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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _______ to ________
Commission File Number 000-32403
NCO PORTFOLIO MANAGEMENT, INC.
(Exact name of registrant as specified in its charter)
Delaware 23-3005839
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1804 Washington Blvd., Department 200, Baltimore, Maryland 21230
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (443) 263-3020
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.01 per share
(Title of class)
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and
will not be contained, to the best of the registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes [ ] No[X]
The aggregate market value of voting and nonvoting common equity held by
nonaffiliates was approximately $32.8 million. (1) Indicate the number of shares
outstanding of each of the registrant's classes of common stock, as of the
latest practicable date.
Outstanding at
Title of Class March 13, 2003
-------------- --------------
Common stock, par value $0.01 per share...... 13,576,519 shares
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the registrant's definitive information statement in
connection with its 2003 Annual Meeting of Stockholders to be filed with the
Securities and Exchange Commission within 120 days after December 31, 2002 are
incorporated by reference into Part III of this report. Other documents
incorporated by reference are listed in the Exhibit Index.
(1) The aggregate market value of the voting and nonvoting common equity held by
nonaffiliates equals the number of shares of the registrant's common stock
outstanding, reduced by the number of shares of common stock held by officers,
directors and stockholders owning in excess of 10 percent of the registrant's
common stock, multiplied by $7.15, the last reported sale price for the
registrant's common stock as of the last business day of the registrant's most
recently completed second fiscal quarter. The information provided shall in no
way be construed as an admission that any officer, director or 10 percent
stockholder of the registrant may be deemed an affiliate of the registrant or
that he or it is the beneficial owner of the shares reported as being held by
him or it, and any such inference is hereby disclaimed. The information provided
herein is included solely for record keeping purposes of the Securities and
Exchange Commission.
FORM 10-K
TABLE OF CONTENTS
Page
----
PART I
Item 1. Business............................................................................................. 1
Item 2. Properties........................................................................................... 9
Item 3. Legal Proceedings.................................................................................... 9
Item 4. Submission of Matters to a Vote of Security Holders.................................................. 9
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................................ 9
Item 6. Selected Financial Data.............................................................................. 10
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations................ 12
Item 7A. Quantitative and Qualitative Disclosures About Market Risk........................................... 24
Item 8. Consolidated Financial Statements and Supplementary Data............................................. 25
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure................. 45
PART III
Item 10. Directors and Executive Officers of the Registrant................................................... 45
Item 11. Executive Compensation............................................................................... 45
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters....... 45
Item 13. Certain Relationships and Related Transactions....................................................... 45
Item 14. Controls and Procedures.............................................................................. 46
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K...................................... 47
Signatures........................................................................................... 52
Certifications....................................................................................... 53
As used in this Annual Report on Form 10-K, unless the context otherwise
requires, "we", "us", "our", "Company", "NCPM", or "NCO Portfolio" refers to NCO
Portfolio Management, Inc. and its subsidiaries.
Forward-Looking Statements
Certain statements included in this Annual Report on Form 10-K ("Annual
Report"), including, without limitation, statements in Item 1. "Business", Item
7. "Management's Discussion and Analysis of Financial Condition and Results of
Operations," statements as to the Company's or management's outlook as to
financial results in 2003 and beyond, statements as to the effects of the
economy on the Company's business, statements as to the Company's or
management's beliefs, expectations or opinions, and all other statements in this
Annual Report, other than historical facts, are forward-looking statements, as
such term is defined in the Private Securities Litigation Reform Act of 1995,
which are intended to be covered by the safe harbors created thereby.
Forward-looking statements are subject to risks and uncertainties, are subject
to change at any time, and may be affected by various factors and risks that may
cause actual results to differ materially from the expected or planned results.
The Company disclaims any intent or obligation to update forward-looking
statements contained in the Annual Report. Certain risk factors, including
without limitation, risks related to the current economic condition in the
United States, threats of war or future terrorist attacks, risks relating to
growth and future accounts receivable purchases, risks related to the Company's
debt, risks related to the recoverability of purchased accounts receivable,
risks related to the use of estimates, risks related to the ability to purchase
accounts receivable at favorable prices in the open market, risks related to
competition, risks related to regulatory oversight, risks related to the
retention of the senior management team, risks related to securitization
transactions, risks related to the fluctuation in quarterly results, risks
related to the ownership control of the Company by NCO Group, Inc. ("NCO Group,"
"NCOG," " or Parent"), risks related to the dependency on NCO Group's subsidiary
for collections, and other risks described under Item 1. "Business - Investment
Considerations," can cause actual results and developments to be materially
different from those expressed or implied by such forward-looking statements.
PART I
Item 1. Business
General
We were incorporated in Delaware on January 22, 1999 (date of inception) under
the name NCO Portfolio Funding, Inc. We changed our name from NCO Portfolio
Funding, Inc. to NCO Portfolio Management, Inc. in February 2001. We purchase
and manage investments in past due accounts receivable from consumer creditors
such as banks, finance companies, retailers, hospitals, utilities, and other
consumer-oriented companies. Our purchased accounts receivable originate from
consumers throughout the United States, Canada and the United Kingdom. On
February 20, 2001, Creditrust Corporation ("Creditrust") merged with and into us
(the "Merger"). Included in the statement of income are the results of
operations of the assets acquired in the Merger of Creditrust for all periods
beginning February 21, 2001. All of our revenues are derived from our
investments in purchased accounts receivable.
NCO Group owns 63.347 percent of our outstanding common stock, based upon the
final resolution of substantially all of the disputed claims and administrative
costs related to the bankruptcy of Creditrust. As part of the Merger, we entered
into a ten-year service agreement with NCO Financial Systems, Inc. ("NCOF"), a
wholly owned subsidiary of NCO Group, to be the provider of collection services
(with certain exceptions). As part of the agreement, NCO Group has agreed to
offer all of its future U.S. accounts receivable purchase opportunities to us.
NCO Group's affiliates in the United Kingdom and Canada have invited us to
invest with them in select opportunities to purchase accounts receivable in
those countries. The relationship with NCO Group allows us to manage investment
risk by leveraging NCO Group's client relationships, experience, analytical
databases and scale. We are one of the largest companies, and one of the few
public companies, in our industry.
Past due consumer receivables are the unpaid debts of individuals to consumer
creditors such as banks, finance companies, retailers, hospitals, utilities, and
other consumer-oriented companies. Most of our receivables are VISA(R) and
MasterCard(R) credit card accounts that the issuing banks have charged off their
books due to non-payment. Since our founding in 1999 through December 31, 2002,
we have purchased almost $11 billion of past due consumer accounts receivable
for approximately $251 million, and have collected approximately $248 million
from over 4 million accounts. We have also invested in smaller balance past due
consumer receivables such as utility and medical debts through our joint venture
with IMNV Holdings, LLC ("IMNV"). Our focus is on maximizing the returns on our
purchased accounts receivable while minimizing our risk of ownership.
1
We have twenty wholly-owned subsidiaries which own all of our purchased accounts
receivable, one wholly-owned subsidiary that employs all of our employees who
handle the acquisition, resale, day-to-day oversight and management of our
accounts receivable, and one wholly-owned subsidiary that holds all of our
excess cash used for operations, investing and financing activities. Each of our
subsidiaries that owns accounts receivable was established for a specific
purpose, including the carry over of the legacy Creditrust entities, accounts
receivable acquired in the ordinary course of business, entities used to secure
collateral on notes payable, and entities that own investments in either a joint
venture or limited partnership interests.
Accounts Receivable Analysis and Acquisition
We are an analytics based purchaser of past due consumer accounts receivable
originated through VISA(R), MasterCard(R), private label credit cards, and
consumer loans issued by consumer creditors such as banks, finance companies,
retailers, hospitals, utilities, and other consumer-oriented companies. We use
our proprietary pricing models, extensive databases and collection experience to
evaluate and value purchases of past due accounts receivable. These past due
accounts receivable typically are charged off by the credit grantors due to
non-payment. We have determined that the average portfolio of accounts
receivable has an estimated economic life of 60 months.
We purchase portfolios of past due accounts receivable typically for less than
10 percent of the unpaid balance at the time of charge off by the credit
grantors. Some credit grantors pursue an auction type sales approach by
constructing a portfolio of accounts receivable and seeking bids from specially
invited competing parties. Other means of purchasing accounts receivable include
privately negotiated direct sales when the credit grantors contact known,
reputable purchasers and the terms are negotiated. Credit grantors have also
entered into "forward flow" contracts that provide for a credit grantor to sell
some or all of its accounts receivable over a period of time to us on the terms
agreed to in a contract.
In 2002, we broadened our acquisition strategy to include larger portfolios. We
believe these types of portfolios have elements of reperforming accounts, and
the competition for them is less intensive. We have also partnered with other
buyers to bid on larger portfolios of accounts receivable and have resold
purchased accounts receivable at a premium immediately after acquisition to
enhance our yields.
Our acquisition team meets with consumer credit grantors and brokers to develop
sources of past due consumer accounts receivable for purchase. Once a portfolio
has been located, the acquisition team is responsible for evaluating and
determining the appropriate price to pay for the portfolio. Then they coordinate
the due diligence, including site visits as needed, bidding, contract
negotiation and execution. The acquisitions team also coordinates the transfer
of information on purchased portfolios into NCOF's collection recovery software
system. We also have staff devoted to post-purchase account verification. The
post-purchase liaison group is a group that verifies buy-backs and returns with
sellers after the purchase of accounts receivable. Buy-backs and returns are
accounts that are returned to the seller because they did not meet the terms of
our purchase agreement with the seller, typically due to prior settlement, or
the death or bankruptcy of the customer prior to purchase.
In developing our maximum purchase price offer, we use the best available
collection statistics available to us from NCOF's collection experience on our
own portfolios or comparable portfolios and other sources. We develop a target
purchase price based on estimated collections less estimated servicing and other
costs that is expected to deliver the desired internal rate of return over five
years.
Financing Purchases
Since the Merger, we have funded our accounts receivable purchases and the
expansion of our business through internal cash flows, borrowings from NCO Group
and the Cargill Financing described below.
Effective with the Merger, NCO Group amended its credit agreement with Citizens
Bank of Pennsylvania ("Citizens Bank") to provide us with a line of credit in
the form of a subfacility under NCO Group's existing credit facility. As of
December 31, 2002, our borrowing limit under the subfacility was $40 million.
Our borrowing limit under the subfacility is subject to mandatory quarterly
reductions of $3.75 million effective March 31, 2003 until the earlier of the
maturity date, currently May 20, 2004, or the date at which the subfacility is
reduced to $25 million. The outstanding balance on the subfacility as of
December 31, 2002 was $36.9 million.
In August 2002, we entered into a four-year financing agreement with CFSC
Capital Corp. XXXIV ("Cargill Financing," "Cargill Financial") to provide
financing for larger purchases of accounts receivable. Cargill Financial, at its
sole discretion, has the right to finance any purchase of $4 million or more.
This agreement gives us the financing necessary to purchase larger portfolios
that we may not otherwise be able to purchase, and has no minimum or maximum
credit authorization. Borrowings under this financing agreement are nonrecourse
to us and NCOG, but are collateralized by the accounts receivable purchased with
the Cargill Financing and cross-collateralized with all other accounts
receivable purchases financed by Cargill Financial. See "Investment
Considerations - We have substantial debt, which could have adverse effects on
our business."
2
Collection Services and Monitoring Results
As part of the Merger, we entered into a ten-year service agreement that
appointed NCOF as the provider of our collection services. Generally, NCOF is
paid a commission ranging from 20 percent to 40 percent of the collected amount
depending on the nature of the accounts. For accounts that do not fit the
proscribed fee range in the agreement, the commission is based on market rates
that have ranged up to 52 percent. NCO Group has agreed to offer all of its
future U.S. accounts receivable purchase opportunities to us. For the years
ended December 31, 2001 and 2002, servicing fees of $27.5 million and $35.5
million, respectively, were paid to NCOF. We believe that the commission rates
paid are reasonable and are consistent with rates charged by other collection
agencies for the same type of services. Our acquisition and finance teams
monitor NCOF's collection process, performance and costs towards meeting our
targeted goals and investment returns. Under the servicing agreement, we may
elect to outsource accounts to other agencies on a test basis. In fact, NCOF has
utilized other collection agencies to augment collections and to test its
performance as servicer. The cost of further outsourcing to third party
collection agencies is generally higher. When outsourcing, the appropriate
commission is determined based on the type of accounts being serviced in
conjunction with current market rates paid to other collection agencies.
Typically, as accounts age, or are further outsourced, the higher the commission
rates are on subsequent outsourcing.
Legal Recovery
We monitor the collection of past due accounts receivable through NCOF's
Attorney Network, which specializes in the pursuit of consumers with past due
obligations who we believe have the financial resources to repay their debts but
are unwilling to do so. During 2002, we transferred our in-house attorney and
support staff to the NCOF Attorney Network. The NCOF Attorney Network processes
thousands of court and arbitration cases each year and is responsible for
coordinating a network of attorneys nationwide, determining the suit criteria
for each individual jurisdiction, placing cases for immediate suit, obtaining
judgment, seizing bank accounts, and instituting wage garnishments to satisfy
judgments. In order to sue or pursue arbitration on accounts, we incur up front
filing fees and court costs.
Competition
Our business is highly competitive. We compete with other purchasers of past due
consumer accounts receivable, including national attorney networks, consortiums
of buyers, and third-party collection agencies. Successful bids are won based on
a combination of price and relationship. Our ability to obtain new customers is
also significantly affected by the financial services companies that choose to
manage their own past due consumer accounts receivable. Some of those companies
have substantially greater personnel and financial resources. The market for
past due consumer accounts receivable has been very competitive at times over
the past several quarters as a result of new purchasers entering the market
causing upward price pressures. We have partnered with other buyers to bid on
larger portfolios of accounts receivable and have resold purchased accounts
receivable at a premium immediately after acquisition to enhance our yields.
Regulation
The accounts receivable management and collection industry is regulated at both
the Federal and state level. The Federal Fair Debt Collection Practices Act
regulates any person who regularly collects or attempts to collect, directly or
indirectly, consumer debts owed or asserted to be owed to another person. The
Fair Debt Collection Practices Act establishes specific guidelines and
procedures which debt collectors must follow in communicating with consumer
debtors, including the time, place and manner of such communications. Further,
it prohibits harassment or abuse by debt collectors, including the threat of
violence or criminal prosecution, obscene language or repeated telephone calls
made with the intent to abuse or harass. The Fair Debt Collection Practices Act
also places restrictions on communications with individuals other than consumer
debtors in connection with the collection of any consumer debt and sets forth
specific procedures to be followed when communicating with such third parties
for purposes of obtaining location information about the consumer. Additionally,
the Fair Debt Collection Practices Act contains various notice and disclosure
requirements and prohibits unfair or misleading representations by debt
collectors. We are also subject to the Fair Credit Reporting Act, which
regulates the consumer credit reporting industry and which may impose liability
on us to the extent that adverse credit information reported on a consumer to a
credit bureau is false or inaccurate. The Federal Trade Commission has the
authority to investigate consumer complaints against debt collection companies
and to recommend enforcement actions and seek monetary penalties. Other laws and
regulations that govern the relationship between a customer and a creditor are
the Federal Truth-In-Lending Act, the Fair Credit Billing Act, the Equal Credit
Opportunity Act, the Electronic Funds Transfer Act, the Graham Leach Bliley
Privacy Act, and various other Federal regulations which relate to these acts,
as well as comparable statutes in the states where account debtors reside or
where credit grantors are located.
It is our policy and a condition of our agreement with NCOF that all collection
activities by NCOF, on our behalf, comply with the provisions of the Fair Debt
Collection Practices Act and other Federal regulations, as well as comparable
state statutes. NCOF's failure to comply with such laws and regulations could
have a materially adverse effect on us. See "Investment Considerations - Our
operations are subject to extensive regulation."
3
Employees
As of the date of this report, we had 16 full-time employees. None of our
employees is represented by a labor union.
Available Information
As part of the services shared with NCO Group, we include information about the
Company at NCO Group's website which is www.ncogroup.com. Information contained
on this website is not part of this Annual Report. We make available, free of
charge, on NCO Group's website, our annual report on Form 10-K, quarterly
reports on Form 10-Q, current reports on Form 8-K, and all amendments to those
reports, filed or furnished pursuant to section 13(a) or 15(d) of the Securities
Exchange Act of 1934, as amended, as soon as reasonably practicable after such
material is electronically filed with or furnished to the Securities and
Exchange Commission ("SEC"). The SEC maintains an Internet site that contains
reports, proxy and information statements, and other information regarding
issuers that file electronically with the SEC. The SEC web site is www.sec.gov.
Investment Considerations
You should carefully consider the risks described below. If any of the risks
actually occur, our business, financial condition or results of operations could
be materially adversely affected. This Annual Report contains forward-looking
statements that involve risks and uncertainties. Our actual results could differ
materially from those anticipated in the forward-looking statements as a result
of many factors, including the risks faced by us described below and elsewhere
in this Annual Report.
Decrease in our collections due to the current economic condition may have an
adverse effect on our operating results, revenue and stock price.
Due to the current economic conditions in the United States, which has led to
the increasing rates of unemployment and personal bankruptcy filings, the
ability of consumers to pay their debts has significantly decreased. Past due
consumer loans that we purchase are generally unsecured, and we may often be
unable to collect these loans in case of the personal bankruptcy of a consumer.
Because of increased unemployment rates and bankruptcy filings, our collections
may significantly decline, which may adversely impact our results of operations,
revenue and stock price.
Threats of war or future terrorist attacks may negatively impact our results of
operations, revenue, and stock price.
Threats of war or actual conflicts involving the United States or its allies,
future terrorist attacks against the United States, as well as future events
occurring in response or in connection with these threats or attacks, may
adversely impact our ability to collect our accounts receivable. Any of these
events could cause consumer confidence and spending to decrease or result in
increased volatility in the economy. They could also result in the deepening of
the economic recession in the United States. Any of these occurrences could have
a material adverse effect on our operating results, collections and revenue, and
may result in volatility of the market price for our common stock.
We may not be able to grow our business.
We intend to expand and rapidly grow our business, which could place great
demands on our administrative, operational and financial resources. Furthermore,
we may not be able to finance our continued growth, or to manage it effectively,
which would harm our business, results of operations and financial condition,
and our ability to meet our debt service obligations. Future growth and
development will depend on numerous factors, including our ability to:
o develop and expand relationships with credit grantors;
o maintain underwriting criteria in purchasing past due consumer accounts
receivable;
o recruit, train and retain qualified employees;
o maintain quality service to customers and credit grantors;
o enhance and maintain information technology, operational and financial
systems;
4
o access sufficient sources of funding to purchase additional accounts
receivable; and
o effectively collect our past due accounts receivable
through NCOF as servicer while adhering to the Fair
Debt Practices Act and similar state regulations.
We have substantial debt, which could have adverse effects on our business.
At December 31, 2002, we had total assets of $167.8 million, total debt
(including certain nonrecourse debt and accounts payable) of approximately $92.1
million and stockholders' equity of approximately $66.6 million. This relatively
high level of debt could result in a number of adverse effects, including:
o increasing our vulnerability to a business downturn;
o limiting our ability to obtain necessary financing in the future;
o requiring us to dedicate a substantial portion or all of our cash flows
from operations to pay debt service obligations rather than for other
purposes, such as working capital or purchasing additional portfolios of
consumer accounts receivable;
o limiting our flexibility to react to changes in our business and market;
and
o making us more highly leveraged than some of our competitors, which
may place us at a competitive disadvantage.
Most of our debt is interest rate sensitive. Any significant rise in interest
rates would increase interest expense, which would decrease net income.
Approximately $53.2 million of debt on our balance sheet is nonrecourse to us.
The cash flows on assets associated with some of the debt may be restricted to
servicing the nonrecourse debt and may not be generally available to us.
Collections may not be sufficient to recover the cost of investments in
purchased accounts receivable and support operations.
We purchase past due accounts receivable generated primarily by consumer credit
transactions. These are obligations that the individual consumer has failed to
pay when due. The accounts receivable are purchased from consumer creditors such
as banks, finance companies, retail merchants, hospitals, utilities, and other
consumer-oriented companies. Substantially all of the accounts receivable
consist of account balances that the credit grantor has made numerous attempts
to collect, has subsequently deemed uncollectible, and charged off its books.
After purchase, collections on accounts receivable could be reduced by consumer
bankruptcy filings, which have been on the rise. The accounts receivable are
purchased at a significant discount, typically less than 10 percent of face
value, to the amount the customer owes and, although we estimate that the
recoveries on the accounts receivable will be in excess of the amount paid for
the accounts receivable, actual recoveries on the accounts receivable will vary
and may be less than the amount expected, or even the purchase price paid for
such accounts. The timing or amounts to be collected on those accounts
receivable cannot be assured. If cash flows from operations are less than
anticipated as a result of our inability to collect our accounts receivable, we
will not be able to purchase new accounts receivable after we have exhausted the
availability under the subfacility, and our future growth and profitability will
be materially adversely affected. There can be no assurance that our operating
performance will be sufficient to service debt on the subfacility or finance the
purchase of new accounts receivable.
We use estimates in reporting our results.
Our revenue is recognized based on estimates of future collections on portfolios
of accounts receivable purchased. Although estimates are based on analytics, the
actual amount collected on portfolios and the timing of those collections will
differ from estimates. If collections on portfolios are materially less than
estimated, we will be required to record impairment expenses that will reduce
earnings and could materially adversely affect our earnings, financial
condition, and creditworthiness.
5
We may experience a shortage of available accounts receivable for purchase at
favorable prices.
The availability of portfolios of past due consumer accounts receivable for
purchase at favorable prices depends on a number of factors outside of our
control, including the continuation of the current growth trend in consumer debt
and competitive factors affecting potential purchasers and sellers of portfolios
of accounts receivable. The growth in consumer debt may also be affected by
changes in credit grantors' underwriting criteria and regulations governing
consumer lending. Any slowing of the consumer debt growth trend could result in
less credit being extended by credit grantors. Consequently, fewer delinquent
accounts receivable could be available at prices that we find attractive. If
competitors raise the prices they are willing to pay for portfolios of accounts
receivable above those we wish to pay, we may be unable to buy the type and
quality of past due accounts receivable at prices consistent with our historic
return targets. In addition, we may overpay for portfolios of delinquent
accounts receivable, which may have a materially adverse effect on our financial
results.
We may be unable to compete with other purchasers of past due accounts
receivable, which may have an adverse effect on our financial results.
We face bidding competition in our acquisitions of portfolios of past due
consumer accounts receivable. Some of our existing competitors and potential new
competitors may have greater financial and other resources that allow them to
offer higher prices for the accounts receivable portfolios. New purchasers of
such portfolios entering the market also cause upward price pressures. We may
not have the resources or ability to compete successfully with our existing and
potential new competitors. To remain competitive, we may have to increase our
bidding prices, which may have an adverse impact on our financial results.
Our operations are subject to extensive regulation.
Federal and state consumer protection and related laws and regulations govern
the relationship of a customer and a creditor. Significant laws include the Fair
Debt Collection Practices Act, the Federal Truth-In-Lending Act, the Fair Credit
Billing Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act and
the Electronic Funds Transfer Act, and various Federal regulations which relate
to these acts, as well as comparable statutes in the states where account
debtors reside or where credit grantors are located. Some of these laws may
apply to our activities. If credit grantors who sell accounts receivable to us
fail to comply with these laws, our ability to collect on those accounts
receivable could be limited regardless of any act or omission on our part. Our
failure to comply with these laws may also limit our ability to collect on the
accounts receivable and may subject us to fines and disciplinary actions. It is
a condition of our agreement with NCOF that all collection activities by NCOF,
on our behalf, comply with the provisions of the Fair Debt Collection Practices
Act and other Federal regulations, as well as comparable state statutes. NCOF's
failure to comply with such laws and regulations could have a materially adverse
effect on us.
Our success depends on our senior management team and if we are not able to
retain our management, it would have a materially adverse effect on us.
We are highly dependent upon the continued services and experience of our senior
management team, including Michael J. Barrist, Chairman of the Board, President
and Chief Executive Officer, and Michael B. Meringolo, Senior Vice President,
Acquisitions and Portfolio Management. We depend on the services of Messrs.
Barrist and Meringolo and the other members of our senior management team to,
among other things, successfully implement our business plan, manage existing
accounts receivable portfolios and find, negotiate and purchase new consumer
accounts receivable portfolios. The loss of service of one or more members of
the senior management team could have a material adverse effect on us.
We engage in securitization transactions that could expose us to risk.
Prior to the Merger, Creditrust completed four securitization transactions, two
of which resulted in a gain on sale. We intend only to pursue securitization
transactions that will not qualify as a sale for accounting purposes. Our
quarterly and annual financial statements could be materially affected by future
write-downs associated with changes in the fair value of the residual investment
in the one remaining previous securitization that resulted in a gain on sale,
Creditrust SPV98-2, LLC ("SPV 98-2"). If NCOF were to lose the right to service
the accounts receivable included in the securitizations, then such loss could
have a material adverse effect on us. A change in servicer could result in lower
collections due to re-establishing contact with customers or for other reasons.
6
The market price for our common stock may be adversely affected by fluctuations
in our quarterly and annual operating results.
Because of the nature of our business, our quarterly and annual operating
results may fluctuate in the future, which may adversely effect the market price
of our common stock. The reasons our results may fluctuate include:
o the timing and amount of collections on our accounts receivable;
o timing, quality and prices paid for new purchases of accounts receivable;
o a decline in value of our residual investment in securitization;
o increases in operating expenses associated with the growth of our
operations;
o announcements of fluctuations in our, or our competitors' operating
results; and
o general market conditions.
In addition, the stock market in recent years has experienced significant price
and volume fluctuations that often have been unrelated or disproportionate to
the operating performance of companies. These broad fluctuations may adversely
effect the market price of our common stock.
NCOG owns 63.347 percent of our common stock and controls our affairs.
NCOG owns 63.347 percent of our outstanding voting securities. Accordingly, NCOG
can elect all of the directors and approve or control most other matters
presented for approval by our stockholders. Under Delaware law and our
certificate of incorporation, owners of a majority of our outstanding common
stock are able to elect all of our directors and approve significant corporate
transactions without the approval of the other stockholders. As a result, NCOG
will have the unilateral ability to elect all of our directors and to control
the vote on all matters submitted to a vote of the holders of our common stock,
including any privatization transaction, merger, consolidation or sale of all or
substantially all of our assets. There can be no assurance that the interests of
NCOG will not conflict with the interests of other stockholders.
Because of NCOG's control of us, potential conflicts could arise between NCOG
and us.
Mr. Barrist, who is the Chairman of the Board, President and Chief Executive
Officer of NCOG, holds the same positions with us. In addition, Mr. Joshua
Gindin, the Executive Vice President, General Counsel and Secretary of NCOG,
also holds the same positions with us. These persons may have conflicts of
interest with respect to matters concerning us and our relationship with NCOG,
and do not devote their full time and attention to our business.
We invested jointly with NCOG, through its United Kingdom subsidiary, in a $3.0
million portfolio in the United Kingdom in December 2002. We plan to invest
jointly with them in additional United Kingdom and Canadian portfolios as
opportunities arise. NCOG's foreign affiliates source and service such
transactions. We have not adopted any formal procedures regarding potential
conflicts of interest with NCOG, although any material transaction is subject to
review and approval by the independent directors on our Audit Committee.
We are dependent upon NCOF for the collection of our accounts receivable.
We have entered into a servicing agreement with NCOF pursuant to which we have
granted to NCOF the exclusive right to service all of our accounts receivable,
subject to limited testing rights, for a period of 10 years. We are materially
dependent upon NCOF's efforts under the servicing agreement to collect our
accounts receivable and able to terminate that agreement only due to NCOF's
default under the agreement. Any poor performance under, or breach of, adverse
change in or termination of, the servicing agreement by NCOF could have a
material adverse effect on our business, assets, financial condition, results of
operations and liquidity.
7
We are highly dependent on NCOF's ability to timely respond to technological
changes in telecommunications and computer systems.
Collections of past due consumer accounts receivable depend on sophisticated
telecommunications and computer systems. NCOF's ability to use such systems is
essential to our competitive position and results of operations. NCOF may not
have the adequate resources necessary to timely adopt technological changes to
the telecommunications and computer systems used by it. Such failure to respond
to technological changes may adversely impact our results of operations.
We are highly dependent on NCOF's telecommunications and computer systems.
As noted above, our business is highly dependent on NCOF's sophisticated
telecommunications and computer systems. NCOF's systems could be interrupted by
natural disasters, power losses, or similar events. NCOF's business also is
materially dependent on services provided by various local and long distance
telephone companies. If NCOF's equipment or systems cease to work or become
unavailable, or if there is any significant interruption in telephone services,
NCOF may be prevented from providing collection services to us. Such
interruption of collection services may adversely impact our results of
operations.
Executive Officers of the Registrant
Name Age Position
---- --- --------
Michael J. Barrist........................ 42 Chairman of the Board, Chief Executive Officer, and
President
Joshua Gindin............................. 46 Executive Vice President, General Counsel and Secretary
Michael B. Meringolo...................... 55 Senior Vice President, Acquisitions and Portfolio Management
Richard J. Palmer......................... 51 Senior Vice President, Chief Financial Officer and Treasurer
Michael J. Barrist, Chairman of the Board, Chief Executive Officer, and
President. Mr. Barrist has also served as our Chairman of the Board, President
and Chief Executive Officer since February 2001. Mr. Barrist has served as
Chairman of the Board, President and Chief Executive Officer of NCO Group since
purchasing that company in 1986. Mr. Barrist was employed by U.S. Healthcare
Inc. from 1984 to 1986, most recently as Vice President of Operations, and was
employed by Gross & Company, a certified public accounting firm, from 1980
through 1984. Mr. Barrist is a Certified Public Accountant.
Joshua Gindin, Executive Vice President, General Counsel and Secretary. Mr.
Gindin has served as Executive Vice President, General Counsel and Secretary
since February 2001. Mr. Gindin has served as Executive Vice President and
General Counsel of NCO Group since May 1998. Prior to joining NCO Group, Mr.
Gindin was a partner in the law firm of Kessler & Gindin since 1995. Mr. Gindin
has practiced law since 1983 and has represented NCOF since 1986 and NCOG since
1996.
Michael B. Meringolo, Senior Vice President, Acquisitions and Portfolio
Management. Mr. Meringolo has served in this capacity since February 2001. Prior
to the Merger, Mr. Meringolo was employed by NCOF in a similar role since
September 1997. Previously he was responsible for consumer recoveries and
outside agency management at several institutions including Chemical Bank,
American Express and First Union National Bank.
Richard J. Palmer, Senior Vice President, Chief Financial Officer and Treasurer.
Mr. Palmer has served as Senior Vice President, Chief Financial Officer and
Treasurer since February 2001. Mr. Palmer was Chief Financial Officer of
Creditrust from 1996 to 2001. From 1983 to 1996, Mr. Palmer served as Chief
Financial Officer of, and in various other financial functions for, CRI, Inc., a
national real estate investment company with headquarters in Rockville,
Maryland. Prior to CRI, Inc., Mr. Palmer was with Grant Thornton LLP from 1976
until 1983 and KPMG Peat Marwick from 1973 to 1976.
8
Item 2. Properties
Our headquarters facility is located at 1804 Washington Blvd., Department 200,
Baltimore, Maryland 21230. We share our headquarters facility space with NCOF,
which is composed of approximately 2,000 square feet in one of NCOF's collection
facilities. NCOF's lease on this facility has a term of 12 years expiring
January 2015. Office space is included as part of shared services with NCO
Group, which are paid directly to NCO Group.
Item 3. Legal Proceedings
We are involved in legal proceedings from time to time in the ordinary course of
business. We believe that none of these legal proceedings will have a materially
adverse effect on our financial condition or results of operations.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Price Range of Common Stock
Our common stock was listed on the Nasdaq National Market on April 4, 2001 under
the symbol "NCPM". From February 23, 2001 through April 3, 2001, our common
stock was quoted on the "Pink Sheets". The following table sets forth the high
and low prices for the common stock as reported by the "Pink Sheets" for the
period from March 8, 2001 (the date on which information regarding such prices
became publicly available) through April 3, 2001, and the high and low prices
for the common stock, as reported by Nasdaq for the period from April 4, 2001 to
December 31, 2001, and for the fiscal year ended December 31, 2002:
High Low
2001 ---- ---
- ----
First Quarter (from March 8, 2001).................. $12.25 $6.00
Second Quarter...................................... 7.90 5.25
Third Quarter....................................... 8.00 5.00
Fourth Quarter...................................... 7.40 5.12
2002
- ----
First Quarter....................................... $ 7.13 $6.21
Second Quarter...................................... 7.36 6.21
Third Quarter....................................... 7.17 4.85
Fourth Quarter...................................... 6.29 4.26
As of March 10, 2003, 57 holders of record held our common stock.
Dividend Policy
We have never declared or paid cash dividends on our common stock, and do not
anticipate paying cash dividends on our common stock in the foreseeable future.
In addition, our line of credit facility restricts the payments of cash
dividends without the lender's prior consent. We currently intend to retain
future earnings to finance our operations and fund the growth of our business.
Any payment of future dividends will be at the discretion of our board of
directors and will depend upon, among other things, our earnings, financial
condition, capital requirements, level of indebtedness, contractual restrictions
with respect to the payment of dividends and other factors that our board of
directors deems relevant.
Equity Compensation Plan Information
See Part III, Item 12 of this Annual Report for disclosure regarding our equity
compensation plan.
9
Item 6. Selected Financial Data
The following table sets forth selected balance sheet information as of December
31, 1999, 2000, 2001 and 2002, and statement of income and cash flow data for
the period January 22, 1999 (date of inception) to December 31, 1999, and each
of the years in the three-year period ended December 31, 2002. The selected
financial data for the period January 22, 1999 (date of inception) to December
31, 1999 and the years ended December 31, 2000, 2001 and 2002 have been derived
from our audited financial statements. The consolidated balance sheets as of
December 31, 2001 and 2002 and the consolidated statements of income,
stockholders' equity and cash flows for the years ended December 31, 2000, 2001
and 2002 are included elsewhere in this Annual Report. The selected financial
data presented below should be read in conjunction with the consolidated
financial statements and the related notes, and Item 7. "Management's Discussion
and Analysis of Financial Condition and Results of Operations" included in this
Annual Report.
For the period
January 22, 1999
(date of inception) to As of and for the years ended December 31,
(Amounts in thousands, except per share data) December 31, 1999 2000 2001 (4) 2002
----------------- ---- -------- ----
Statement of income data:
Revenue........................................................... $ 1,959 $ 13,151 $ 62,929 $ 63,379
Operating costs and expenses:
Payroll and related expenses................................... 180 327 1,624 1,532
Servicing fee expenses......................................... 981 5,741 27,771 35,534
Selling, general, and administrative expenses.................. 57 112 2,017 2,794
Amortization expense........................................... -- -- 250 320
Impairment of purchased accounts receivable.................... -- -- 2,649 1,935
------- ------- -------- --------
Total operating costs and expenses................................ 1,218 6,180 34,311 42,115
------- ------- -------- --------
Income from operations............................................ 741 6,971 28,618 21,264
Other income (expense):
Interest and other income...................................... -- -- 531 1,024
Interest expense............................................... (253) (1,334) (8,230) (8,224)
------- ------- -------- --------
Total other expense........................................ (253) (1,334) (7,699) (7,200)
------- ------- -------- --------
Income before income tax expense.................................. 488 5,637 20,919 14,064
Income tax expense................................................ 183 2,114 7,845 5,269
------- ------- -------- --------
Income from operations before minority interest................... 305 3,523 13,074 8,795
Minority interest................................................. -- -- -- (15)
------- ------- -------- --------
Net income........................................................ $ 305 $ 3,523 $ 13,074 $ 8,780
======= ======= ======== ========
Basic net income per common share................................. $0.04 $0.41 $ 1.02 $ 0.65
Diluted net income per common share............................... $0.04 $0.41 $ 1.02 $ 0.65
Weighted average number of basic shares outstanding............... 8,599 8,599 12,871 13,576
Weighted average number of diluted shares outstanding............. 8,599 8,599 12,871 13,577
Other data:
Revenue as a percentage of collections (1)........................ 48.2% 74.2% 60.5% 52.0%
Collections on managed accounts receivable (2).................... $ 4,064 $ 17,716 $ 104,080 $ 121,806
Collections applied to principal of managed accounts
receivable (3)................................................. 2,105 4,565 41,151 58,427
Cash flows provided by (used in):
Operating activities............................................ 928 7,840 23,032 16,496
Investing activities............................................ (4,694) (27,452) (25,067) (14,029)
Financing activities............................................ 3,766 19,612 8,544 (2,588)
Impaired purchased accounts receivable as a percentage of total
purchased accounts receivable................................... 0% 0% 4.2% 3.9%
Balance sheet data:
Cash and cash equivalents......................................... -- -- 6,509 6,388
Purchased accounts receivable..................................... 4,694 31,480 136,339 148,968
Total debt........................................................ 3,765 23,377 92,509 92,144
Stockholders' equity.............................................. 306 3,829 57,864 66,637
10
(1) Revenue as a percentage of collections is presented because we rely on
this indicator in the management of our business as a key measure of our
overall return on investment on purchased accounts receivable.
(2) Managed accounts receivable includes purchased accounts receivable that
we own and accounts receivable that we invest in but do not own,
including purchased accounts receivable in our investment in
securitization, SPV 98-2, but excluding purchased accounts receivable of
our joint venture with IMNV.
(3) Collections applied to principal of managed accounts receivable is
calculated by subtracting revenue recognized from collections on managed
accounts receivable. Collections applied to principal of owned purchased
accounts receivable amounted to $4,565, $34,159, and $53,819 for the
years ended December 31, 2000, 2001 and 2002, respectively.
(4) The information presented as of and for the year ended December 31, 2001
includes the results of the Merger from February 21, 2001 to December
31, 2001, and is not comparable to 2000 and 2002.
11
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview
We are an analytics-based purchaser and manager of past due consumer accounts
receivable. Past due accounts receivable are the unpaid debts of individuals to
consumer creditors such as banks, finance companies, retail merchants,
hospitals, utilities, and other consumer-oriented companies. We use our
proprietary pricing models and extensive analytical databases to evaluate and
value accounts receivable purchases. Most of our accounts receivable are VISA(R)
and MasterCard(R) credit card accounts that the issuing banks have charged off
their books for non-payment. By selling past due accounts receivable to us,
credit grantors recover some of their charged off accounts.
On February 20, 2001, Creditrust merged with and into us, at which time we
became a publicly traded company. The Merger was accounted for using the
purchase method of accounting. As a result of the Merger, we issued 4,977,482
shares of common stock resulting in a total of 13,576,519 shares of our common
stock outstanding, including 291,732 shares held in escrow. In 2002, the 291,732
shares held in escrow were distributed to eligible stockholders upon the final
resolution of certain disputed and administrative claims. The purchase price was
valued at approximately $25 million. Additional acquisition related costs
incurred in connection with the Merger were $4.2 million. We allocated the
purchase price based on the fair value of the net assets acquired, principally
to purchased accounts receivable, deferred tax asset and certain assumed
liabilities. The net deferred tax asset of $14.4 million was the result of the
combination of a significant net operating loss carryforward acquired in the
Merger, offset by deferred tax liabilities arising from book tax differences in
the carrying value of the acquired accounts receivable. The purchase price
allocation and determination of certain income tax valuations estimated at the
Merger date have been finalized and are reflected in the financial statements as
of December 31, 2001 and 2002.
From our inception in 1999, we have invested $251.4 million ($6.8 million in
1999, $31.4 million in 2000, $141.7 million in 2001 including $93.5 million from
the Merger, and $71.5 million in 2002) in past due consumer accounts receivable.
At December 31, 2002, we managed over 4 million accounts with an original
charged off amount of almost $11 billion measured as the amount charged off by
the credit grantors that originated the charged off VISA(R), MasterCard(R),
private label credit cards and consumer loan accounts at the date of charge off.
The following table illustrates our revenue and collection experience for the
periods indicated (Amounts in thousands):
For the years ended December 31,
2000 2001 (4) 2002
---- -------- ----
Revenue............................................................. $ 13,151 $ 62,929 $ 63,379
Revenue as a percentage of collections (1).......................... 74.2% 60.5% 52.0%
Collections on managed accounts receivable (2)...................... $ 17,716 $ 104,080 $ 121,806
Collections applied to principal on managed accounts receivable (3). $ 4,565 $ 41,151 $ 58,427
(1) Revenue as a percentage of collections is presented because we
rely on this indicator in the management of our business as a
key measure of our overall return on investment on purchased
accounts receivable.
(2) Managed accounts receivable include purchased accounts
receivable that we own and accounts receivable that we invest in
but do not own, including purchased accounts receivable in our
investment in securitization, SPV 98-2, but excluding purchased
accounts receivable of our joint venture with IMNV.
(3) Collections applied to principal of managed accounts receivable
is calculated by subtracting revenue recognized from collections
on managed accounts receivable. Collections applied to principal
of owned purchased accounts receivable amounted to $4,565,
$34,159, and $53,819 for the years ended December 31, 2000, 2001
and 2002, respectively.
(4) The information presented for the year ended December 31, 2001
includes the results of the Merger from February 21, 2001 to
December 31, 2001, and is not comparable to 2000 and 2002.
12
Critical Accounting Policies
General
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and the accompanying notes. Actual results will differ
from those estimates. We believe the following accounting policies include the
estimates that are the most critical and could have the most potential impact on
our results of operations. For further discussion of other significant
accounting policies, see Notes to Consolidated Financial Statements of the
Company - Note B.
Purchased Accounts Receivable
We account for our investment in purchased accounts receivable on an accrual
basis under the guidance of the American Institute of Certified Public
Accountants' Practice Bulletin 6, "Amortization of Discounts on Certain Acquired
Loans," using unique and exclusive portfolios. Portfolios are established with
accounts having similar attributes. Typically, each portfolio consists of an
individual acquisition of accounts that are initially recorded at cost. Once a
portfolio is established, the accounts in the portfolio are not changed.
Proceeds from the sale of accounts and return of accounts within a portfolio are
accounted for as collections in that portfolio. The discount between the cost of
each portfolio and the face value of the portfolio is not recorded since we
expect to collect a relatively small percentage of each portfolio's face value.
Collections on the portfolios are allocated to revenue and principal reduction
based on the estimated internal rate of return ("IRR") for each portfolio. The
IRR for each portfolio is derived based on the expected monthly collections over
the estimated economic life of each portfolio (generally five years, based on
our collection experience), compared to the original purchase price. Revenue on
purchased accounts receivable is recorded monthly based on applying each
portfolio's effective IRR to each portfolio's monthly opening carrying value
(effective interest method). To the extent collections exceed the revenue, the
carrying value is reduced and the reduction is recorded as collections are
applied to principal. Because the IRR reflects estimated collections for the
entire economic life of the portfolio, and those collections are not constant,
lower collection rates, typically in the early months of ownership, can result
in a situation where the actual collections are less than the revenue accrual.
In this situation, the carrying value of the portfolio may be increased by the
difference between the revenue accrual and collections.
To the extent actual collections differ from the estimate of collections, we
prospectively adjust the IRR. If the carrying value of a particular portfolio
exceeds its expected future collections, a charge to income would be recognized
in the amount of such impairment. Additional impairments on previously impaired
portfolios may occur if the current estimates of future collections are less
than the current carrying value recorded. After the impairment of a portfolio,
all collections are recorded as a return of capital and no income is recorded on
that portfolio until the full carrying value of the portfolio has been
recovered. For the years ended December 31, 2001 and 2002, impairments of $2.6
million and $1.9 million, respectively, were recorded as a charge to income on
portfolios where the carrying amounts exceeded the expected future cash flows.
No income will be recognized on these portfolios until the carrying values have
been fully recovered. The combined carrying values on these impaired portfolios
aggregated approximately $5.7 million, or 4.2 percent, and $5.8 million, or 3.9
percent, of purchased accounts receivable, as of December 31, 2001 and 2002,
respectively, representing their net realizable value. There were no impairments
recorded in 2000.
Use of Estimates
In the ordinary course of accounting for purchased accounts receivable,
estimates have been made by management as to the amount of future cash flows
expected from each portfolio. The estimated future cash flow of each portfolio
is used to compute the IRR for the portfolio. The IRR is used to allocate
collections between revenue and amortization of the carrying values of the
purchased accounts receivable.
On an ongoing basis, we compare the historical trends of each portfolio to
projected collections. Projected collections are then increased, within preset
limits, or decreased based on the actual cumulative performance of each
portfolio. We review each portfolio's adjusted projected collections to
determine if further downward adjustment is warranted. Management regularly
reviews the trends in collection patterns and uses its best efforts to improve
under-performing portfolios. However, actual results will differ from these
estimates and a material change in these estimates could occur within one year.
For the year ended December 31, 2001, differences between actual and estimated
collections on existing portfolios as of the beginning of 2001 resulted in a
reduction in revenue, net of estimated servicing costs and impairment expense,
of $2.5 million. For the year ended December 31, 2002, differences between
actual and estimated collections on existing portfolios as of the beginning of
2002 resulted in a reduction in revenue, net of estimated servicing costs and
impairment expense, of $7.5 million.
13
Cargill Financing:
Our Cargill Financing carries both a conventional coupon rate of interest and a
residual share of collections, net of servicing fees, for the life of each
portfolio financed. We account for this deferred interest expense throughout the
life of the receivables financed by accruing interest equal to Cargill
Financial's share of book net income on each portfolio financed.
Investments in debt and equity securities
We acquired an investment in securitization in connection with the Merger. The
investment in securitization, SPV 98-2, qualified as a sale under generally
accepted accounting principles in 1998 when the securitization was completed.
The investment in securitization is accounted for under the provisions of
Statement of Financial Accounting Standards No. 115, " Accounting for Certain
Investments in Debt and Equity Securities," as a debt security held
available-for-sale. This investment accrues income as a noncash item included in
the statement of income as other income, and in the balance sheet as a component
of the fair value of the investment in securitization. Once the securitization
note is retired, recoveries will be applied to reduce the carrying value of the
investment in securitization. We record our investment in securitization at fair
value and any unrealized gain or loss, net of the related tax effect, generally
is not reflected in earnings but is recorded as a separate component of
stockholders' equity until realized. As of December 31, 2002, the carrying value
approximated fair value. A decline in the value of the investment in
securitization below cost that is deemed other than temporary would be charged
to income as an impairment and result in the establishment of a new cost basis
for the security. No impairments were recorded in 2001 and 2002.
Income Taxes
Income taxes or tax benefits have been provided in the results of operations
based on the statutory Federal and state rates at 37.5 percent of pre-tax
income. For financial reporting purposes, revenue is recognized over the life of
the portfolio. Because the portfolios of purchased accounts receivable are
comprised of distressed debt and collection results are not guaranteed until
received, for tax purposes, any gain on a particular portfolio is deferred until
the full cost of the portfolio is recovered (cost recovery method). Temporary
differences arise due to the differences in revenue recognition methods.
Permanent differences between the statutory tax rates and actual rates are
minimal. Temporary differences arising from the recognition of revenue on
purchased accounts receivable have resulted in deferred tax liabilities. Assumed
utilization of net operating losses acquired in the Merger have resulted in
deferred tax assets. Our deferred tax liabilities grew significantly through
2002 as a result of the increase in purchased accounts receivable, providing us
with additional liquidity. As of December 31, 2002, the net deferred tax
liability of $4.3 million was the result of the combination of deferred tax
assets generated principally by the assumed utilization of net operating loss
carryforwards from the Merger, offset by the deferred tax liabilities arising
from book tax differences on purchased accounts receivable, including the
purchased accounts receivable acquired in the Merger. The utilization of net
operating loss carryforwards is an estimate based on a number of factors beyond
our control, including the level of taxable income available from successful
operations in the future. The utilization of net operating losses acquired in
the Merger has been further impacted by Federal tax law provisions that limit
the amount of net operating loss carryforwards that can be utilized subsequent
to a change in control.
14
Results of Operations
The following table sets forth certain data from the statement of income on an
historical basis, each as a percentage of revenue:
For the years ended December 31,
2000 2001 (1) 2002
---- -------- ----
Revenue................................................... 100.0% 100.0% 100.0%
Operating costs and expenses:
Payroll and related expenses.......................... 2.5 2.6 2.4
Servicing fee expenses................................ 43.7 44.1 56.0
Selling, general, and administrative expenses......... 0.8 3.2 4.4
Amortization expense.................................. -- 0.4 0.5
Impairment of purchased accounts receivable........... -- 4.2 3.1
----- ------ ------
Total operating costs and expenses........................ 47.0 54.5 66.4
----- ------ ------
Income from operations.................................... 53.0 45.5 33.6
Other income (expense):
Interest and other income............................. -- 0.8 1.6
Interest expense...................................... (10.1) (13.1) (13.0)
----- ------ ------
Total other expense....................................... (10.1) (12.3) (11.4)
----- ------ ------
Income before income tax expense.......................... 42.9 33.2 22.2
Income tax expense........................................ 16.1 12.5 8.3
----- ------ ------
Income from operations before minority interest........... 26.8 20.7 13.9
Minority interest......................................... -- -- --
----- ------ ------
Net income................................................ 26.8% 20.7% 13.9%
===== ====== ======
(1) The information presented for the year ended December 31, 2001 includes
the results of the Merger from February 21, 2001 to December 31, 2001,
and is not comparable to 2000 and 2002.
15
Year Ended December 31, 2002 Compared to Year Ended December 31, 2001
For comparison purposes, the year ended December 31, 2001 includes the results
of operations for Creditrust from February 21, 2001 through December 31, 2001.
Revenue. Total revenue increased by $450,000, or 0.7 percent, from $62.9 million
for the year ended December 31, 2001 to $63.4 million for the year ended
December 31, 2002. Collections on managed purchased accounts receivable
increased $17.7 million, or 17.0 percent, from $104.1 million for the year ended
December 31, 2001 to $121.8 million for the year ended December 31, 2002 as the
total amount of purchased accounts receivable under management grew from $136.3
million in 2001 to $149.0 million in 2002. Total purchases were $48.2 million in
2001 versus $71.5 million in 2002. Included in collections for the year ended
December 31, 2002, was $3.7 million in proceeds from the sales of accounts, of
which $1.7 million was received as a payment on the sale of certain
nonperforming accounts to a leading credit card issuer. Additionally, during
2002, we concluded a contract renegotiation with the seller of several existing
portfolios resulting in a $4 million cash price reduction on purchases from 2000
and 2001. The $4 million proceeds were recorded as an adjustment to purchase
price of the affected portfolios. On several previously impaired portfolios, the
cash price reduction reduced the carrying value of such portfolios, resulting in
the cost of certain of the portfolios becoming fully recovered. Included in
revenue for the year ended December 31, 2002, was $803,000 that resulted from
the contract price reduction of these fully recovered portfolios.
Actual collection results have differed from estimated projections. For the year
ended December 31, 2002, differences between actual and estimated collections on
existing portfolios as of the beginning of 2002 resulted in a reduction in
revenue, net of estimated servicing costs and impairment expense, of $7.5
million.
Revenue as a percentage of collections was 60 percent and 52 percent for the
years ended December 31, 2001 and 2002, respectively. Revenue as a percentage of
collections can fluctuate period over period due to a number of factors
including:
(i) the relative under- or over-achievement of actual
collections versus the established estimates. Actual collections exceeding
estimates will tend to lower the percentage because revenue is not impacted at
the same rate as the change in collections due to the effective interest method
of computing revenue, and conversely, not meeting collection estimates will tend
to increase the percentage;
(ii) the differences in the composition of portfolios at a
point in time in their life cycle. Over the life cycle of a portfolio, the
percentage will fluctuate due to the variable collection stream. However, in the
aggregate, the percentage of collections recognized as revenue should
approximate the lifetime profit, before servicing costs, recognized and the
remainder is amortized as a return of capital;
(iii) the composition of the targeted IRRs present in all of
the portfolios combined. Fresher purchased accounts receivable (portfolios with
few or no placements to collection agencies prior to purchase) generally have
lower IRRs than purchased accounts receivable that have been placed with
multiple collection agencies prior to purchase. Fresher accounts receivable
typically cost more. However, net of servicing fees, lower IRRs are offset by
lower costs to collect, resulting in similar targeted net returns;
(iv) collection trends will increase or decrease our expected
IRR. Increases or decreases in collections have the effect of raising (within
specified parameters) or lowering the future collection projections on all
portfolios, which translates into higher or lower IRRs, and in turn, affects the
percentage of collections recognized as revenue, and finally;
(v) portfolios that become impaired are placed on cost
recovery, and no revenue will be recorded until their carrying value has been
fully recovered. After the carrying value has been fully recovered, all
collections are recorded as revenue.
Revenue as a percentage of collections declined in 2002 versus 2001 due to a
number of these factors. First, the total composition of purchased accounts
receivable has changed somewhat from 2001. Purchased accounts receivable
acquired in, and subsequent to, the Merger were acquired at a lower IRR compared
to accounts receivable purchased in prior years. Purchases of accounts
receivable made in the latter half of 2001 and continuing through 2002 have
returns that were targeted lower at the time of acquisition due to reduced
collection estimates due to the tougher economic climate facing us in the near
term, and due to larger purchases with components of reperforming accounts
(past due accounts that are now performing). Second, the overall percentage was
lowered due to a slow down in collections on existing portfolios as a result of
the continued softening economic climate in 2002. Shortfalls in current period
collection estimates had the effect of lowering the future projections on most
older portfolios, which translated to lower IRRs and revenue compared to
collections in the current period. Third, proceeds from sales of accounts
totaling $3.7 million are included in collections and had a marginal impact on
revenue as the rate at which revenue is recognized period-to-period is not
affected at the same rate as changes in collections due to the effective
interest method of computing revenue. Finally, portfolios with $5.8 million in
carrying value, or 3.9 percent of total purchased accounts receivable, as of
December 31, 2002 have been impaired and placed on cost recovery status.
Accordingly, no revenue was recorded on these portfolios after their impairment.
All of these factors equate to a lower ratio of revenue to collections.
16
Payroll and related expenses. Payroll and related expenses decreased $100,000,
or 6.3 percent, from $1.6 million for the year ended December 31, 2001 to $1.5
million for the year ended December 31, 2002. Payroll and related expenses
remain a small part of the business model as a percentage of revenue because our
collection activities and many administrative functions are outsourced to NCOF.
The decrease in payroll and related expenses was principally due to the legal
recovery and agency outsourcing groups being transferred to the NCOF attorney
network during 2002, as well as a decrease in overall incentive compensation in
2002 compared to 2001.
Servicing fee expenses. Servicing fee expenses increased $7.7 million, or 27.7
percent, from $27.8 million for the year ended December 31, 2001 to $35.5
million for the year ended December 31, 2002. Servicing fees are paid as a
commission on collections and include contingency legal fees. Servicing fee
expenses are impacted by the volume of collections on purchased accounts
receivable and the type of accounts receivable acquired, which effects the
servicing fee rates charged by NCOF. Servicing fees paid as a percentage of
collections were 26.7 percent and 29.1 percent for the years ended December 31,
2001 and 2002, respectively. Substantially all servicing fees were paid to NCOF
for the years ended December 31, 2001 and 2002. Included in servicing fees for
the year ended December 31, 2002 was $170,000 in servicing fees paid on $1.7
million in sale proceeds received from the sale of nonperforming accounts to a
leading credit card issuer. The increase in servicing fees as a percentage of
collections from 2001 to 2002 was principally attributable to the change in the
composition of accounts receivable under management. In general, the accounts
receivable acquired in the Merger have lower servicing fees as compared to
accounts receivable purchased since the Merger because collections were more
predictable as a result of Creditrust's experience with these portfolios and had
a component of re-performing accounts. We expect that servicing fees as a
percentage of collections will increase in the future as collections from
accounts receivable acquired in the Merger decline in proportion to total
collections. Further, NCOF has and may continue to outsource collections in an
attempt to offset negative economic trends, to test itself, and generally to
augment resources. The servicing cost to us resulting from outsourcing is
generally higher on such accounts since they are relatively more difficult to
resolve.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased $800,000, or 40 percent, from $2.0 million for
the year ended December 31, 2001 to $2.8 million for the year ended December 31,
2002. Selling, general and administrative expenses consist primarily of filing
fees and court costs associated with legal collections, insurance, professional
fees, trustee fees, and office expenses. The increase was principally
attributable to increased court costs associated with legal collections,
professional fees associated with operational compliance activities, and postage
in connection with mailings required by the Graham Leach Bliley Privacy Act.
Selling, general and administrative expenses for the year ended December 31,
2002, have been reduced by $340,000 relating to the reduction of certain
estimated Merger related liabilities as finally determined from the closure of
Creditrust's Chapter 11 bankruptcy, in the fourth quarter.
Impairment of purchased accounts receivable. During 2002, we recorded an
impairment of $1.9 million, compared to $2.6 million in 2001. The combined
remaining carrying value on impaired portfolios aggregated $5.8 million, or 3.9
percent of total purchased accounts receivable, as of December 31, 2002,
compared to $5.7 million, or 4.2 percent of total purchased accounts receivable
as of December 31, 2001. Impairments have occurred principally on older
portfolios purchased prior to the Merger at somewhat higher prices and with
original projections predicated on higher collection rates experienced
historically under better economic circumstances. The decline in impairment
experience is principally due to most of these earlier purchases becoming
impaired in 2001. Further, by adjusting under performing portfolios downward by
each portfolio's historical trend, the remaining collection estimates are
lowered and the likelihood of additional impairments is reduced.
Other income (expense). Other income (expense) decreased $500,000, or 6.5
percent, from $7.7 million for the year ended December 31, 2001 to $7.2 million
for the year ended December 31, 2002. Interest expense was flat year over year
at $8.2 million due to increased borrowings on new purchases largely offsetting
debt repayment on the existing revolver and secured debt. Offsetting interest
expense and included in other income is income from two unconsolidated
subsidiaries. Interest expense totaled $8.2 million for each of the years ended
December 31, 2001 and 2002. Interest income and other income totaled $531,000
and $1.0 million for the years ended December 31, 2001 and 2002, respectively.
The increase was principally attributable to growth in net earnings due to
additional investments in the joint venture with IMNV.
Income tax expense. Income tax expense was recorded at 37.5 percent of pre-tax
income for each of the years ended December 31, 2001 and 2002. Tax payments in
2001 and 2002 were deferred due to the book tax difference of accounting for
purchased accounts receivable on the accrual basis for Generally Accepted
Accounting Principles and the cost recovery basis for tax reporting.
17
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000
Revenue. Total revenue increased by $49.7 million, or 378.5 percent, from $13.2
million for the year ended December 31, 2000 to $62.9 million for the year ended
December 31, 2001. The increase in revenue was attributable to the purchase of
$141.7 million in accounts receivable, consisting of $93.5 million of accounts
receivable acquired in our merger with Creditrust, and an additional $48.2
million in accounts receivable purchased in 2001 through normal operations. The
carrying value of the purchased accounts receivable increased significantly over
the prior year. Collections on purchased accounts receivable increased from
$17.7 million for the year ended December 31, 2000 to $104.1 million for the
year ended December 31, 2001 due to the increase in purchased accounts
receivable. Revenue as a percentage of collections was 74 percent and 60 percent
for the years ended December 31, 2000 and 2001, respectively.
Revenue as a percentage of collections for the year ended December 31, 2001,
declined principally due to changes in the mix of purchased accounts receivable
in 2001 versus 2000. Purchased accounts receivable acquired in the Merger were
acquired at a lower IRR compared to accounts receivable purchased in prior
years. Net after servicing costs, these purchased accounts receivable are
expected to equal or exceed our usual targeted net returns. Further affecting
the lower percentage for 2001 were current acquisitions that had returns that
were targeted lower at the time of acquisition due to the tougher economic
climate facing us in the near term. Finally, the overall percentage was lowered
due to a slow down in collections due to the softening economic climate in the
first three quarters of 2001, accelerated by the events of September 11.
Actual collection results have differed from estimated projections. For the year
ended December 31, 2001, differences between actual and estimated collections on
existing portfolios as of the beginning of 2001, resulted in a reduction of
revenue, net of estimated servicing costs and impairment expense, of $2.5
million
Portfolios with $5.7 million in carrying value, or 4.2 percent of purchased
accounts receivable, as of December 31, 2001 were impaired during 2001 and
placed on cost recovery. Accordingly, no revenue was recorded on these
portfolios after their impairment, equating to a lower ratio of revenue to
collections. See impairment of purchased accounts receivable below.
Payroll and related expenses. Payroll and related expenses increased from
$327,000 for the year ended December 31, 2000 to $1.6 million for the year ended
December 31, 2001. The increase was attributable to an increase in personnel
during the first quarter of 2001 directly related to the Merger. Payroll and
related expenses after the Merger increased as more staffing was implemented for
us to operate as an independent public company and to manage a significant
increase in purchased accounts receivable due to the Merger and internal growth.
Servicing fee expenses. Servicing fee expenses increased $22.1 million, or 383.7
percent, from $5.7 million for the year ended December 31, 2000 to $27.8 million
for the year ended December 31, 2001. The increase in servicing fee expenses is
directly attributable to the increase in collections on purchased accounts
receivable. Servicing fees paid as a percentage of collections were 32.4 percent
and 26.7 percent for the years ended December 31, 2000 and 2001, respectively.
The decrease in servicing fees as a percentage of collections was principally
attributable to the lower serving fees paid in connection with the purchased
accounts receivable acquired in the Merger. Though the mix of accounts acquired
in the Merger were generally older and had been through multiple placements
(compared to current purchases), collections were more predictable as a result
of Creditrust's experience with these portfolios, and had a component of
re-performing accounts. We expect that servicing fees as a percentage of
collections will increase in the future as collections from accounts receivable
acquired in the Merger decline in proportion to total collections. Further, NCOF
has and may continue to outsource collections in an attempt to offset negative
economic trends, to test itself, and generally to augment resources. The
servicing cost to us resulting from outsourcing is generally higher on such
accounts since they are relatively more difficult to resolve.
Selling, general and administrative expenses. Selling, general and
administrative expenses increased from $112,000 for the year ended December 31,
2000 to $2 million for the year ended December 31, 2001. Selling, general and
administrative expenses consist primarily of filing fees and court costs
associated with legal collections, insurance, professional fees, trustee fees,
and office expenses. The increase was attributable to costs incurred in
connection with being an independent public company, and outside collection
costs related to the accounts receivable acquired in the Merger.
Impairment of purchased accounts receivable. During 2001, we recorded an
impairment of $2.6 million. The combined remaining carrying value on impaired
portfolios aggregated $5.7 million, or 4.2 percent of purchased accounts
receivable, as of December 31, 2001. No impairments were recorded in 2000.
Impairments have occurred principally on older portfolios purchased prior to the
Merger at somewhat higher prices and with original projections predicated on
higher collection rates experienced historically under better economic
circumstances.
18
Other income (expense). Other income (expense) consisted principally of interest
expense and increased $6.4 million, or 477.1 percent, from $1.3 million for the
year ended December 31, 2000 to $7.7 million for the year ended December 31,
2001. This increase was principally attributable to an increase in interest
expense as a result of $65.3 million in debt incurred and assumed in connection
with the Merger, as well as increased borrowings from NCO Group to fund the
purchase of accounts receivable in 2001. Included in other income is $329,000 of
income from two unconsolidated subsidiaries.
Income tax expense. Income tax expense was recorded at 37.5 percent of pre-tax
income for the years ended December 31, 2000 and 2001. Tax payments in 2000 were
deferred due to the book tax difference of accounting for purchased accounts
receivable on the accrual basis for GAAP and the cost recovery basis for tax
reporting. Prior to the Merger, we were included in the consolidated tax return
of NCO Group. We received a tax sharing payment of $601,000 from NCO Group for
tax losses incurred during the period prior to the Merger.
Liquidity and Capital Resources
Historically, we derived all of our cash flow from collections on purchased
accounts receivable and borrowings from NCO Group. Effective with the Merger, we
entered into a credit agreement with NCO Group in the form of a subfacility
under its existing credit facility. Borrowings under the subfacility have been
used primarily for the purchase of accounts receivable, the Merger and working
capital to support our growth.
NCO Group has a credit agreement with Citizens Bank, for itself and as
administrative agent for other participating lenders that originally provided
for borrowings up to $350 million, structured as a revolving credit facility.
The borrowing capacity of the credit facility is subject to quarterly reductions
of $5.2 million until maturity, and 50 percent of the net proceeds received from
any offering of debt or equity. As of December 31, 2002, there was $51.2 million
available under the credit agreement. NCO Group's borrowings are collateralized
by substantially all the assets of NCO Group, including our common stock owned
by NCO Group. Pursuant to the Merger, we entered into a credit agreement with
NCO Group in the form of a subfacility under its existing credit facility.
Certain of our assets have been pledged to Citizens Bank and other participating
lenders to secure our borrowings under the subfacility. The balance on the NCOG
credit facility and our subfacility will become due on May 20, 2004. The
borrowing capacity of the subfacility is subject to quarterly reductions.
Effective March 31, 2003, quarterly reductions of $3.75 million are required
until the earlier of May 20, 2004 or the date at which the subfacility is
reduced to $25 million. The maximum borrowing capacity on the subfacility was
reduced by $2.5 million each quarter in 2002 and was $40 million as of December
31, 2002.
The NCO Group credit agreement and the NCOG subfacility contain certain
financial covenants such as maintaining net worth and funded debt to earnings
before interest, taxes, depreciation, and amortization ("EBITDA") ratio
requirements, and include restrictions on, among other things, acquisitions and
distributions to stockholders. As of December 31, 2002, NCOG and we were in
compliance with all of the financial covenants.
The subfacility carries interest at 2 percent over NCO Group's underlying rate
from Citizens Bank and other participating lenders, of which 1 percent is paid
to the lenders and 1 percent is paid to NCO Group. At the option of NCO Group,
NCO Group's borrowings bear interest at a rate equal to either Citizens Bank's
prime rate plus a margin ranging from 0.25 percent to 0.50 percent that is
determined quarterly based upon NCO Group's consolidated funded debt to EBITDA
ratio (Citizens Bank's prime rate was 4.25 percent at December 31, 2002), or the
London InterBank Offered Rate ("LIBOR") plus a margin ranging from 1.25 percent
to 2.25 percent depending on NCO Group's consolidated funded debt to EBITDA
ratio (LIBOR was 1.38 percent at December 31, 2002). As of December 31, 2001 and
2002, the outstanding balance under the subfacility was $47.1 million and $36.9
million, respectively. Total availability under the subfacility as of December
31, 2002 was $3.1 million.
We have two secured notes payable which were assumed in the Merger that have
debt service payments equal to total collections less servicing fees and
expenses. No additional borrowings are available on these notes. The combined
balances of these two secured notes payable amounted to $41.6 million and $35.5
million as of December 31, 2001 and 2002, respectively. These borrowings carry
interest at LIBOR plus 0.65 percent and 15 percent, respectively, and mature on
March 2005 and December 2004, respectively. One of these secured notes has a
$900,000 liquidity reserve that restricts our use of cash. The reserve will be
returned to us upon full satisfaction of the note. As of December 31, 2002, we
were in compliance with all of the financial covenants under the notes.
19
We also have a note payable related to our unconsolidated subsidiary that we
assumed in connection with the Merger. This note payable matures on January
2004, carries an interest rate of 8.61 percent, and had a balance of $5.5
million and $2.4 million as of December 31, 2001 and 2002, respectively. In May
2002, another secured note assumed in the Merger was paid off. All collections
from this note are now remitted directly to us and are used to purchase new
receivables and fund operations.
In August 2002, we entered into a four-year financing agreement with Cargill
Financial to provide financing for larger purchases of accounts receivable at 90
percent of the purchase price, unless otherwise negotiated. Cargill Financial,
at its sole discretion, has the right to finance any purchase of $4 million or
more. This agreement gives us the financing to purchase larger portfolios that
we may not otherwise be able to purchase, and has no minimum or maximum credit
authorization. Borrowings carry interest at the prime rate plus 3.25 percent
(prime rate was 4.25 percent as of December 31, 2002), and are nonrecourse to us
and NCOG, except for the assets within the special purpose entities established
in connection with this financing agreement. Debt service payments equal total
collections less servicing fees and expenses until each individual borrowing is
fully repaid and our original investment is returned, including interest.
Thereafter, Cargill Financial is paid a residual of 40 percent of collections
less servicing costs, unless otherwise negotiated. Individual loans are required
to be repaid based on collections, but not more than two years from the date of
borrowing. Total debt outstanding under this facility as of December 31, 2002
was $17.6 million. As of December 31, 2002, we were in compliance with all of
the financial covenants.
We currently have a fixed price, three-month renewable agreement
("forward-flow") with a major financial institution that obligates us to
purchase, on a monthly basis, portfolios of charged off receivables meeting
certain criteria. As of December 31, 2002, we were obligated to purchase
accounts receivable to a maximum of $1.8 million per month through May 2003. A
portion of the purchase price is deferred for twelve months, including a nominal
rate of interest. NCOG guarantees this forward-flow agreement. Included in notes
payable is $2.1 million of deferred purchase price as of December 31, 2002
incurred on purchases from June 2002 through December 2002.
The debt service requirements associated with borrowings under our secured
credit facilities, including the borrowings under the Cargill Financial
agreement, and the mandatory reductions on our subfacility from NCOG have
increased liquidity requirements. The availability under the subfacility was
reduced to $40.0 as of December 31, 2002, and provides for additional mandatory
reductions of $3.75 million per quarter starting March 31, 2003 until the
subfacility is reduced to $25 million. All of our secured debt requires
amortization of principal based on total collections net of servicing fees and
expenses on the secured portfolios. We anticipate that cash flows from
operations will be sufficient to fund all mandatory reductions on the
subfacility, debt service payments on secured debt, operating expenses, interest
expense and mandatory purchases of accounts receivable under our existing
forward-flow agreement. Cash flows from operations are directly related to the
amount of collections actually received. Estimates are used to forecast
collections and revenue. A decrease in cash flows from operations due to a
decrease in collections from changes in the economy or the performance of NCOF
as service provider, may require us to reduce the amount of accounts receivable
purchased. The effect of reduced accounts receivable purchases would be a
reduction in planned collections and revenue in the periods affected.
Contractual Obligations
The following summarizes our contractual obligations as of December 31, 2002
(amounts in thousands). For detailed discussion of our contractual obligations,
see Notes to Consolidated Financial Statements of the Company -- Notes G, H and
I.
Payments Due by Period
---------------------------------------------------------------------
Less than 1 1 to 3 Years 3 to 5 Years More than 5
Total Year Years
------------ ----------- ------------ ----------- -----------
NCOG subfacility $ 36,880 $11,880 $25,000 $ -- $ --
Secured notes 55,264 27,166 28,098 -- --
Forward flow agreement 9,000 9,000 -- -- --
-------- ------- ------- ----------- -----------
Total contractual obligations $101,144 $48,046 $53,098 $ -- $ --
======== ======= ======= =========== ===========
20
Cash Flows from Operating Activities
Net cash provided by operating activities was $16.5 million for the year ended
December 31, 2002, compared to $23.5 million for the year ended December 31,
2001. The decrease in cash and cash equivalents provided by operations was
principally attributable to the decrease in net income and deferred income tax
expense. Net income decreased from $13.1 million in 2001 to $8.8 million in
2002. Additionally, $2.6 million in restricted cash was released and used to pay
down debt in 2001 pursuant to the Merger, compared to $200,000 of restricted
cash being released in 2002 when a secured note was fully paid off.
Net cash provided by operating activities was $23.5 million for the year ended
December 31, 2001, compared to $7.8 million for the year ended December 31,
2000. The increase in cash and cash equivalents provided by operations was
principally attributable to the large increase in net income and deferred income
tax expense. Net income grew due to the significant increase in revenue
generated from the $93.5 million of accounts receivable acquired in the Merger,
and $48.2 million in other accounts receivable purchased in the normal course of
business in 2001. Additionally, approximately $2.6 million in restricted cash
was released and used to pay down debt in the first quarter of 2001 pursuant to
the Merger.
Cash Flows from Investing Activities
Net cash used in investing activities was $14 million for the year ended
December 31, 2002, compared to $25.5 million for the year ended December 31,
2001. Net cash used in investing activities is principally a function of the
amount of accounts receivable purchased, offset by collections applied to
principal of purchased accounts receivable. While cash purchases of accounts
receivable grew to $69.6 million in 2002 from $48.2 million in 2001, the amount
of collections applied to principal of accounts receivable, including a purchase
price adjustment of $3.2 million from the renegotiation of a contract, grew to
$57 million in 2002 from $34.1 million in 2001. In 2002, we invested $2.0
million in our joint venture, and we received $546,000 in cash through our
investment in a consolidated subsidiary from the minority interest.
Additionally, in 2001, $11.1 million in cash was used for pre-acquisition
liabilities and related costs in connection with the Merger.
Net cash used in investing activities was $25.5 million for the year ended
December 31, 2001, compared to $27.5 million for the year ended December 31,
2000. While cash purchases of accounts receivable grew to $48.2 million in 2001
from $31.4 million in 2000, the amount of collections applied to principal of
purchased accounts receivable grew to $34.1 million in 2001 from $4.6 million in
2000. Additionally, in 2001, $11.1 million in cash and cash equivalents was used
for pre-acquisition liabilities and related costs in connection with the Merger.
Cash Flows from Financing Activities.
Net cash used in financing activities was $2.6 million for the year ended
December 31, 2002, compared to cash provided by investing activities of $8.5
million for the year ended December 31, 2001. Borrowings under the Cargill
Financing totaled $24.5 million for 2002, compared to borrowings under the NCOG
subfacility of $47.1 million in 2001. Payments on secured notes payable and the
NCOG subfacility amounted to $26.8 million in 2002, compared to $40 million in
repayments on secured notes payable in 2001. In 2001, there was $2.3 million in
proceeds from the issuance of common stock at the time of the Merger, and
$901,000 in fees paid to secure the NCO Group credit facility. In 2002, $217,000
in fees were paid to acquire secured debt.
Net cash provided by financing activities was $8.5 million for the year ended
December 31, 2001, compared to $19.6 million for the year ended December 31,
2000. Total borrowings increased to $47.1 million in 2001, of which $36.3
million related to debt incurred in the Merger, from $19.6 million in 2000.
Partially offsetting total borrowings, $40.0 million was repaid on notes payable
during 2001. All of the borrowings in 2001 were from the NCO Group credit
facility. Additionally, there was $2.3 million in proceeds from the issuance of
common stock at the time of the Merger, and $901,000 in fees paid to secure the
NCO Group credit facility.
21
Off-Balance Sheet Arrangements
We own a 100 percent retained residual interest in an investment in
securitization, SPV 98-2, which was acquired in the Merger. This transaction
qualified for gain on sale accounting when the purchased receivables were
originally securitized. This securitization issued a nonrecourse note that is
due the earlier of January 2004 or satisfaction of the note from collections,
and had a balance of $2.4 million and $5.5 million as of December 31, 2002 and
2001, respectively. The retained interest represents the present value of the
residual interest in the securitization using discounted future cash flows after
the securitization note is fully repaid, plus a cash reserve. As of December 31,
2002 and 2001, the investment in securitization was $7.5 million and $7.3
million, respectively, composed of $4.2 million and $4.0 million, respectively,
in the present value of discounted residual cash flows plus $3.3 million in cash
reserves. The maximum exposure to loss as a result of the Company's involvement
with this investment in securitization would be limited to the carrying value of
the investment in the securitization. The investment accrues noncash income at a
rate of 8 percent per annum on the residual cash flow component only. The income
earned increases the investment balance until the securitization note has been
repaid, after which, collections are split between income and amortization of
the investment in securitization based on the discounted cash flows. We recorded
$162,000 and $211,000 of income on this investment for the year ended December
31, 2002 and for the period from February 21, 2001 to December 31, 2001,
respectively. The off balance sheet cash reserves of $3.3 million plus the first
$1.3 million in residual cash collections received, after the securitization
note has been repaid, have been pledged as collateral against another
securitized note.
We have a 50 percent ownership interest in a joint venture,
InoVision-MEDCLR-NCOP Ventures, LLC ("Joint Venture"), with IMNV Holdings, LLC
("IMNV"). This Joint Venture was set up in 2001 to purchase utility, medical and
various other small balance accounts receivable and is accounted for using the
equity method of accounting. Included in other assets on the balance sheet is
our investment in the Joint Venture of $3.4 million and $574,000 as of December
31, 2002 and 2001, respectively. Included in the Statement of Income, in "other
income," was $762,000 and $118,000 for the years ended December 31, 2002 and
2001, respectively, representing our 50 percent share of operating income from
this unconsolidated subsidiary. The Joint Venture has access to capital from
Cargill Financial, who, at its option, lends 90 percent of the value of the
purchased accounts receivable to the Joint Venture. Borrowings carry interest at
the prime rate plus 4.25 percent (prime rate was 4.25 percent as of December 31,
2002). Debt service payments equal total collections less servicing fees and
expenses until each individual borrowing is fully repaid and the Joint Venture's
original investment is returned, including interest. Thereafter, Cargill
Financial is paid a residual of 40 percent of collections, less servicing costs.
Individual loans are required to be repaid based on collections, but not more
than two years from the date of borrowing. The debt is cross-collateralized by
all portfolios in which the lender participates, and is nonrecourse to us.
Related Party Transactions
Servicing Fees
See discussion of servicing fees contained in Item 1. "Business - Collection
Services and Monitoring Results".
Services Shared with NCO Group
NCO Group paid certain costs on our behalf during the years ended December 31,
2000, 2001 and 2002. We reimbursed NCO Group in full for these costs. These
costs related to certain shared services, including office space, human
resources, insurance, legal, payroll processing, external reporting, management
information systems and certain other administrative expenses. Pursuant to
management's estimate of the fair allocation of the costs, shared services
amounted to $112,000, $180,000 and $180,000 for the years ended December 31,
2000, 2001 and 2002, respectively.
NCO Group Credit Subfacility
See discussion of the NCO Group subfacility contained in Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources".
22
Limited Partnership
In December 2002, we, through one of our subsidiaries, invested $2.4 million for
an 80 percent limited partnership interest in a portfolio from a major financial
institution in the United Kingdom. The portfolio is comprised of charged off
consumer loans to residents of the United Kingdom. Our 20 percent general
partner in the transaction is NCO Financial Services (UK) Ltd. ("NCO (UK)"), a
wholly owned subsidiary of NCO Group. NCO (UK) is in the business of contingency
fee based collections in the United Kingdom, and also purchases accounts
receivable in the United Kingdom. NCO (UK) has been servicing the portfolio
since originally outsourced by the seller and will continue to do so under the
partnership agreement between the two companies. Under the partnership
agreement, NCO (UK) will receive a 15 percent preferred distribution for its
services to the partnership, including the ongoing servicing of the portfolio.
Thereafter, collections are split 80 percent to us and 20 percent to NCO (UK).
The operating results of the partnership have been included in our consolidated
results. NCO (UK)'s 20 percent interest is deducted from earnings as a minority
interest in consolidated earnings. The minority interest was $15,000 for the
year ended December 31, 2002.
Impact of Recently Issued and Proposed Accounting Pronouncements
FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements
for Guarantees, Including Indirect Guarantees of Indebtedness of Others"
In November 2002, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 45 ("FIN 45"), "Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others." FIN 45 elaborates on the disclosures required by guarantors in their
interim and annual financial statements. FIN 45 also requires a guarantor to
recognize a liability at the date of inception for the fair value of the
obligation it assumes under the guarantee. The disclosure requirements are
effective for periods ending after December 15, 2002. The initial recognition
and measurement provisions apply on a prospective basis to guarantees issued or
modified after December 31, 2002. We adopted the disclosure requirements of FIN
45, and do not believe the adoption of the recognition and measurement
provisions of FIN 45 will have a material impact on our financial position and
results of operations.
FASB Interpretation No. 46, "Consolidation of Variable Interest Entities"
In January 2003, the FASB issued Interpretation No. 46 ("FIN" 46),
"Consolidation of Variable Interest Entities". The objective of FIN 46 is to
improve financial reporting by companies involved with variable interest
entities. FIN 46 defines variable interest entities and requires that variable
interest entities be consolidated by a company if that company is subject to a
majority of the risk of loss from the variable interest entity's activities or
is entitled to receive a majority of the entity's residual returns or both. The
disclosure requirements are effective for periods ending after December 15,
2002. The consolidation requirements apply immediately to variable interest
entities created after January 31, 2003, and apply to existing variable interest
entities in the first fiscal year or interim period beginning after June 15,
2003. We adopted the disclosure requirements of FIN 46, and do not believe the
adoption of FIN 46 will have a material impact on our financial position and
results of operations.
Accounting for Certain Purchased Loans or Debt Securities (formerly known as
Discounts Related to Credit Quality) (Exposure Draft-December 1998)
The exposure draft applies to all companies that acquire loans for which it is
probable at the acquisition date that all contractual amounts due under the
acquired loans will not be collected. The proposal addresses accounting for
differences between contractual and expected future cash flows from an
investor's initial investment in certain loans when such differences are
attributable, in part, to credit quality. The scope also includes such loans
acquired in purchased business combinations. If adopted, the proposed Statement
of Position ("SOP") would supersede Practice Bulletin 6, Amortization of
Discounts on Certain Acquired Loans. In June 2001, the FASB cleared the SOP for
issuance subject to minor editorial changes and planned to issue a final SOP in
early 2002. The SOP has not yet been issued.
The proposed SOP would limit the revenue that may be accrued to the excess of
the estimate of expected future cash flows over the portfolio's initial cost of
accounts receivable acquired. The proposed SOP would require that the excess of
the contractual cash flows over expected future cash flows not be recognized as
an adjustment of revenue, expense or on the balance sheet. The proposed SOP
would freeze the IRR originally estimated when the accounts receivable are
purchased for subsequent impairment testing. Rather than lower the estimated IRR
if the original collection estimates are not received, the carrying value of a
portfolio would be written down to maintain the original IRR. Increases in
expected future cash flows would be recognized prospectively through adjustment
of the IRR over a portfolio's remaining life. The exposure draft provides that
previously issued annual financial statements would not need to be restated.
Until final issuance of this SOP, we cannot ascertain its effect on our
reporting.
23
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to various types of market risk in the normal course of business,
including the impact of interest rate changes, changes in corporate tax rates,
and foreign currency exchange rate fluctuations. A material change in these
rates could adversely affect our operating results and cash flows. A 25
basis-point increase in interest rates could increase our annual interest
expense by $25,000 for each $10 million of variable debt outstanding for the
entire year. We retain an investment in securitization with respect to our
securitized accounts receivable, which is a market risk sensitive financial
instrument held for purposes other than trading. This investment exposes us to
market risk, which may arise from changes in interest and discount rates
applicable to this investment. The impact of a 1 percent increase in the
discount rate used by us in the fair value calculations would not have a
material impact on our balance sheet as of December 31, 2002. There would be no
impact on our future cash flows. We own an 80 percent interest in a limited
partnership that invests in accounts receivable in the United Kingdom. This
investment exposes us to risk due to fluctuations in foreign currency exchange
rates. As of December 31, 2002, exchange rate fluctuations did not have a
material impact on our balance sheet. We do not invest in derivative financial
or commodity instruments.
Inflation
We believe that inflation has not had a material impact on our results of
operations for the years ended December 31, 2000, 2001 and 2002.
24
Item 8. Consolidated Financial Statements and Supplementary Data
NCO Portfolio Management, Inc.
Index to Consolidated Financial Statements
Report of Independent Auditors........................................ 26
Consolidated Financial Statements:
Consolidated Balance Sheets as of December 31, 2001 and 2002..... 27
Consolidated Statements of Income for each of the
three years in the period ended December 31, 2002.............. 28