NCO GROUP INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q

(Mark one)

	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

	For the quarterly period ended March 31, 2005, 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 0-21639

NCO GROUP, INC.

(Exact name of registrant as specified in its charter)

PENNSYLVANIA			23-2858652

(State or other jurisdiction of			(IRS Employer Identification Number)
incorporation or organization)

507 Prudential Road, Horsham, Pennsylvania 19044

(Address of principal executive offices) (Zip Code)

215-441-3000

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes No

The number of shares outstanding of each of the issuer’s classes of common stock as of May 9, 2005 was: 32,089,147 shares of common stock, no par value.

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NCO GROUP, INC.
INDEX

PART I – FINANCIAL INFORMATION			PAGE

	Item 1.	FINANCIAL STATEMENTS (Unaudited)

		Condensed Consolidated Balance Sheets -
		March 31, 2005 and December 31, 2004	1

		Condensed Consolidated Statements of Income -
		Three months ended March 31, 2005 and 2004	2

		Condensed Consolidated Statements of Cash Flows -
		Three months ended March 31, 2005 and 2004	3

		Notes to Condensed Consolidated Financial Statements	4

	Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF
		FINANCIAL CONDITION AND RESULTS OF OPERATIONS	23

	Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES
		ABOUT MARKET RISK	30

	Item 4.	CONTROLS AND PROCEDURES	30

PART II – OTHER INFORMATION			31

	Item 1.	LEGAL PROCEEDINGS
	Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES
		AND USE OF PROCEEDS
	Item 3.	DEFAULTS UPON SENIOR SECURITIES
	Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
	Item 5.	OTHER INFORMATION
	Item 6.	EXHIBITS

	SIGNATURES		33

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Part 1. Financial Information
Item 1. Financial Statements

NCO GROUP, INC.
Condensed Consolidated Balance Sheets
(Amounts in thousands)



	ASSETS		March 31, 2005 (Unaudited)			December 31, 2004
Current assets:
	Cash and cash equivalents	$	41,471		$	26,334
	Restricted cash		—			900
	Accounts receivable, trade, net of allowance for
	doubtful accounts of $7,281 and $7,878, respectively		109,146			104,699
	Purchased accounts receivable, current portion, net of
	allowance for impairment of $328 at March 31, 2005		62,791			50,388
	Deferred income taxes		16,980			18,911
	Bonus receivable, current portion		13,418			10,325
	Prepaid expenses and other current assets		24,989			34,282

	Total current assets		268,795			245,839

Funds held on behalf of clients

Property and equipment, net			114,007			114,256

Other assets:
	Goodwill		610,277			609,562
	Other intangibles, net of accumulated amortization		23,025			25,054
	Purchased accounts receivable, net of current portion		66,826			88,469
	Other assets		29,758			30,709

	Total other assets		729,886			753,794

Total assets		$	1,112,688		$	1,113,889

	LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities:
	Long-term debt, current portion	$	91,868		$	64,684
	Income taxes payable		14,448			11,946
	Accounts payable		10,050			5,022
	Accrued expenses		44,496			53,472
	Accrued compensation and related expenses		26,009			21,424
	Deferred revenue, current portion		19,735			18,821

	Total current liabilities		206,606			175,369

Funds held on behalf of clients

Long-term liabilities:
	Long-term debt, net of current portion		143,348			186,339
	Deferred revenue, net of current portion		773			955
	Deferred income taxes		32,675			36,174
	Other long-term liabilities		18,806			19,451

Minority interest			8			—

Commitments and contingencies
Shareholders’ equity:
	Preferred stock, no par value, 5,000 shares authorized,
	no shares issued and outstanding		—			—
	Common stock, no par value, 50,000 shares authorized,
	32,082 and 32,078 shares issued and outstanding, respectively		473,499			473,410
	Other comprehensive income		12,702			13,526
	Deferred compensation		(3,115	)		(3,458	)
	Retained earnings		227,386			212,123

	Total shareholders’ equity		710,472			695,601

Total liabilities and shareholders’ equity		$	1,112,688		$	1,113,889

See accompanying notes.
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NCO GROUP, INC.
Condensed Consolidated Statements of Income
(Unaudited)
(Amounts in thousands, except per share data)

		For the Three Months Ended March 31,

			2005			2004

Revenue		$	260,349		$	201,231

Operating costs and expenses:
	Payroll and related expenses		127,731			91,039
	Selling, general and administrative expenses		93,037			76,645
	Depreciation and amortization expense		10,758			7,778

	Total operating costs and expenses		231,526			175,462

Income from operations			28,823			25,769

Other income (expense):
	Interest and investment income		734			996
	Interest expense		(5,175	)		(5,288	)
	Other income		93			—

	Total other income (expense)		(4,348	)		(4,292	)

Income before income tax expense			24,475			21,477

Income tax expense			9,204			8,888

Income before minority interest			15,271			12,589

Minority interest			(8	)		(606	)


Net income		$	15,263		$	11,983

Net income per share:
	Basic	$	0.48		$	0.46
	Diluted	$	0.45		$	0.43

Weighted average shares outstanding:
	Basic		32,080			26,125
	Diluted		36,173			30,234

See accompanying notes.
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NCO GROUP, INC
Condensed Consolidated Statements of Cash Flows
(Unaudited)
(Amounts in thousands)

					For the Three Months Ended March 31,

					2005			2004

Cash flows from operating activities:
	Net income			$	15,263		$	11,983
	Adjustments to reconcile income from operations
		to net cash provided by operating activities:
			Depreciation		8,674			6,669
			Amortization of intangibles		2,084			1,109
			Amortization of deferred compensation		343			—
			Amortization of deferred training asset		653			—
			Provision for doubtful accounts		774			1,269
			Allowance and impairment of purchased accounts receivable		329			388
			Accrued noncash interest		1,933			1,456
			Loss on disposal of property, equipment and other net assets		—			38
			Changes in non-operating income		(95	)		(594	)
			Minority interest		8			606
			Changes in operating assets and liabilities, net of acquisitions:
			Restricted cash		900			4,468
			Accounts receivable, trade		(8,500	)		(7,049	)
			Deferred income taxes		(1,657	)		1,481
			Bonus receivable		(3,093	)		(4,050	)
			Other assets		8,381			351
			Accounts payable and accrued expenses		10,666			7,478
			Income taxes payable		2,708			6,178
			Deferred revenue		731			2,412
			Other long-term liabilities		147			(714	)

			Net cash provided by operating activities		40,249			33,479

Cash flows from investing activities:
	Purchases of accounts receivable – see note 11				(5,402	)		(6,586	)
	Collections applied to principal of purchased accounts receivable				17,511			22,110
	Purchases of property and equipment				(8,713	)		(7,485	)
	Net distribution from joint venture				618			55
	Proceeds from notes receivable				361			305
	Net cash paid for acquisitions and related costs				(8,434	)		(2,552	)

			Net cash (used in) provided by investing activities		(4,059	)		5,847

Cash flows from financing activities:
	Repayment of notes payable				(9,735	)		(11,239	)
	Repayment of borrowings under revolving credit agreement				(11,250	)		(11,250	)
	Payment of fees to acquire debt				(58	)		(4	)
	Issuance of common stock, net of taxes				82			1,445

			Net cash used in financing activities		(20,961	)		(21,048	)

Effect of exchange rate on cash					(92	)		88

Net increase in cash and cash equivalents					15,137			18,366

Cash and cash equivalents at beginning of the period					26,334			45,644

Cash and cash equivalents at end of the period				$	41,471		$	64,010

See accompanying notes.
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NCO GROUP, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1.	Nature of Operations:

NCO Group, Inc. (“the Company” or “NCO”) is a leading global provider of business process outsourcing solutions, primarily focused on accounts receivable management (“ARM”) and customer relationship management (“CRM”). NCO provides services through 87 offices in the United States, Canada, the United Kingdom, India, the Philippines, the Caribbean, and Panama. The Company provides services to more than 24,000 active clients including many of the Fortune 500, supporting a broad spectrum of industries, including financial services, telecommunications, healthcare, utilities, retail and commercial, transportation/logistics, education, technology and government services. These clients are primarily located throughout the United States, Canada, the United Kingdom, and Puerto Rico. The Company’s largest client during the three months ended March 31, 2005 was Capital One Financial Corporation and it represented 10.9 percent of the Company’s consolidated revenue for the three months ended March 31, 2005. The Company also purchases and manages past due consumer accounts receivable from consumer creditors such as banks, finance companies, retail merchants, and other consumer-oriented companies.

The Company’s business consists of four operating divisions: ARM North America, CRM, Portfolio Management and ARM International.

2.	Accounting Policies:

	Interim Financial Information:

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of only normal recurring accruals, except as otherwise disclosed herein) considered necessary for a fair presentation have been included. Because of the seasonal nature of the Company’s business, operating results for the three-month period ended March 31, 2005, are not necessarily indicative of the results that may be expected for the year ending December 31, 2005, or for any other interim period. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Principles of Consolidation:

The condensed consolidated financial statements include the accounts of the Company and all affiliated subsidiaries and entities controlled by the Company. All intercompany accounts and transactions have been eliminated. The Company does not control InoVision-MEDCLR NCOP Ventures, LLC (see note 14) and, accordingly, its financial condition and results of operations are not consolidated with the Company’s financial statements.

Revenue Recognition:

ARM Contingency Fees:

ARM contingency fee revenue is recognized upon collection of funds by NCO or its client.

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2.	Accounting Policies (continued):


	Revenue Recognition (continued):

ARM Contingency Fees (continued):

In January 2005, the Company was notified by the Staff of the Securities and Exchange Commission that their interpretation of Staff Accounting Bulletin No. 104 (“SAB 104”) was inconsistent with the Company’s long-standing policy with respect to the timing of revenue recognized on certain cash receipts related to contingency revenues. The Company previously recognized contingency fee revenue attributable to payments postmarked prior to the end of the period and received in the mail from the consumers on the first business day after such period as applicable to the prior reporting period. This revenue recognition policy had been in effect since prior to NCO becoming a public company and was consistently applied over time. The Company corrected its policy in order to recognize revenue when physically received. The impact of this correction was a $2.7 million reduction in revenues and a $947,000 reduction in net income, or $0.03 per diluted share, for the three months ended December 31, 2004.

ARM Contractual Services:

Fees for ARM contractual services are recognized as services are performed and earned under service arrangements with clients where fees are fixed or determinable and collectibility is reasonably assured.

Long-Term Collection Contract:

The Company has a long-term collection contract with a large client to provide collection services that includes guaranteed collections, subject to limits. The Company also earns a bonus to the extent collections are in excess of the guarantees. The Company is required to pay the client, subject to limits, if collections do not reach the guarantees. Any guarantees in excess of the limits will only be satisfied with future collections. The Company is entitled to recoup at least 90 percent of any such guarantee payments from subsequent collections in excess of any remaining guarantees. This long-term collection contract only covers placements by the client from January 1, 2000 through December 31, 2003.

The Company defers all of the base service fees, subject to the limits, until the collections exceed the collection guarantees. At the end of each reporting period, the Company assesses the need to record an additional liability if deferred fees are less than the estimated guarantee payments, if any, due to the client, subject to the limits. There was no additional liability recorded as of March 31, 2005 and December 31, 2004.

CRM Hourly:

Revenue is recognized based on the billable hours of each CRM representative as defined in the client contract. The rate per billable hour charged is based on a predetermined contractual rate, as agreed in the underlying contract. The contractual rate can fluctuate based on certain pre-determined objective performance criteria related to quality and performance as measured on a monthly basis. The impact of the performance criteria on the rate per billable hour is continually updated as revenue is recognized. Some clients are contractually entitled to penalties when the Company is not in compliance with certain obligations as defined in the client contract. Monthly performance penalties are recorded as a reduction to revenues as incurred.

CRM Performance Based:

Under performance-based arrangements, the Company is paid by its customers based on achievement of certain levels of sales or other client-determined criteria specified in the client contract. The Company recognizes performance-based revenue by measuring its actual results against the performance criteria specified in the contracts. Amounts collected from customers prior to the performance of services are recorded as deferred revenues.

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2.	Accounting Policies (continued):


	Revenue Recognition (continued):

Training Revenue:

In connection with the provisions of certain inbound and outbound CRM services, the Company incurs costs to train its CRM representatives. Training programs relate to both program start-up training in connection with new CRM programs (“Start-up Training”) and on-going training for updates of existing CRM programs (“On-going Training”). The Company bills some of its customers for the costs incurred under these training programs based on the terms in the contract. Training revenue is integral to the CRM revenue being generated over the course of a contract and cannot be separated as a discrete earning process under SEC Staff Accounting Bulletin No. 104. Start-up Training and On-going Training revenues are recognized over the shorter of the term of the customer contract, or the period to be benefited. Direct costs associated with providing Start-up Training and On-going Training, which consist exclusively of salary and benefit costs, are also deferred and amortized over a time period consistent with the deferred training revenue. When a business relationship is terminated with one of the Company’s customers, the unamortized deferred training revenue and unamortized deferred direct costs associated with that customer are immediately recognized. At March 31, 2005, the balance of deferred training revenue was $1.6 million and deferred capitalized costs were $1.2 million.

Purchased Accounts Receivable:

Prior to January 1, 2005, the Company accounted for its investment in purchased accounts receivable on an accrual basis under the guidance of American Institute of Certified Public Accountants (“AICPA”) Practice Bulletin No. 6, “Amortization of Discounts on Certain Acquired Loans” (“PB6”). Effective January 1, 2005, the Company adopted AICPA Statement of Position 03-3, “Accounting for Loans or Certain Securities Acquired in a Transfer” (“SOP 03-3”). SOP 03-3 addresses accounting for differences between contractual versus expected cash flows over an investor’s initial investment in certain loans when such differences are attributable, at least in part, to credit quality. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004, and amends PB6 for loans acquired in fiscal years before the effective date. Previously issued annual and quarterly financial statements are not restated and there is no prior period effect of these new provisions.

The Company has maintained historical collection records for all of its purchased accounts receivable since 1991, as well as debtor records since 1986, which provides a reasonable basis for the Company’s judgment that it is probable that it will ultimately collect the recorded amount of its purchased accounts receivable plus a premium or yield. The historical collection amounts also provide a reasonable basis for determining the timing of the collections. The Company uses all available information to forecast the cash flows of its purchased accounts receivable including, but not limited to, historical collections, payment patterns on similar purchases, credit scores of the underlying debtors, seller’s credit policies, and location of the debtor.

The Company acquires loans in groups or portfolios that are initially recorded at cost, which includes external costs of acquiring portfolios. Once a portfolio is acquired, the accounts in the portfolio are not changed, unless replaced or returned. All acquired loans have experienced deterioration of credit quality between origination and the Company’s acquisition of the loans, and the amount paid for a portfolio of loans reflects the Company’s determination that it is probable the Company will be unable to collect all amounts due according to each loan’s contractual terms. As such, the Company determines whether each portfolio of loans is to be accounted for individually or whether such loans will be aggregated based on common risk characteristics. The Company considers expected collections, and estimates the amount and timing of undiscounted expected principal, interest, and other cash flows (expected at acquisition) for each portfolio of loans and subsequently aggregated pools of loans. The Company determines nonaccretable difference, or the excess of the portfolio’s contractual principal over all cash flows expected at acquisition as an amount that should not be accreted. The remaining amount represents accretable yield, or the excess of the portfolio’s cash flows expected to be collected over the amount paid and is accreted into earnings over the remaining life of the portfolio.

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2.	Accounting Policies (continued):


	Revenue Recognition (continued):

Purchased Accounts Receivable (continued):

At acquisition, the Company derives an internal rate of return (“IRR”) based on the expected monthly collections over the estimated economic life of each portfolio of loans compared to the original purchase price. Collections on the portfolios are allocated to revenue and principal reduction based on the estimated IRR for each portfolio of loans (typically up to seven years, based on the Company’s collection experience). Revenue on purchased accounts receivable is recorded monthly based on applying each portfolio’s effective IRR for the quarter to its carrying value. Over the life of a portfolio, the Company continues to estimate cash flows expected to be collected. The Company evaluates at the balance sheet date whether the present value of its portfolios determined using the effective interest rates has decreased, and if so, records an expense to establish a valuation allowance to maintain the original IRR established at acquisition. Any increase in actual or estimated cash flows expected to be collected is first used to reverse any existing valuation allowance for that portfolio, or aggregation of portfolios, and any remaining increases in cash flows is recognized prospectively through an increase in the IRR. The updated IRR then becomes the new benchmark for subsequent allowance testing.

Credit Policy:

Management carefully monitors its client relationships in order to minimize the Company’s credit risk and assesses the likelihood of collection based on a number of factors including the client’s collection history and credit-worthiness. The Company maintains a reserve for potential collection losses when such losses are deemed to be probable.

The Company has two types of arrangements under which it collects its ARM contingency fee revenue. For certain clients, the Company remits funds collected on behalf of the client net of the related contingency fees while, for other clients, the Company remits gross funds collected on behalf of clients and bills the client separately for its contingency fees.

The Company generally does not require collateral and it does not charge finance fees on outstanding trade receivables. In many cases, in the event of collection delays from ARM clients, management may, at its discretion, change from the gross remittance method to the net remittance method. The Company also maintains a reserve for deposits on debtor accounts that may ultimately prove to have insufficient funds. Trade accounts receivable are written off to the allowances when collection appears highly unlikely.

Goodwill:

Goodwill represents the excess of purchase price over the fair market value of the net assets of the acquired businesses based on their respective fair values at the date of acquisition. Goodwill is tested for impairment each year on October 1, and as triggering events occur. The goodwill impairment test is performed at the reporting unit level and involves a two-step approach, the first step identifies any potential impairment and the second step measures the amount of impairment, if applicable. The first test for potential impairment uses a fair-value based approach, whereby the implied fair value of a reporting unit’s goodwill is compared to its carrying amount, if the fair value is less than the carrying amount, the reporting unit’s goodwill would be considered impaired. Fair value estimates are based upon the discounted value of estimated cash flows. The Company does not believe that goodwill is impaired as of March 31, 2005 (see note 7).

Other Intangible Assets:

Other intangible assets consist primarily of customer relationships and deferred financing costs, which relate to debt issuance costs incurred. Customer relationships are amortized over five years and deferred financing costs are amortized over the term of the debt, using the straight-line method (see note 7).

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2.	Accounting Policies (continued):


	Stock Options:

The Company accounts for stock option grants in accordance with APB Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations. Under APB 25, because the exercise price of the stock options equaled the fair value of the underlying common stock on the date of grant, no compensation cost was recognized. In accordance with SFAS 123, “Accounting for Stock-Based Compensation,” the Company does not recognize compensation cost based on the fair value of the options granted at the grant date. If the Company had elected to recognize compensation cost based on the fair value of the options granted at the grant date, net income and net income per share would have been reduced to the pro forma amounts indicated in the following table (amounts in thousands, except per share amounts):