Associates, Inc. (“PRA Inc”) was formed in August 2002. On November 8, 2002, PRA Inc completed its initial public offering (“IPO”) of common stock. As a result, all of the membership units and warrants of PRA were exchanged on a one to one basis for warrants and shares of a single class of common stock of PRA Inc. PRA Inc now owns all outstanding membership units of PRA and PRA Receivables Management, LLC (d/b/a Anchor Receivables Management) (“Anchor”). PRA owns all of the membership units of PRA III, LLC, a special purpose borrowing entity (“PRA III”), PRA Funding, LLC, whose name was changed from PRA AG Funding, LLC in February 2003 (“PRA Funding”), and PRA Holding I, LLC, an entity established to hold real property (“PRA Holding I”). PRA Inc, a Delaware corporation, and its subsidiaries (collectively, the “Company”) purchases, collects and manages portfolios of defaulted consumer receivables. The defaulted consumer receivables the Company collects are in substantially all cases either purchased from the credit originator or are collected on behalf of clients on a commission fee basis. This is primarily accomplished by maintaining a staff of highly skilled collectors whose purpose is to contact the customers and arrange payment of the debt. Secondarily, the Company has contracted with independent attorneys to allow the Company to undertake legal action to satisfy the outstanding debt.
The consolidated financial statements of the Company include the accounts of PRA Inc, PRA, PRA Funding, PRA Holding I, Anchor and PRA III.
The accompanying unaudited financial statements of the Company have been prepared in accordance with Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission and, therefore, do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the United States of America. In the opinion of the Company, however, the accompanying unaudited consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the Company’s financial position as of September 30, 2003, its results of operations for the three and nine month periods ended September 30, 2003 and 2002, and its cash flows for the nine month periods ended September 30, 2003 and 2002, respectively. The results of operations of the Company for the three and nine month periods ended September 30, 2003 and 2002 may not be indicative of future results. These 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 amended, filed for the year ended December 31, 2002.
2. Finance Receivables:
The Company accounts for its investment in finance receivables using the interest method under the guidance of Practice Bulletin 6, “Amortization of Discounts on Certain Acquired Loans.” Static pools of relatively homogenous accounts are established. Once a static pool is established, the receivable accounts in the pool are not changed. Each static pool is recorded at cost, and is accounted for as a single unit for the recognition of income, principal payments and loss provision. Income on finance receivables is accrued monthly based on each static pool’s effective interest rate. This interest rate is estimated based on the timing and amount of anticipated cash flows using the Company’s proprietary collection models. Monthly cash flows greater than the interest accrual will reduce the carrying value of the static pool. Likewise, monthly cash flows that are less than the monthly accrual will accrete the carrying balance. Each pool is reviewed monthly and compared to the Company’s models to ensure complete amortization of the carrying balance at the end of each pool’s life.
In the event that cash collections would be inadequate to amortize the carrying balance, an impairment charge would be taken with a corresponding write-off of the receivable balance. Accordingly, we do not maintain an allowance for credit losses.
The agreements to purchase the aforementioned receivables include general representations and warranties from the sellers covering account holder death or bankruptcy, and accounts settled or disputed prior to sale. The representation and warranty period permitting the return of these accounts from the Company to the seller is typically 90 to 180 days.
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Changes in finance receivables for the three and nine months ended September 30, 2003 and 2002 were as follows:
(1) Estimated Remaining Collections refers to the sum of all future projected cash collections on the Company’s owned portfolios. ERC is not a balance sheet item, however, it is provided here for informational purposes.
At the time of acquisition, the life of each pool is generally set at between 60 and 72 months based upon the proprietary models of the Company. As of September 30, 2003 the Company has $89,836,418 in finance receivables included in the Statement of Financial Position. Based upon current projections, cash collections applied to principal will be as follows for the twelve months in the periods ending:
3. Revolving Lines of Credit:
On September 18, 2001, PRA III arranged with a commercial lender to provide financing under a revolving line of credit of up to $40 million. The agreement was amended on December 18, 2002 to reduce the available credit to $25 million. The December 2002 amendment also allowed for a reduction in the borrowing spread and an increase in the unused line fee. This line of credit is collateralized by all receivables, collections on receivables and assets of PRA III along with a lien on Company assets excluding PRA Funding and certain other excluded assets. The agreement expires September 15, 2005. Interest is variable based on LIBOR. No amount was outstanding at September 30, 2003 and December 31, 2002. Restrictive covenants under this agreement include:
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As of September 30, 2003 the Company is in compliance with all of the covenants of this agreement.
In addition, PRA Funding maintains a $2.5 million revolving line of credit with RBC Centura Bank. This line of credit had an expiration date of July 2003; however, in September 2003, this facility was extended and now expires on September 28, 2004. The line of credit bears interest at a spread over LIBOR. The terms of this agreement require that PRA maintain a current ratio of 1.6:1.0 or greater, the current ratio being defined to include finance receivables as a current asset and to include the credit facility in place as of September 30, 2003 as a current liability. The agreement further requires that PRA maintain a debt to tangible net worth ratio of 1.5:1.0 or less and a minimum balance sheet cash position at month end of $2 million. Distributions are limited under the terms of the facility to 75% of net income. As of September 30, 2003, the Company is in full compliance with these covenants. This $2.5 million facility had no amounts outstanding as of September 30, 2003 or December 31, 2002.
4. Property and Equipment:
Property and equipment, at cost, consist of the following as of the dates indicated:
5. Hedging Activity:
During 2001, the Company entered into an interest rate swap for the purpose of managing exposure to fluctuations in interest rates related to variable rate financing. The interest rate swap effectively fixed the interest rate on $10 million of the Company’s outstanding debt. The swap required payment or receipt of the difference between a fixed rate of 5.33% and a variable rate of interest based on 1-month LIBOR. The unrealized gains and losses associated with the change in market value of the interest rate swap are recognized as other comprehensive income. This swap transaction, which was to expire in May 2004, was paid in full and terminated in September 2002.
Expenses incurred related to the swap agreement were interest expenses of $616,954 and $792,047 for the three and nine months ending September 30, 2002. The net interest payments are a component of “Interest Expense” on the income statement and a reduction of net income in the cash flow statement.
6. Stock-Based Compensation:
The Company has a stock warrant plan and a stock option plan. Prior to 2002, the Company accounted for stock compensation issued under the recognition and measurement provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and related Interpretations. No stock-based employee compensation cost is reflected in pro forma net income for the nine months ended September 30, 2002. Effective January 1, 2002, the Company
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adopted the fair value recognition provisions of FASB Statement No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation”, prospectively to all employee awards granted, modified, or settled after January 1, 2002. Therefore, the cost related to stock-based employee compensation included in the determination of net income for 2002 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS 123. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period.
Stock Warrants
The PRA management committee was authorized to issue warrants to partners, employees or vendors to purchase membership units. Generally, warrants granted had a term between 5 and 7 years and vested within 3 years. Warrants had been issued at or above the fair market value on the date of grant. Warrants vest and expire according to terms established at the grant date.
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The following summarizes all warrant related transactions from December 31, 1999 through September 30, 2003:
At September 30, 2003, the Company had 142,500 exercisable warrants outstanding. All were issued to employees of the Company. During the nine months ended September 30, 2003, no warrants were issued. During the nine months ended September 30, 2002, 50,000 warrants were issued to an employee of the Company.
The following information is as of September 30, 2003:
Had compensation cost for granted warrants been determined pursuant to SFAS 123, the Company’s net income would have decreased. Using a fair-value (minimum value calculation), the following assumptions were used:
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The fair value model utilizes the risk-free interest rate at grant with an expected exercise date sometime in the future generally assuming an exercise date in the first half of 2005. In addition, warrant valuation models require the input of highly subjective assumptions, including the expected exercise date and risk-free interest rates. Prior to the IPO, the Company’s warrants had characteristics significantly different from those of traded warrants, and changes in the subjective input assumptions can materially affect the fair value estimate. Based upon the above assumptions, the weighted average fair value of employee warrants granted during the years ended December 31, 2002, 2001 and 2000 was $1.24, $0.35, and $0.21, respectively.
Effective December 30, 1999, PRA’s management committee issued warrants to acquire 125,000 membership units to an affiliate of Angelo, Gordon & Co. The warrants immediately vested and were exercisable at $3.60 per unit. As these warrants are not issued as compensation to an employee or operating member of the Company, an expense of $0 and $12,801 was incurred and recognized during the nine months ended September 30, 2003 and 2002, respectively. The value of the warrants was calculated using the fair value approach as designated by SFAS 123, which utilizes a comparison of the discounted value of the underlying units discounted using a risk-free interest rate at the date of grant. All warrants issued to AG 1999 have been exercised and none remain outstanding as of September 30, 2003.
Effective August 18, 1999, PRA’s management committee issued warrants to acquire 200,000 membership units to SMR Research Corporation (“SMR”). The warrants were to vest over a 60 month period and are exercisable at $4.20 per unit. The warrants vested as to 80,000 membership units and the remaining 120,000 membership units were cancelled upon the termination of an agreement between the Company and SMR Research Corporation. The value of the warrants was calculated using the intrinsic method and no expense was recognized on these warrants. The fair value approach was then applied, as designated by SFAS 123, which utilizes a comparison of the discounted value of the underlying units discounted using a risk-free interest rate at the date of grant. As a result, these warrants were shown to have a negative present value and as such no expense has been recorded. All warrants issued to SMR have been exercised and none remain outstanding as of September 30, 2003.
Stock Options
The Company created the 2002 Stock Option Plan (the “Plan”) on November 7, 2002. Up to 2,000,000 shares of common stock may be issued under this program. The Plan expires November 7, 2012. All options issued under the Plan vest ratably over 5 years. Granted options expire seven years from grant date. Expiration dates range between November 7, 2009 and July 31, 2010. No grant of options to a single person can exceed 200,000 in a single year. As of September 30, 2003, 875,000 options have been granted under the Plan of which 22,075 have been cancelled. These options are accounted for under SFAS 123 and all expense for 2003 and 2002 are included in earnings as a component of compensation. The Company issued 55,000 options during the three months ended September 30, 2003.
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The following summarizes all option related transactions from December 31, 2001 through September 30, 2003:
The Company had total stock options outstanding of 852,925 at September 30, 2003, none of which were exercisable. All of the stock options were issued to employees of the Company except for 20,000 which were issued to the board of directors.
The Company utilizes the Black-Scholes option pricing model to calculate the value of the stock options when granted. This model was developed to estimate the fair value of traded options, which have different characteristics than employee stock options. In addition, changes to the subjective input assumptions can result in materially different fair market value estimates. Therefore, the Black-Scholes model may not necessarily provide a reliable single measure of the fair value of employee stock options.
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Utilizing these assumptions, each employee stock option granted in 2002 is valued at $2.71 per share and each director stock option is valued at $3.37 per share. For stock options issued to employees in 2003, the per share values range between $5.80 and $6.25.
Restricted Stock
Restricted stock shares are permitted to be issued as an incentive to attract new employees when the stock has traded for less than one year, as is the case for PRA Inc. During the three months ended September 30, 2003, the Company issued 12,545 shares of restricted stock. The terms are similar to the stock option plan where the shares are issued at or above market values and vest ratably over 5 years.
7. Commitments and Contingencies:
Employment Agreements:
The Company has employment agreements with all of its executive officers and with several members of its senior management group, the terms of which expire on March 31, 2004 or December 31, 2005. Such agreements provide for base salary payments as well as bonuses which are based on the attainment of specific management goals. Estimated remaining compensation under these agreements is approximately $2,509,543. The agreements also contain confidentiality and non-compete provisions.
Leases:
The Company is party to various operating and capital leases with respect to its facilities and equipment. Please refer to the Company’s consolidated financial statements and notes thereto in the Company’s Annual Report on Form 10-K, as amended, as filed with the Securities and Exchange Commission for discussion of these leases. On June 27, 2003, the Company entered into a lease for an additional 25,000 square feet of office space at its Norfolk, VA headquarters. The lease is for a term of 10 years, beginning on January 1, 2004, at an annualized rent of $447,000.
In addition, the Company amended its existing lease for its Norfolk, VA headquarters to extend the term of that lease an additional 90 months. This lease now expires December 31, 2013. Beginning in 2004, annualized rental expense in conjunction with this lease will be $691,000.
Litigation:
The Company is from time to time subject to routine litigation incidental to its business. The Company believes that the results of any pending legal proceedings will not have a material adverse effect on the financial condition, results of operations or liquidity of the Company.
8. Income Taxes
Prior to November 8, 2002, the Company was organized as a limited liability company, taxed as a partnership, and as such was not subject to federal or state income taxes. Immediately before the IPO, the Company was reorganized as a corporation and became subject to income taxes.
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The income tax expense recognized for the three and nine months ended September 30, 2003 is composed of the following:
The Company also recognized a net deferred tax asset of $5,414,082 as of September 30, 2003 and a net deferred tax liability of $286,882 as of December 31, 2002. The components of this net asset and liability are:
A valuation allowance has not provided at September 30, 2003 or December 31, 2002 since management believes it is more likely than not that the deferred tax assets will be realized.
The Company presented pro forma tax information assuming it has been a taxable corporation since inception and assuming tax rates equal to the rates that would have been in effect had it been required to report income tax expense in such years. A reconciliation of the Company’s statutory tax rates to the effective tax rates for the three and nine months ended September 30, 2003 and the pro forma income tax expense for the three and nine months ended September 30, 2002, consists of the following components:
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Cautionary Statements Pursuant to Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995:
This report contains forward-looking statements within the meaning of the federal securities laws. These forward-looking statements involve risks, uncertainties and assumptions that, if they never materialize or prove incorrect, could cause the results of the Company to differ materially from those expressed or implied by such forward-looking statements. All statements, other than statements of historical fact, are forward-looking statements, including statements regarding overall trends, gross margin trends, operating cost trends, liquidity and capital needs and other statements of expectations, beliefs, future plans and strategies, anticipated events or trends, and similar expressions concerning matters that are not historical facts. The risks, uncertainties and assumptions referred to above may include the following:
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Results of Operations
The following table sets forth certain operating data as a percentage of total revenue for the periods indicated:
The Company uses the following terminology throughout its reports. “Cash Receipts” refers to all collections of cash, regardless of the source. “Cash Collections” refers to collections on the Company’s owned portfolios only, exclusive of commission income and sales of finance receivables. “Cash Sales of Finance Receivables” refers to the sales of the Company’s owned portfolios. “Commissions” refers to fee income generated from the Company’s wholly-owned contingent fee subsidiary.
Three Months Ended September 30, 2003 Compared To Three Months Ended September 30, 2002
Revenue
Total revenue was $22.2 million for the three months ended September 30, 2003, an increase of $7.0 million or 46.1% compared to total revenue of $15.2 million for the three months ended September 30, 2002.
Income Recognized on Finance Receivables
Income recognized on finance receivables was $21.4 million for the three months ended September 30, 2003, an increase of $6.7 million or 45.6% compared to income recognized on finance receivables of $14.7 million for the three months ended September 30, 2002. The majority of the increase was due to an increase in the Company’s cash collections on its owned defaulted consumer receivables to $30.2 million from $20.7 million, an increase of 45.9%.
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The Company’s amortization rate on owned portfolio for the three months ended September 30, 2003 was 29.2% while for the three months ended September 30, 2002 it was 29.0%. During the three months ended September 30, 2003, the Company acquired defaulted consumer receivables portfolios with an aggregate face value amount of $323.4 million at a cost of $11.8 million. During the three months ended September 30, 2002, the Company acquired defaulted consumer receivable portfolios with an aggregate face value of $342.1 million at a cost of $10.1 million. The Company’s relative cost basis of acquiring defaulted consumer receivable portfolios increased from 2.96% of face value for the three months ended September 30, 2002 to 3.65% of face value for the three months ended September 30, 2003.
Commissions
Commissions were $784,000 for the three months ended September 30, 2003, an increase of $263,000 or 50.5% compared to commissions of $521,000 for the three months ended September 30, 2002. Commissions increased as a result of a growing inventory of accounts.
Net gain on cash sales of defaulted consumer receivables
Net gain on cash sales of defaulted consumer receivables were $0 for the three months ended September 30, 2003 and 2002.
Operating Expenses
Total operating expenses were $13.1 million for the three months ended September 30, 2003, an increase of $4.1 million or 45.6% compared to total operating expenses of $9.0 million for the three months ended September 30, 2002. Total operating expenses, including compensation and employee services expenses, were 42.3% of cash receipts excluding sales for the three months ended September 30, 2003 compared with 42.5% for the same period in 2002.
Compensation and Employee Services
Compensation and employee services expenses were $7.4 million for the three months ended September 30, 2003, an increase of $1.9 million or 34.5% compared to compensation and employee services expenses of $5.5 million for the three months ended September 30, 2002. Compensation and employee services expenses increased as total employees grew to 747 at September 30, 2003 from 568 at September 30, 2002. Compensation and employee services expenses as a percentage of cash receipts excluding sales decreased to 23.9% for the three months ended September 30, 2003 from 25.9% of cash receipts excluding sales for the same period in 2002.
Outside Legal and Other Fees and Services
Outside legal and other fees and services expenses were $3.9 million for the three months ended September 30, 2003, an increase of $1.7 million or 77.3% compared to outside legal and other fees and services expenses of $2.2 million for the three months ended September 30, 2002. The increase was attributable to the increased cash collections resulting from the increased number of accounts referred to independent contingent fee attorneys. This increase is consistent with the growth the Company experienced in its portfolio of defaulted consumer receivables, and a portfolio management strategy shift implemented in mid 2002. This strategy resulted in the Company referring to the legal suit process previously unsuccessfully liquidated accounts that have an identified means of repayment but that are nearing their legal statute of limitations.
Communications
Communications expenses were $703,000 for the three months ended September 30, 2003, an increase of $163,000 or 30.2% compared to communications expenses of $540,000 for the three months ended September 30, 2002. The increase was attributable to growth in mailings and higher telephone expenses incurred to collect on a greater number of defaulted consumer receivables owned and serviced. Mailings were responsible for 41.2% of this increase, while the remaining 58.8% is attributable to higher telephone expenses.
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Rent and Occupancy
Rent and occupancy expenses were $317,000 for the three months ended September 30, 2003, an increase of $108,000 or 51.7% compared to rent and occupancy expenses of $209,000 for the three months ended September 30, 2002. The increase was attributable to increased leased space due to the opening of a call center in Hampton, Virginia, a storage facility, an off-site administrative and mail handling site and contractual increases in annual rental rates. The Hampton call center accounted for $88,000 of the increase, the new storage facility accounted for $8,000 of the increase and the administrative/mail site accounted for $3,000 of the increase. The remaining increase was attributable to contractual increases in annual rental rates.
Other Operating Expenses
Other operating expenses were $393,000 for the three months ended September 30, 2003, an increase of $69,000 or 21.3% compared to other operating expenses of $324,000 for the three months ended September 30, 2002. The increase was due to increases in repairs and maintenance, hiring and insurance expenses and offset in part by decreases in taxes, fees and licenses and miscellaneous expenses. Repairs and maintenance expenses increased by $64,000, hiring expenses increased by $33,000, and insurance expenses increased by $51,000, taxes, fees and licenses decreased by $86,000, and miscellaneous expenses increased by $7,000.
Depreciation
Depreciation expenses were $383,000 for the three months ended September 30, 2003, an increase of $140,000 or 57.6% compared to depreciation expenses of $243,000 for the three months ended September 30, 2002. The increase was attributable to continued capital expenditures on equipment, software and computers related to the Company’s growth and systems upgrades. Of the increase in depreciation expenses, 62.9% is the result of the March 2003 opening of its new Hampton office and an associated $1.2 million in equipment purchases. The remaining increase of 37.1% was the result of system upgrades.
Interest Income
Interest income was $1,000 for the three months ended September 30, 2003, an increase of $1,000 compared to interest income of $0 for the three months ended September 30, 2002. This increase is the result of investing in overnight repo funds as compared to keeping cash in the Company’s depository bank and earning fee credit offsets in 2002.
Interest Expense
Interest expense was $84,000 for the three months ended September 30, 2003, a decrease of $982,000 or 92.1% compared to interest expense of $1,066,000 for the three months ended September 30, 2002. This decrease is primarily the result of the termination of the interest rate swap agreement in September 2002 and having no outstanding debt on the revolving line of credit. The interest rate swap expense for the three months ended September 30, 2002 was $617,000 and other debt related expenses for the same time period were $449,000.
Nine Months Ended September 30, 2003 Compared To Nine Months Ended September 30, 2002
Total revenue was $61.9 million for the nine months ended September 30, 2003, an increase of $21.7 million or 54.0% compared to total revenue of $40.2 million for the nine months ended September 30, 2002.
Income recognized on finance receivables was $59.6 million for the nine months ended September 30, 2003, an increase of $20.9 million or 54.0% compared to income recognized on finance receivables of $38.7 million for the
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nine months ended September 30, 2002. The majority of the increase was due to an increase in the Company’s cash collections on its owned defaulted consumer receivables to $86.2 million from $57.9 million, an increase of 48.9%. The Company’s amortization rate on owned portfolio for the nine months ended September 30, 2003 was 30.8% while for the nine months ended September 30, 2002 it was 33.1%. During the nine months ended September 30, 2003, the Company acquired defaulted consumer receivables portfolios with an aggregate face value amount of $1,853.1 million at a cost of $50.3 million. During the nine months ended September 30, 2002, the Company acquired defaulted consumer receivable portfolios with an aggregate face value of $930.1 million at a cost of $26.4 million. The Company’s relative cost basis of acquiring defaulted consumer receivable portfolios decreased from 2.84% of face value for the nine months ended September 30, 2002 to 2.71% of face value for the nine months ended September 30, 2003.
Commissions were $2.3 million for the nine months ended September 30, 2003, an increase of $930,000 or 71.5% compared to commissions of $1.3 million for the nine months ended September 30, 2002. Commissions increased as a result of a growing inventory of accounts.
Net gain on cash sales of defaulted consumer receivables were $0 for the nine months ended September 30, 2003, a decrease of $100,000 compared to net gain on cash sales of defaulted consumer receivables of $100,000 for nine months ended September 30, 2002. The Company completed one small sale transaction in June 2002.
Total operating expenses were $36.7 million for the nine months ended September 30, 2003, an increase of $11.8 million or 47.4% compared to total operating expenses of $24.9 million for the nine months ended September 30, 2002. Total operating expenses, including compensation and employee services expenses, were 41.1% of cash receipts excluding sales for the nine months ended September 30, 2003 compared with 42.1% for the same period in 2002.
Compensation and employee services expenses were $21.4 million for the nine months ended September 30, 2003, an increase of $5.7 million or 36.3% compared to compensation and employee services expenses of $15.7 million for the nine months ended September 30, 2002. Compensation and employee services expenses increased as total employees grew to 747 at September 30, 2003 from 568 at September 30, 2002. Compensation and employee services expenses as a percentage of cash receipts excluding sales decreased to 24.2% for the nine months ended September 30, 2003 from 26.5% of cash receipts excluding sales for the same period in 2002.
Outside legal and other fees and services expenses were $10.0 million for the nine months ended September 30, 2003, an increase of $4.6 million or 85.2% compared to outside legal and other fees and services expenses of $5.4 million for the nine months ended September 30, 2002. The increase was attributable to the increased cash collections resulting from the increased number of accounts referred to independent contingent fee attorneys. This increase is consistent with the growth the Company experienced in its portfolio of defaulted consumer receivables, and a portfolio management strategy shift implemented in mid 2002. This strategy resulted in the Company referring to the legal suit process previously unsuccessfully liquidated accounts that have an identified means of repayment but that are nearing their legal statute of limitations.
Communications expenses were $2.0 million for the nine months ended September 30, 2003, an increase of $500,000 or 33.3% compared to communications expenses of $1.5 million for the nine months ended September 30, 2002. The increase was attributable to growth in mailings and higher telephone expenses incurred to collect on a
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greater number of defaulted consumer receivables owned and serviced. Mailings were responsible for 46.2% of this increase, while the remaining 53.8% is attributable to higher telephone expenses.
Rent and occupancy expenses were $872,000 for the nine months ended September 30, 2003, an increase of $301,000 or 52.7% compared to rent and occupancy expenses of $571,000 for the nine months ended September 30, 2002. The increase was attributable to increased leased space due to the opening of a call center in Hampton, Virginia, a storage facility, an off-site administrative and mail handling site and contractual increases in annual rental rates. The Hampton call center accounted for $205,000 of the increase, the new storage facility accounted for $24,000 of the increase and the administrative/mail site accounted for $19,000 of the increase. The remaining increase was attributable to contractual increases in annual rental rates.
Other operating expenses were $1.3 million for the nine months ended September 30, 2003, an increase of $300,000 or 30.0% compared to other operating expenses of $1.0 million for the nine months ended September 30, 2002. The increase was due to changes in repairs and maintenance, travel and meals, hiring, insurance and miscellaneous expenses. Repairs and maintenance increased by $87,000, travel and meals increased by $35,000, hiring expenses increased by $60,000, insurance expenses increased by $149,000 and miscellaneous expenses decreased by $31,000.
Depreciation expenses were $1,054,000 for the nine months ended September 30, 2003, an increase of $378,000 or 55.9% compared to depreciation expenses of $676,000 for the six months ended June 30, 2002. The increase was attributable to growth and systems upgrades. Of the increase in depreciation expenses, 48.1% is the result of the March 2003 opening of its new Hampton office and an associated $1.2 million in equipment purchases. The remaining increase of 51.9% was the result of system upgrades.
Interest income was $29,000 for the nine months ended September 30, 2003, an increase of $27,000 or 1350.0% compared to interest income of $2,000 for the nine months ended September 30, 2002. This increase is the result of investing in short term federally tax-exempt Auction Rate Certificates in 2003, as compared to keeping cash in the Company’s depository bank and earning fee credit offsets in 2002.
Interest expense was $243,000 for the nine months ended September 30, 2003, a decrease of $1,957,000 or 89.0% compared to interest expense of $2.2 million for the nine months ended September 30, 2002. This decrease is primarily the result of the termination of the interest rate swap agreement in September 2002 and having no outstanding debt on the revolving line of credit in 2003. The interest rate swap expense for the nine months ended September 30, 2002 was $792,000 and other debt related expenses for the same time period were $1,408,000.
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Supplemental Performance Data
Owned Portfolio Performance:
The following table shows the Company’s portfolio buying activity by year, setting forth, among other things, the purchase price, actual cash collections and estimated remaining cash collections as of September 30, 2003.
($ in thousands)
When the Company acquires a portfolio of defaulted accounts, it generally does so with a forecast of future total estimated collections to purchase price paid of no more than 2.4 to 2.6 times. Only after the portfolio has established probable and estimable performance in excess of that projection will estimated remaining collections be increased. If actual cash collections are less than the original forecast, the Company moves aggressively to lower estimated remaining collections to appropriate levels.
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The following graph shows the Company’s purchase price in its owned portfolios by year beginning in 1996 and includes the year to date as of September 30, 2003 acquisition amount. This purchase price number represents the cash paid to the seller to acquire defaulted consumer receivables, plus certain capitalized expenses, less the purchase price refunded by the seller due to the return of non-compliant accounts.
The Company utilizes a long-term approach to collecting its owned pools of receivables. This approach has historically caused the Company to realize significant cash collections and revenues from purchased pools of finance receivables years after they are originally acquired. As a result, the Company has in the past been able to reduce its level of current period acquisitions without a corresponding negative current period impact on cash collections and revenue.
The following table, which excludes any proceeds from cash sales of finance receivables, demonstrates the Company’s ability to realize significant multi-year cash collection streams on its owned pools as of September 30, 2003.
Cash Collections By Year, By Year of Purchase
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When the Company acquires a new pool of finance receivables, a 60 to 72 month projection of cash collections is created. The following chart shows the Company’s historical cash collections (including cash sales of finance receivables) in relation to the aggregate of the total estimated collection projections made at the time of each respective pool purchase.
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Owned Portfolio Personnel Performance:
The Company measures the productivity of each collector each month, breaking results into groups of similarly tenured collectors. The following three tables display various productivity measures tracked by the Company.
Collector by Tenure
1 Calculated based on actual employees (collectors) with one year of service or more.
2 Calculated using total hours worked by all collectors, including those in training to produce a full time equivalent “FTE”.
Monthly Cash Collections by Tenure 1
1 Cash collection numbers include only accounts assigned to collectors. Significant cash collections do occur on “unassigned” accounts.
2 Calculated using average YTD monthly cash collections of all collectors with one year or more of tenure.
3 Calculated using weighted average YTD monthly cash collections of all collectors with less than one year of tenure, including those in training.
YTD Cash Collections per Hour Paid 1
1 Cash collections (assigned and unassigned) divided by total hours paid ( including holiday, vacation and sick time) to all collectors (including those in training).
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Cash collections have substantially exceeded revenue in each quarter since the Company’s formation. The following chart illustrates the consistent excess of the Company’s cash collections on its owned portfolios over the income recognized on finance receivables on a quarterly basis. The difference between cash collections and income recognized is referred to as Payments Applied to Principal. It is also referred to as Amortization. This amortization is the portion of cash collections that is used to recover the cost of the portfolio investment represented on the Statement of Financial Position.
Seasonality
The Company depends on the ability to collect on its owned and serviced defaulted consumer receivables. Collections tend to be higher in the first and second quarters of the year and lower in the third and fourth quarters of the year, due to consumer payment patterns in connection with seasonal employment trends, income tax refunds, and holiday spending habits. Due to the Company’s historical quarterly increases in cash collections, its growth has partially masked the impact of this seasonality.
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The following table shows the changes in finance receivables, including the amounts paid to acquire new portfolios.
The following tables categorize the Company’s owned portfolios as of September 30, 2003 into the major asset types and account types represented, respectively:
As shown in the following chart, as of September 30, 2003 a majority of the Company’s portfolios are secondary and tertiary accounts but it purchases or services accounts at any point in the delinquency cycle.
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The Company also reviews the geographic distribution of accounts within a portfolio because it has found that certain states have more debtor-friendly laws than others and, therefore, are less desirable from a collectibility perspective. In addition, economic factors and bankruptcy trends vary regionally and are factored into the Company’s maximum purchase price equation.
As the following chart illustrates, as of September 30, 2003 the Company’s overall portfolio of defaulted consumer receivables is generally balanced geographically.
Liquidity and Capital Resources
Historically, the Company’s primary sources of cash have been cash flows from operations, bank borrowings, and equity offerings. Cash has been used for acquisitions of finance receivables, repayments of bank borrowings, purchases of property and equipment, and working capital to support the Company’s growth.
The Company believes that funds generated from operations, together with existing cash and available borrowings under its credit agreement will be sufficient to finance its current operations, planned capital expenditure requirements, and internal growth at least through the next twelve months. However, the Company could require additional debt or equity financing if it were to make any other significant acquisitions requiring cash during that period.
Cash generated from operations is dependent upon the Company’s ability to collect on its defaulted consumer receivables. Many factors, including the economy and the Company’s ability to hire and retain qualified collectors and managers, are essential to its ability to generate cash flows. Fluctuations in these factors that cause a negative impact on the Company’s business could have a material impact on its expected future cash flows.
The Company’s operating activities provided cash of $22.6 million and $14.6 million for the nine months ended September 30, 2003 and 2002, respectively. In these periods, cash from operations was generated primarily from net income earned through cash collections, commissions received and gains on cash sales of defaulted consumer receivables for the period which increased from $13.1 million for the nine months ended September 30, 2002 to $15.3 million for the nine months ended September 30, 2003.
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The Company’s investing activities used cash of $26.4 million and $8.0 million during the nine months ended September 30, 2003 and 2002, respectively. Cash used in investing activities is primarily driven by acquisitions of defaulted consumer receivables, net of cash collections applied to principal on finance receivables.
The Company’s financing activities provided cash of $749,000 and used cash of $5.4 million during the nine months ended September 30, 2003 and 2002, respectively. Cash used in financing activities is primarily driven by distributions of capital and payments on long term debt and capital lease obligations. During 2003, the Company completed a financing arrangement with its main depository institution to finance equipment purchases at its new location in Hampton, VA.
Cash paid for interest expenses was $241,000 and $2.1 million for the nine months ended September 30, 2003 and 2002, respectively. The majority of interest expenses were paid for lines of credit used to finance acquisitions of defaulted consumer receivable portfolios, capital lease obligations and other long-term debt. In addition in 2002, the interest rate swap agreement was paid in full in September for $542,000.
PRA III, LLC, our wholly owned subsidiary, maintains a $25.0 million revolving line of credit with Westside Funding Corporation (“Westside”) pursuant to an agreement entered into on September 18, 2001 and amended on December 18, 2002. The Company, excluding PRA Funding, as well as Anchor and PRA Holding I, which are wholly-owned subsidiaries of the Company are guarantors to this agreement. The credit facility bears interest at a spread over LIBOR and extends through September 15, 2005. The agreement provides for:
The facility had no amounts outstanding at September 30, 2003.
In addition, PRA Funding maintains a $2.5 million revolving line of credit, pursuant to an agreement entered into with RBC Centura Bank on June 30, 2002. The credit facility, bearing interest at a spread over LIBOR, which was due to expire in July, 2003, was extended in September, 2003 and now expires on September 28, 2004. The agreement provides:
This $2.5 million facility had no amounts outstanding at September 30, 2003. In addition, on February 20, 2003, the name of PRA AG Funding, LLC was changed to PRA Funding, LLC. No changes were made with regards to the terms of the facility agreement.
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As of September 30, 2003 there are four loans outstanding. On July 20, 2000, PRA Holding I, entered into a credit facility with Bank of America, N.A., for a $550,000 loan, for the purpose of purchasing a building and land in Hutchinson, Kansas. The loan bears interest at a variable rate based on LIBOR and consists of monthly principal payments for 60 months and a final installment of unpaid principal and accrued interest payable on July 21, 2005. On February 9, 2001, the Company entered into a commercial loan agreement with Bank of America, N.A. in the amount of $107,000 in order to purchase equipment for its Norfolk, Virginia location. This loan bears interest at a fixed rate of 7.9% and matures on February 1, 2006. On February 20, 2002, PRA Holding I entered into an additional arrangement with Bank of America, N.A. for a $500,000 commercial loan in order to finance construction of a parking lot at the Company’s Norfolk, Virginia location. This loan bears interest at a fixed rate of 6.47% and matures on September 1, 2007. On May 1, 2003, the Company entered into a commercial loan agreement with RBC Centura Bank in the amount of $975,000 to finance equipment purchases for its Hampton, Virginia location. This loan bears interest at a fixed rate of 4.25% and matures on May 1, 2008.
Contractual Obligations
Obligations of the Company that exist as of September 30, 2003 are as follows:
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board issued FASB Interpretation (“FIN”) No. 46, Consolidation of Variable Interest Entities. FIN No. 46 is an interpretation of ARB No. 51 and addresses consolidation by business enterprises of variable interest entities (“VIEs”). This interpretation is based on the theory that an enterprise controlling another entity through interests other than voting interests should consolidate the controlled entity. Business enterprises are required under the provisions of this interpretation to identify VIEs, based on specified characteristics, and then determine whether they should be consolidated. An enterprise that holds a majority of the variable interests is considered the primary beneficiary, the enterprise that should consolidate the VIE. The primary beneficiary of a VIE is also required to include various disclosures in interim and annual financial statements. Additionally, an enterprise that holds a significant variable interest in a VIE, but that is not the primary beneficiary, is also required to make certain disclosures. This interpretation is effective for all enterprises with variable interest in VIEs created after January 31, 2003. A public entity with variable interests in a VIE created before February 1, 2003, is required to apply the provisions of this interpretation to that entity by the end of the first interim or annual reporting period beginning after December 15, 2003. The adoption of this interpretation is not expected to have a material impact on the Company’s financial position or the results of operations.
In October 2003, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 03-03, “Accounting for Loans or Certain Securities Acquired in a Transfer.” This SOP proposes guidance on accounting for differences between contractual and expected cash flows from an investors initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. This SOP is currently under review by the Financial Accounting Standards Board. If this SOP becomes effective, it will have an effective date for companies whose fiscal years end on or after December 15, 2004. Management is in the process of evaluating this statement’s impact on the Company.
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Critical Accounting Policy
The Company utilizes the interest method under guidance provided by Practice Bulletin 6 to determine income recognized on finance receivables. Under this method, each static pool of receivables it acquires is statistically modeled to determine its projected cash flows. A yield is then established which, when applied to the outstanding balance of the receivables, results in the recognition of income at a constant yield relative to the remaining balance in the pool. Each pool is analyzed monthly to assess the actual performance to that expected by the model. If differences are noted, the yield is adjusted prospectively to reflect the estimate of cash flows.
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Item 3. Quantitative and Qualitative Disclosure About Market Risk.
The Company’s exposure to market risk relates to interest rate risk with its variable rate credit line. The Company terminated its only derivative financial instrument to manage or reduce market risk in September 2002. As of September 30, 2003, the Company had no variable rate debt outstanding on its revolving credit lines. The Company did have variable rate debt outstanding on its long-term debt collateralized by the Kansas real estate. A 10% change in future interest rates on the variable rate credit line would not lead to a material decrease in future earnings assuming all other factors remained constant.
Item 4. Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized 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 necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective in timely alerting the Company’s management to material information relating to the Company required to be included in the Company’s Exchange Act reports.
There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Company completed its evaluation.
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PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
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SIGNATURES
Pursuant to the requirements of the Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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