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EX-31.1 - EX-31.1 - SquareTwo Financial Corp | q22014ex311ceocertification.htm |
EXCEL - IDEA: XBRL DOCUMENT - SquareTwo Financial Corp | Financial_Report.xls |
EX-32.1 - EX-32.1 - SquareTwo Financial Corp | q22014ex321soxcertification.htm |
EX-31.2 - EX-31.2 - SquareTwo Financial Corp | q22014ex312cfocertification.htm |
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
________________________________________________________________
FORM 10-Q
________________________________________________________________
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2014
or
o 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: 333-170734
_____________________________________________
SquareTwo Financial Corporation
(Exact name of Registrant as Specified in Its Charter)
_____________________________________________
Delaware | 84-1261849 | |
(State or Other Jurisdiction of Incorporation or Organization) | (I.R.S. Employer Identification No.) | |
4340 South Monaco Street, Second Floor | ||
Denver, Colorado | 80237 | |
(Address of Principal Executive Offices) | (Zip Code) |
303-296-3345
(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 x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o | Accelerated filer o | |
Non-accelerated filer x (Do not check if a smaller reporting company) | Smaller reporting company o |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act): Yes o No x
As of August 14, 2014, 1,000 shares of the registrant’s common stock, par value $0.001 per share, were outstanding.
TABLE OF CONTENTS
Page | ||
i
PART I
Item 1. Condensed Consolidated Financial Statements.
SquareTwo Financial Corporation and Subsidiaries
Condensed Consolidated Balance Sheets
(unaudited, in thousands except share data)
June 30, 2014 | December 31, 2013 | |||||||
Assets | ||||||||
Cash and cash equivalents | $ | 16,528 | $ | 9,379 | ||||
Restricted cash | 7,306 | 6,484 | ||||||
Receivables: | ||||||||
Trade, net of allowance for doubtful accounts of $15 and $221, respectively | 2,532 | 1,986 | ||||||
Notes receivable | 403 | 212 | ||||||
Taxes receivable | — | 275 | ||||||
Purchased debt, net | 253,720 | 274,357 | ||||||
Property and equipment, net | 23,982 | 24,356 | ||||||
Goodwill and intangible assets | 171,348 | 171,348 | ||||||
Other assets | 9,301 | 10,007 | ||||||
Total assets | $ | 485,120 | $ | 498,404 | ||||
Liabilities and equity | ||||||||
Payables: | ||||||||
Accounts payable, trade | $ | 2,588 | $ | 3,505 | ||||
Payable from trust accounts | 2,006 | 1,933 | ||||||
Taxes payable | 67 | 748 | ||||||
Accrued interest and other liabilities | 24,670 | 27,861 | ||||||
Deferred tax liability | 11,028 | 9,936 | ||||||
Line of credit | 144,785 | 145,269 | ||||||
Notes payable, net of discount | 289,397 | 289,414 | ||||||
Obligations under capital lease agreements | 3,285 | 2,744 | ||||||
Total liabilities | 477,826 | 481,410 | ||||||
Commitments and contingencies (Note 9) | ||||||||
Equity | ||||||||
Common stock, par value $0.001 per share; 1,000 shares authorized, issued and outstanding | — | — | ||||||
Additional paid-in capital | 190,161 | 190,262 | ||||||
Accumulated deficit | (186,757 | ) | (176,354 | ) | ||||
Accumulated other comprehensive loss | (1,283 | ) | (1,347 | ) | ||||
Total SquareTwo equity | 2,121 | 12,561 | ||||||
Noncontrolling interest | 5,173 | 4,433 | ||||||
Total equity | 7,294 | 16,994 | ||||||
Total liabilities and equity | $ | 485,120 | $ | 498,404 |
See Notes to the Condensed Consolidated Financial Statements
1
SquareTwo Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Operations
(unaudited, in thousands)
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2014 | 2013 | 2014 | 2013 | |||||||||||||
Revenues | ||||||||||||||||
Purchased debt revenue, net | $ | 66,838 | $ | 90,499 | $ | 138,328 | $ | 179,646 | ||||||||
Other revenue | 9 | 151 | 28 | 391 | ||||||||||||
Total revenues | 66,847 | 90,650 | 138,356 | 180,037 | ||||||||||||
Expenses | ||||||||||||||||
Purchased debt expense | 34,495 | 44,178 | 69,667 | 90,635 | ||||||||||||
Court costs, net | 9,958 | 11,623 | 19,141 | 21,926 | ||||||||||||
Other direct operating expense | 3,904 | 3,701 | 7,810 | 6,092 | ||||||||||||
Salaries and payroll taxes | 7,530 | 7,158 | 15,087 | 14,005 | ||||||||||||
General and administrative | 3,538 | 4,000 | 7,581 | 7,448 | ||||||||||||
Depreciation and amortization | 1,706 | 1,997 | 3,348 | 3,911 | ||||||||||||
Total operating expenses | 61,131 | 72,657 | 122,634 | 144,017 | ||||||||||||
Operating income | 5,716 | 17,993 | 15,722 | 36,020 | ||||||||||||
Other expenses | ||||||||||||||||
Interest expense | 11,075 | 11,605 | 22,084 | 23,383 | ||||||||||||
Other expense | 87 | 74 | 193 | 2,343 | ||||||||||||
Total other expenses | 11,162 | 11,679 | 22,277 | 25,726 | ||||||||||||
(Loss) income before income taxes | (5,446 | ) | 6,314 | (6,555 | ) | 10,294 | ||||||||||
Income tax expense | (2,071 | ) | (1,940 | ) | (3,108 | ) | (2,590 | ) | ||||||||
Net (loss) income | (7,517 | ) | 4,374 | (9,663 | ) | 7,704 | ||||||||||
Less: Net income attributable to the noncontrolling interest | 399 | 445 | 740 | 666 | ||||||||||||
Net (loss) income attributable to SquareTwo | $ | (7,916 | ) | $ | 3,929 | $ | (10,403 | ) | $ | 7,038 |
See Notes to the Condensed Consolidated Financial Statements
2
SquareTwo Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Comprehensive (Loss) Income
(unaudited, in thousands)
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2014 | 2013 | 2014 | 2013 | |||||||||||||
Net (loss) income | $ | (7,517 | ) | $ | 4,374 | $ | (9,663 | ) | $ | 7,704 | ||||||
Other comprehensive income (loss), net of tax: | ||||||||||||||||
Currency translation adjustment | 898 | (742 | ) | 64 | (1,129 | ) | ||||||||||
Comprehensive (loss) income | (6,619 | ) | 3,632 | (9,599 | ) | 6,575 | ||||||||||
Less: Comprehensive income attributable to the noncontrolling interest | 399 | 445 | 740 | 666 | ||||||||||||
Comprehensive (loss) income attributable to SquareTwo | $ | (7,018 | ) | $ | 3,187 | $ | (10,339 | ) | $ | 5,909 |
See Notes to the Condensed Consolidated Financial Statements
3
SquareTwo Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Changes in Equity
(unaudited, in thousands)
Common Stock | Additional Paid-In Capital | Accumulated Deficit | Accumulated Other Comprehensive Loss | Total SquareTwo Equity | Noncontrolling Interest | Total Equity | ||||||||||||||||||||||
Balances, December 31, 2013 | $ | — | $ | 190,262 | $ | (176,354 | ) | $ | (1,347 | ) | $ | 12,561 | $ | 4,433 | $ | 16,994 | ||||||||||||
Net (loss) income | — | — | (10,403 | ) | — | (10,403 | ) | 740 | (9,663 | ) | ||||||||||||||||||
Currency translation adjustment | — | — | — | 64 | 64 | — | 64 | |||||||||||||||||||||
Distribution to Parent | — | (150 | ) | — | — | (150 | ) | — | (150 | ) | ||||||||||||||||||
Stock option expense | — | 49 | — | — | 49 | — | 49 | |||||||||||||||||||||
Balances, June 30, 2014 | $ | — | $ | 190,161 | $ | (186,757 | ) | $ | (1,283 | ) | $ | 2,121 | $ | 5,173 | $ | 7,294 |
See Notes to the Condensed Consolidated Financial Statements
4
SquareTwo Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(unaudited, in thousands)
Six Months Ended | ||||||||
June 30, | ||||||||
2014 | 2013 | |||||||
Operating activities | ||||||||
Net (loss) income | $ | (9,663 | ) | $ | 7,704 | |||
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: | ||||||||
Depreciation and amortization | 3,348 | 3,911 | ||||||
Amortization of loan origination fees and debt discount | 1,466 | 1,692 | ||||||
Recovery of step-up in basis of purchased debt | — | 107 | ||||||
Purchased debt valuation allowance reversals | (523 | ) | (3,751 | ) | ||||
Stock option expense | 49 | 67 | ||||||
Amortization of prepaid and other non-cash expenses | 2,084 | 2,241 | ||||||
Deferred tax provision, net of valuation allowance | 1,092 | — | ||||||
Changes in operating assets and liabilities: | ||||||||
Income tax payable/receivable | (396 | ) | (2,332 | ) | ||||
Restricted cash | (822 | ) | (196 | ) | ||||
Other assets | (2,798 | ) | (2,822 | ) | ||||
Accounts payable and accrued liabilities | (3,840 | ) | 18 | |||||
Net cash (used in) provided by operating activities | (10,003 | ) | 6,639 | |||||
Investing activities | ||||||||
Investment in purchased debt | (67,816 | ) | (157,251 | ) | ||||
Proceeds applied to purchased debt principal | 88,900 | 122,690 | ||||||
Payments to branch offices related to asset purchase program | — | (297 | ) | |||||
Net (investment in) proceeds from notes receivable | (193 | ) | 64 | |||||
Investment in property and equipment, including internally developed software | (2,063 | ) | (2,818 | ) | ||||
Net cash provided by (used in) investing activities | 18,828 | (37,612 | ) | |||||
Financing activities | ||||||||
Repayments of investment by Parent | (150 | ) | — | |||||
Payments on notes payable, net | (377 | ) | (224 | ) | ||||
Proceeds from lines-of-credit | 229,236 | 309,655 | ||||||
Payments on lines-of-credit | (229,720 | ) | (274,792 | ) | ||||
Origination fees on lines-of-credit | (244 | ) | (856 | ) | ||||
Payments on capital lease obligations | (742 | ) | (720 | ) | ||||
Net cash (used in) provided by financing activities | (1,997 | ) | 33,063 | |||||
Increase in cash and cash equivalents | 6,828 | 2,090 | ||||||
Impact of foreign currency translation on cash | 321 | (796 | ) | |||||
Cash and cash equivalents at beginning of period | 9,379 | 7,538 | ||||||
Cash and cash equivalents at end of period | $ | 16,528 | $ | 8,832 | ||||
Supplemental cash flow information | ||||||||
Cash paid for interest | $ | 20,673 | $ | 21,784 | ||||
Cash paid for income taxes | 2,431 | 4,918 | ||||||
Property and equipment financed with capital leases and notes payable | 1,282 | 2,041 |
See Notes to the Condensed Consolidated Financial Statements
5
SquareTwo Financial Corporation and Subsidiaries
Notes to the Condensed Consolidated Financial Statements
(unaudited, in thousands except share amounts or otherwise indicated)
1. Organization and Basis of Presentation
SquareTwo Financial Corporation (together with its subsidiaries referred to herein as “SquareTwo,” "we," "our," "us," or the “Company”) is a Delaware corporation that was organized in February 1994 and is headquartered in Denver, Colorado. On August 5, 2005, CA Holding Inc. (“Parent”) acquired 100% of the outstanding stock of SquareTwo and its subsidiaries (the “Acquisition”). The accompanying consolidated financial statements reflect Parent’s basis in SquareTwo. SquareTwo’s subsidiaries purchase domestic and Canadian charged-off receivables (referred to herein as “purchased debt”).
The Company is a leading purchaser of charged-off consumer and commercial receivables in the accounts receivable management industry. Our primary business is the acquisition, management and collection of charged-off consumer and commercial accounts receivable that we purchase from financial institutions, finance and leasing companies, and other issuers in the U.S. and Canada. SquareTwo, excluding our Canadian operations and SquareTwo Financial Commercial Funding Corporation ("Commercial Funding"), serves as a network of attorney based branch offices which pursue proceeds on debt owned by the Company for a fee. Each of our branch offices is independently owned, but has executed detailed agreements that provide the legal structure for the relationship with SquareTwo. Once we acquire the charged-off accounts receivable we place the accounts with the branch offices for liquidation. Also, to a much lesser extent, we currently utilize specialized third party non-legal and legal collection firms in the U.S. Commercial Funding employs collectors focused exclusively on collections of charged-off commercial finance accounts purchased through our other subsidiaries.
Our Canadian subsidiaries exclusively purchase charged-off Canadian accounts. In Canada, we utilize internal collectors and third-party non-legal and legal collection firms which exclusively service our Canadian customers.
The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission (“SEC”) and, therefore, do not include all information and disclosures required by GAAP for complete financial statements. In the opinion of the Company, however, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the Company’s condensed consolidated balance sheet as of June 30, 2014, its condensed consolidated statements of operations and condensed consolidated statements of comprehensive (loss) income for the three and six months ended June 30, 2014 and 2013, its condensed consolidated statements of changes in equity for the six months ended June 30, 2014, and its condensed consolidated statements of cash flows for the six months ended June 30, 2014 and 2013. The condensed consolidated statements of operations and condensed consolidated statements of comprehensive (loss) income of the Company for the three and six months ended June 30, 2014 may not be indicative of future results. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2013 included in the Company’s most recent Annual Report on Form 10-K.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The condensed consolidated financial statements of the Company are prepared in accordance with GAAP and include the accounts of SquareTwo and its subsidiaries. SquareTwo owns the following subsidiaries: ReFinance America, Ltd.; CACV of Colorado, LLC; CACH, LLC; Collect Air, LLC; Healthcare Funding Solutions, LLC; SquareTwo Financial Commercial Funding Corporation, Collect America of Canada, LLC, and certain other inactive entities not listed. Collect America of Canada, LLC has a wholly-owned subsidiary, SquareTwo Financial Canada Corporation, which has an 86% ownership interest in CCL Financial Inc. ("CCL"). CCL is a consolidated subsidiary of the Company. As previously disclosed, Parent owns 100% of the outstanding equity of SquareTwo and all other Parent investments are dormant. All material expenses incurred by Parent on SquareTwo’s behalf have been allocated to SquareTwo and are reflected in the condensed consolidated financial statements of SquareTwo. All significant intercompany transactions and balances have been eliminated in consolidation.
SquareTwo has two reportable operating segments, as defined by the Financial Accounting Standards Board's ("FASB") Accounting Standards Codification ("ASC") Topic 280, Segment Reporting (“ASC 280”): Domestic and Canada.
6
Accounting Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes.
Actual results could differ from those estimates. The Company's condensed consolidated financial statements are based on a number of significant estimates, including the collectability of purchased debt and the timing of such proceeds, impairment testing of goodwill and the branch office network indefinite-lived intangible asset, and accounting for income taxes. Due to the uncertainties inherent in the estimation process, it is at least reasonably possible that the Company's estimates in connection with these items could be materially revised within the near term.
Revenue Recognition from Purchased Debt
Purchased debt represents receivables that have been charged-off as uncollectible by the originating organization and that may or may not have been subject to previous collection efforts. Through its subsidiaries, the Company purchases the rights to the unrecovered balances owed by individual customers from various financial institutions at a substantial discount from face value and records the purchase at the Company's cost to acquire the portfolio.
We account for our purchased debt under the guidance of ASC Topic 310-30, "Loans and Debt Securities Acquired with Deteriorated Credit Quality" ("ASC 310-30"). Under ASC 310-30, static pools of purchased debt may be established and accounted for under either the interest method of accounting (referred to by us as "level yield") or the cost recovery method of accounting. These pools are aggregated based on certain common risk criteria. Each static pool is recorded at cost and is accounted for as a single unit for the recognition of income, reduction of carrying value and any valuation allowance. Once a static pool is established, individual accounts are not added to or removed from the pool. Purchased debt accounted for under our level yield method of accounting is pooled each quarter, whereas purchased debt accounted for under cost recovery is pooled by each individual purchase. The cost recovery method prescribed by ASC 310-30 is required when cash proceeds on a particular purchase cannot be reasonably predicted in timing or amount. Purchased debt accounted for under the cost recovery method is comprised of Canadian portfolios acquired prior to January 1, 2012, commercial, student loan, medical, and any other purchases in the U.S. or Canada for which we do not have the necessary experience to forecast the timing and amount of cash flows. For purchased debt that we believe we can reasonably forecast the timing and amount of our cash proceeds we utilize the level yield method.
Level Yield Method
Most of our purchased debt is accounted for under the level yield method of accounting. Under the level yield method of accounting, cash proceeds on each static pool are allocated to both revenue and to reduce the carrying value (the purchased debt, net line item on the condensed consolidated balance sheets) based on an estimated gross internal rate of return ("IRR") for that pool. We determine the applicable IRR for each static pool based on our estimate of the expected cash proceeds of that pool which is based on our estimated remaining proceeds ("ERP") for the static pool, and the rate of return required to reduce the carrying value of that pool to zero over its estimated life. Each pool's IRR is typically determined using an expected life of six to nine years. As described below, if cash proceeds for a pool deviate from the forecast in timing or amount, we adjust the carrying value of the pool or its IRR (which determines our future revenue recognition), as applicable.
Purchased debt portfolios with similar economic characteristics accounted for under the level yield method are accumulated into static pools on a quarterly basis. Cash proceeds on a pool that are greater than the revenue recognized in accordance with the established IRR will reduce the carrying value of the static pool (also referred to as "amortization" of the pool). Cash proceeds on a pool that are lower than the revenue recognized in accordance with the established IRR will increase the carrying value of the static pool as required by ASC 310-30.
The expected trends of each pool are analyzed at least quarterly. If these trends are different than the original estimates, certain adjustments may be required. Each quarter, we use our ERP to determine our estimate of future cash proceeds for each pool. We then use all factors available, such as the types of assets within the pool, our experience with those assets, the age of the pool, any recent fluctuations in our recovery rates from the various channels we collect from, and where that pool is in its own collection life cycle. We use these factors for each static pool to determine a range of future proceeds, which becomes smaller as we gain more experience with each static pool. We determine our best estimate of future proceeds within that range, which may be used for adjustments to our revenue recognition, or for our determination of allowance charges.
7
Using our best estimate of future proceeds, if we estimate a reduction or delay in the receipt of the aggregate future cash proceeds on a pool, a valuation allowance may be recognized and the original IRR remains unchanged. The valuation allowance is determined to the extent that the present value (using the established IRR) of the revised future cash proceeds is less than the current carrying value of the pool. If we estimate an increase in the aggregate future cash proceeds or an acceleration of the timing of future cash proceeds on a pool, the IRR may be increased prospectively to reflect revised best estimates of those future cash proceeds over the remaining life of the pool. If there was a previous valuation allowance taken, reversal of the previously recognized valuation allowance occurs prior to any increases to the IRR. ASC 310-30 requires that each pool be evaluated independently and does not allow netting across pools. Thus, even in periods of increasing cash proceeds for our entire purchased debt portfolio, we may be required to record a valuation allowance. Allowance charges for purchased debt are included as adjustments to the purchased debt revenue, net line item in the condensed consolidated statements of operations.
Canadian purchases made on or after January 1, 2012 are being accounted for under the level yield method unless we are unable to reasonably forecast the timing and amount of cash proceeds. Purchases eligible for the level yield method are being accumulated into static pools on a quarterly basis separately from U.S. purchases.
Cost Recovery Method
Treatment of cash proceeds under the cost recovery method differs from treatment under the level yield method. Under the cost recovery method, as cash proceeds, excluding court cost recoveries, less collection fees paid are received, they directly reduce the carrying value of the purchased debt. For every dollar recorded as a fee paid to the branch offices or third party collection firms, there is a corresponding dollar recorded as revenue in the purchased debt revenue, net line item in the condensed consolidated statements of operations (i.e. the expense and revenue amounts are equal). Once the purchase's carrying value has been reduced to zero, all cash proceeds, excluding court cost recoveries, are recorded as revenues. Court cost recoveries received for purchased debt accounted for under the cost recovery method of accounting are netted against court cost expenditures in the court costs, net line item in the condensed consolidated statements of operations. As compared to the level yield method of accounting, the cost recovery method of accounting generally results in a more rapid reduction in the carrying value of purchased debt and slower recognition of revenue with respect thereto.
We assess our purchased debt accounted for under the cost recovery method at least annually, or more frequently if necessary, to determine if a valuation allowance is necessary. If the carrying value of a purchase is greater than our best estimate of future cash proceeds, excluding court cost recoveries, net of the fees expected to be paid for collections on that purchase, we record a valuation allowance for the difference. In the instance that our best estimate of future cash proceeds, excluding court cost recoveries, increases for a cost recovery purchase that had a valuation allowance previously recorded, we may reverse a portion or the entire valuation allowance, as estimates indicate. Similar to our process to determine our revenue recognition, or allowance charges for our level yield pools as described above, we use all factors available, and our ERP to determine our best estimate of future cash proceeds for our purchased debt accounted for under the cost recovery method.
Reclassifications
Certain reclassifications have been made to prior year amounts in order to conform to the current year presentation. The Company has revised the presentation of its condensed consolidated statement of operations for all the periods presented to provide improved visibility and comparability with the current year presentation.
Recently Issued Accounting Pronouncements
In March 2013, the FASB issued ASU No. 2013-05, "Foreign Currency Matters (Topic 830): Parent's Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity." ASU No. 2013-05 amends the requirements for a parent entity's accounting for the cumulative translation adjustment upon derecognition of certain subsidiaries or groups of assets within a foreign entity or of an investment in a foreign entity. A parent entity is required to release any cumulative translation adjustment into net income if: (i) a parent entity ceases to have a controlling financial interest in a subsidiary or group of assets that is a business within a foreign entity if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided; (ii) a partial sale of an equity method investment; (iii) a partial sale of an equity method investment that is not a foreign entity when the partial sale represents a complete or substantially complete liquidation of the foreign entity that contains the equity method investment; and (iv) the sale of an investment in a foreign entity with certain other characteristics. The amendments in this update are effective prospectively for fiscal years and interim reporting periods beginning after December 15, 2013. The Company's adoption of ASU No. 2013-05 did not to have a material impact on the Company's financial position or results of operations.
8
In July 2013, the FASB issued ASU No. 2013-11, "Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Credit Carryforward Exists." ASU No. 2013-11 provides explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The amendments in this update are effective for fiscal years and interim reporting periods beginning after December 15, 2013, and should be applied prospectively for all unrecognized tax benefits that exist as of the effective date. ASU No. 2013-11 does not have an impact on the Company's consolidated financial statements.
In May 2014, the FASB and the IASB issued ASU No. 2014-09, "Revenue from Contracts with Customers." ASU No. 2014-09 is a comprehensive new revenue recognition standard that supersedes virtually all existing revenue guidance under US GAAP and IFRS. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under current guidance. The Company will be required to apply the standard retrospectively in the first quarter of 2017. The Company is in the process of determining the impact this standard may have on its financial statements.
In June 2014, the FASB issued ASU No. 2014-11, "Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures.” ASU No. 2014-11 amends prior accounting and disclosure requirements for repurchase-to-maturity transactions and repurchase financing arrangements and will be effective for the Company in the first quarter of 2015. ASU No. 2014-11 does not have an impact on the Company's consolidated financial statements.
In June 2014, the FASB issued ASU No. 2014-12, "Compensation-Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period.” ASU No. 2014-12 provides explicit guidance regarding share-based payments where the performance target could be achieved post-termination of employment and will be effective for the Company in the first quarter of 2016. As the Company, at times, issues these types of compensation arrangements, when applicable, this guidance will be used. ASU No. 2014-12 does not have an impact on the Company's consolidated financial statements at this time.
3. Purchased Debt
Changes in purchased debt, net for the periods presented were as follows:
Three Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Balance at beginning of period | $ | 240,314 | $ | 226,712 | $ | 17,272 | $ | 27,138 | $ | 257,586 | $ | 253,850 | ||||||||||||
Purchases | 39,617 | 91,580 | 2,435 | 3,401 | 42,052 | 94,981 | ||||||||||||||||||
Valuation allowance reversals (charges) | 318 | 5,255 | — | (2,888 | ) | 318 | 2,367 | |||||||||||||||||
Proceeds applied to purchased debt principal | (43,775 | ) | (56,567 | ) | (2,858 | ) | (4,618 | ) | (46,633 | ) | (61,185 | ) | ||||||||||||
Other(1) | 386 | (451 | ) | 11 | 8 | 397 | (443 | ) | ||||||||||||||||
Balance at end of period | $ | 236,860 | $ | 266,529 | $ | 16,860 | $ | 23,041 | $ | 253,720 | $ | 289,570 |
Six Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Balance at beginning of period | $ | 254,419 | $ | 230,773 | $ | 19,938 | $ | 20,909 | $ | 274,357 | $ | 251,682 | ||||||||||||
Purchases | 64,362 | 143,095 | 3,454 | 14,156 | 67,816 | 157,251 | ||||||||||||||||||
Valuation allowance reversals (charges) | 523 | 6,621 | — | (2,870 | ) | 523 | 3,751 | |||||||||||||||||
Proceeds applied to purchased debt principal | (82,376 | ) | (113,271 | ) | (6,524 | ) | (9,419 | ) | (88,900 | ) | (122,690 | ) | ||||||||||||
Other(1) | (68 | ) | (689 | ) | (8 | ) | 265 | (76 | ) | (424 | ) | |||||||||||||
Balance at end of period | $ | 236,860 | $ | 266,529 | $ | 16,860 | $ | 23,041 | $ | 253,720 | $ | 289,570 |
9
(1) Other includes impacts of the Company’s currency translation, branch office asset purchase program (discontinued), and recovery of step-up in basis on purchased debt.
The following tables show the relationship of purchased debt proceeds to gross revenue recognized and proceeds applied to principal during the following periods:
Three Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Proceeds | $ | 99,171 | $ | 130,584 | $ | 12,733 | $ | 16,398 | $ | 111,904 | $ | 146,982 | ||||||||||||
Less: | ||||||||||||||||||||||||
Gross revenue recognized | 55,396 | 74,017 | 9,561 | 11,408 | 64,957 | 85,425 | ||||||||||||||||||
Cost recovery court cost recoveries(1) | — | — | 314 | 372 | 314 | 372 | ||||||||||||||||||
Proceeds applied to purchased debt principal | 43,775 | 56,567 | 2,858 | 4,618 | 46,633 | 61,185 | ||||||||||||||||||
$ | — | $ | — | $ | — | $ | — | $ | — | $ | — |
Six Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Proceeds | $ | 198,652 | $ | 260,946 | $ | 25,492 | $ | 32,909 | $ | 224,144 | $ | 293,855 | ||||||||||||
Less: | ||||||||||||||||||||||||
Gross revenue recognized | 116,276 | 147,675 | 18,332 | 22,755 | 134,608 | 170,430 | ||||||||||||||||||
Cost recovery court cost recoveries(1) | — | — | 636 | 735 | 636 | 735 | ||||||||||||||||||
Proceeds applied to purchased debt principal | 82,376 | 113,271 | 6,524 | 9,419 | 88,900 | 122,690 | ||||||||||||||||||
$ | — | $ | — | $ | — | $ | — | $ | — | $ | — |
(1) Cost recovery court cost recoveries are recorded as a contra expense in the court costs, net line item in the condensed consolidated statements of operations.
The following tables reconcile gross revenue recognized to purchased debt revenues, net for the following periods:
Three Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Gross revenue recognized | $ | 55,396 | $ | 74,017 | $ | 9,561 | $ | 11,408 | $ | 64,957 | $ | 85,425 | ||||||||||||
Purchased debt royalties | 1,348 | 2,427 | 258 | 343 | 1,606 | 2,770 | ||||||||||||||||||
Valuation allowance reversals (charges) | 318 | 5,255 | — | (2,888 | ) | 318 | 2,367 | |||||||||||||||||
Other(1) | — | — | (43 | ) | (63 | ) | (43 | ) | (63 | ) | ||||||||||||||
Purchased debt revenue, net | $ | 57,062 | $ | 81,699 | $ | 9,776 | $ | 8,800 | $ | 66,838 | $ | 90,499 |
Six Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Gross revenue recognized | $ | 116,276 | $ | 147,675 | $ | 18,332 | $ | 22,755 | $ | 134,608 | $ | 170,430 | ||||||||||||
Purchased debt royalties | 2,804 | 4,925 | 482 | 706 | 3,286 | 5,631 | ||||||||||||||||||
Valuation allowance reversals (charges) | 523 | 6,621 | — | (2,870 | ) | 523 | 3,751 | |||||||||||||||||
Other(1) | — | — | (89 | ) | (166 | ) | (89 | ) | (166 | ) | ||||||||||||||
Purchased debt revenue, net | $ | 119,603 | $ | 159,221 | $ | 18,725 | $ | 20,425 | $ | 138,328 | $ | 179,646 |
(1) Other items relate to certain profit sharing items that reduce the Company’s revenue recorded on purchased debt, the branch office asset purchase program (discontinued), and recovery of step-up in basis.
10
The following tables show detail of the Company’s purchases during the following periods:
Three Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Purchase price | $ | 39,617 | $ | 91,580 | $ | 2,435 | $ | 3,401 | $ | 42,052 | $ | 94,981 | ||||||||||||
Face value | 286,787 | 975,124 | 54,020 | 75,272 | 340,807 | 1,050,396 | ||||||||||||||||||
% of face | 13.8 | % | 9.4 | % | 4.5 | % | 4.5 | % | 12.3 | % | 9.0 | % |
Six Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Purchase price | $ | 64,362 | $ | 143,095 | $ | 3,454 | $ | 14,156 | $ | 67,816 | $ | 157,251 | ||||||||||||
Face value | 471,204 | 1,580,547 | 90,400 | 263,840 | 561,604 | 1,844,387 | ||||||||||||||||||
% of face | 13.7 | % | 9.1 | % | 3.8 | % | 5.4 | % | 12.1 | % | 8.5 | % |
Accretable yield represents the difference between the ERP of our purchased debt accounted for under the level yield method and the carrying value of those assets. The ERP is used in determining our revenue recognition, and adjustments to our revenue recognition, for our purchased debt accounted for under the level yield method, which is described in further detail in Note 2.
In the three months ended June 30, 2014, the Company spent $39.6 million in capital to acquire purchased debt that qualified for the level yield method of accounting. The corresponding face amount (or the actual amount owed by the customers) of the debt purchased was $286.8 million, which is a purchase price equal to 13.8% of the face amount. The ERP expected at acquisition for level yield portfolios purchased during the three months ended June 30, 2014 amounted to $55.9 million. The accretable yield for these purchases was $16.2 million, or the ERP of $55.9 million less the purchase price of $39.6 million. During six months ended June 30, 2014, the Company purchased $471.2 million in face value debt that qualified for the level yield method of accounting for a purchase price of $64.4 million. The ERP at acquisition amounted to $93.8 million.
The following represents the change in accretable yield for the three months ended June 30, 2014 and 2013:
2014 | 2013 | |||||||
Balance at December 31, prior year | $ | 523,006 | $ | 596,849 | ||||
Impact from revenue recognized on purchased debt, net | (61,085 | ) | (75,024 | ) | ||||
Additions from current purchases | 13,150 | 62,109 | ||||||
Reclassifications to accretable yield, including foreign currency translation | 13,555 | 10,475 | ||||||
Balance at March 31, | $ | 488,626 | $ | 594,409 | ||||
Impact from revenue recognized on purchased debt, net | (55,714 | ) | (79,272 | ) | ||||
Additions from current purchases | 16,241 | 72,278 | ||||||
Reclassifications to accretable yield, including foreign currency translation | (10,751 | ) | 12,639 | |||||
Balance at June 30, | $ | 438,402 | $ | 600,054 |
11
The changes in the valuation allowance for the Company’s purchased debt during the periods presented are as follows:
Three Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Balance at beginning of period | $ | 125,879 | $ | 135,236 | $ | 17,584 | $ | 13,696 | $ | 143,463 | $ | 148,932 | ||||||||||||
Valuation allowance (reversals) charges | (318 | ) | (5,255 | ) | — | 2,888 | (318 | ) | (2,367 | ) | ||||||||||||||
Balance at end of period | $ | 125,561 | $ | 129,981 | $ | 17,584 | $ | 16,584 | $ | 143,145 | $ | 146,565 |
Six Months Ended | ||||||||||||||||||||||||
Level Yield | Cost Recovery | Totals | ||||||||||||||||||||||
June 30, | June 30, | June 30, | ||||||||||||||||||||||
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | |||||||||||||||||||
Balance at beginning of period | $ | 126,084 | $ | 136,602 | $ | 17,584 | $ | 13,714 | $ | 143,668 | $ | 150,316 | ||||||||||||
Valuation allowance (reversals) charges | (523 | ) | (6,621 | ) | — | 2,870 | (523 | ) | (3,751 | ) | ||||||||||||||
Balance at end of period | $ | 125,561 | $ | 129,981 | $ | 17,584 | $ | 16,584 | $ | 143,145 | $ | 146,565 |
4. Goodwill and Other Intangibles
Indefinite lived intangible assets consist of goodwill and the value of the Company’s branch offices and were identified as part of purchase accounting at the date of the Acquisition. The Company tests its indefinite lived intangibles annually for impairment unless there is a triggering event during an interim period that would necessitate testing.
We have two operating segments: Domestic and Canada. In accordance with FASB ASC Topic 350, Intangibles-Goodwill and Other (“ASC 350”), we have deemed our operating segments to be reporting units for the purpose of testing goodwill for impairment.
The following is a summary of intangibles:
June 30, 2014 | December 31, 2013 | |||||||
Goodwill | $ | 146,458 | $ | 146,458 | ||||
Branch office intangible | 24,890 | 24,890 | ||||||
Total intangible assets | $ | 171,348 | $ | 171,348 |
5. Notes Payable and Other Borrowings
Line of Credit
During the three months ended June 30, 2014, SquareTwo Financial Corporation and certain of SquareTwo Financial Corporations' subsidiaries entered into Amendment No. 5 to its Loan Agreement ("Amendment No. 5") for the senior revolving credit facility. Pursuant to the terms of Amendment No. 5, the following adjustments have been made to the Loan Agreement: (i) the formula which determines the maximum amount of borrowings has been modified to include Canadian Estimated Remaining Proceeds and (ii) the collateral pool securing the loan has been modified to include Canadian assets. The remaining terms of the Loan Agreement were not impacted by Amendment No. 5.
The following is a listing of the Company’s outstanding line of credit borrowings, balances, and interest rates under the revolving credit facility:
June 30, 2014 | December 31, 2013 | |||||||||||||||||
Type of Debt | Weighted Average Interest Rate(1) | Balance | Maturity | Weighted Average Interest Rate(1) | Balance | Maturity | ||||||||||||
Line of Credit US | 4.8 | % | $ | 144,785 | April 2016 | 4.9 | % | $ | 145,269 | April 2016 | ||||||||
Line of Credit Canada | 5.8 | % | — | April 2016 | 5.8 | % | — | April 2016 | ||||||||||
Total Line of Credit | $ | 144,785 | $ | 145,269 |
(1) Weighted average interest rates exclude the impact of amortization of fees associated with the origination of these instruments.
12
The remaining unamortized costs of the facility were $1,451 and $1,673 at June 30, 2014 and December 31, 2013, respectively, and are included in the other assets line on the condensed consolidated balance sheets. These costs are amortized on a straight-line basis over the remaining term of the facility. The Company had accrued interest on its lines of credit of $87 and $122 at June 30, 2014 and December 31, 2013, respectively, which are included in the accrued interest and other liabilities line item on the condensed consolidated balance sheets.
At June 30, 2014, our availability under the line of credit facility was $75.3 million based on our borrowing base calculation.
Notes Payable
The following is a listing of the Company’s outstanding notes payable borrowings, balances, and interest rates:
June 30, 2014 | December 31, 2013 | |||||||||||||||||
Type of Debt | Weighted Average Interest Rate(1) | Balance | Maturity | Weighted Average Interest Rate(1) | Balance | Maturity | ||||||||||||
Senior Second Lien Notes, net of $1,990 and $2,350 unamortized discount | 11.625 | % | $ | 288,010 | April 2017 | 11.625 | % | $ | 287,650 | April 2017 | ||||||||
Other Notes Payable | 5.6 | % | 1,387 | 2015 - 2021 | 5.5 | % | 1,764 | 2015 - 2021 | ||||||||||
Total Notes Payable | $ | 289,397 | $ | 289,414 |
(1) Weighted average interest rates exclude the impact of the amortization of fees associated with the origination of these instruments.
The remaining unamortized costs of the Senior Second Lien Notes were $3,545 and $4,185 at June 30, 2014 and December 31, 2013, respectively, and are included in the other assets line on the condensed consolidated balance sheets. These costs are amortized on a straight-line basis over the term of the notes.
The Company had accrued interest on its Senior Second Lien Notes payable of $8,428 at June 30, 2014 and at December 31, 2013, which is included in the accrued interest and other liabilities line item on the condensed consolidated balance sheets.
Covenants
The senior revolving credit facility, as amended, and the Senior Second Lien Notes have certain covenants and restrictions, as is customary for such facilities, with which the Company must comply. As of June 30, 2014, the Company was in compliance with all covenants and restrictions of the revolving credit facility and Senior Second Lien Notes.
Letters of Credit
The Company had outstanding letters of credit totaling $492 at June 30, 2014 and December 31, 2013. At June 30, 2014 letters of credit totaling $492 had not been drawn on and remained outstanding. The letters of credit have been issued to provide support in connection with our licensing applications.
6. Stockholder's Equity
Common Stock
As of June 30, 2014 and December 31, 2013, the Company is authorized to issue 1,000 shares, all of which are reserved as common stock, with 1,000 shares outstanding with a par value of $0.001 per share. There are no other equity shares outstanding that would take preference over the common stock in the instance that the Company pays dividends or liquidates. The outstanding shares are voting common stock and are owned 100% by Parent.
Non-Controlling Interest
The Company holds a controlling interest of approximately 86% in its Canadian subsidiary, CCL. The portions of net income and comprehensive income attributable to the non-controlling interest in CCL are shown on our condensed consolidated statements of operations and condensed consolidated statements of comprehensive (loss) income.
13
Accumulated Other Comprehensive Loss
During the six months ended June 30, 2014 and 2013, accumulated other comprehensive loss included currency translation adjustments resulting from converting transactions and balances related to our Canada segment's operations from Canadian dollars to U.S. dollars. The following is a summary of the changes in accumulated other comprehensive loss during the six months ended June 30, 2014 and 2013:
Accumulated Other Comprehensive Loss | Currency Translation Adjustment | Total Accumulated Other Comprehensive Loss | ||||||
Balance, December 31, 2013 | $ | (1,347 | ) | $ | (1,347 | ) | ||
Other comprehensive income, net of tax of $0, before reclassifications | 64 | 64 | ||||||
Amounts reclassified from accumulated other comprehensive income | — | — | ||||||
Balance, June 30, 2014 | $ | (1,283 | ) | $ | (1,283 | ) |
Accumulated Other Comprehensive Loss | Currency Translation Adjustment | Total Accumulated Other Comprehensive Loss | ||||||
Balance, December 31, 2012 | $ | (111 | ) | $ | (111 | ) | ||
Other comprehensive loss, net of tax of $0, before reclassifications | (1,129 | ) | (1,129 | ) | ||||
Amounts reclassified from accumulated other comprehensive income | — | — | ||||||
Balance, June 30, 2013 | $ | (1,240 | ) | $ | (1,240 | ) |
7. Fair Value of Financial Instruments
ASC 820, "Fair Value Measurements and Disclosures", defines fair value based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. ASC 820 establishes a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value. The fair value hierarchy consists of three broad levels, which are described below:
· Level 1-Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.
· Level 2-Inputs other than quoted prices included in Level 1, that are observable for the asset or liability, either directly or indirectly, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
· Level 3-Unobservable inputs that are supported by little, if any, market activity and that are significant to the fair value of the assets and liabilities. This includes certain pricing models, discounted cash flow methodologies and similar techniques that use significant unobservable inputs.
Purchased Debt Receivables
The Company initially records purchased debt receivables at cost. Purchased debt receivables, for which a valuation allowance has not been recorded, are subsequently recorded net of amortization under the interest method or the cost recovery method as discussed previously in Note 2. If a valuation allowance is required for a level yield pool, the Company records that portion of the total purchased debt balance by discounting the future cash flows generated by its proprietary forecasting model using the IRR as a discount rate. Valuation allowances for cost recovery pools are determined using the Company's proprietary forecasting model cash flows, which are undiscounted.
14
Estimated Fair Value
The following tables display the carrying value and estimated fair value of the Company's financial instruments held in accordance with ASC 820-10-50-2E at June 30, 2014 and December 31, 2013:
June 30, 2014 | ||||||||||||||||||||
Carrying amounts | Estimated fair value | Level 1 | Level 2 | Level 3 | ||||||||||||||||
Purchased debt(1) | $ | 253,720 | $ | 614,765 | $ | — | $ | — | $ | 614,765 | ||||||||||
Line of credit(2) | 144,785 | 144,785 | — | 144,785 | — | |||||||||||||||
Senior Second Lien Notes, net of $1,990 unamortized discount(3) | 288,010 | 286,559 | 286,559 | — | — | |||||||||||||||
Other Notes Payable(4) | 1,387 | 1,387 | — | 1,387 | — |
December 31, 2013 | ||||||||||||||||||||
Carrying amounts | Estimated fair value | Level 1 | Level 2 | Level 3 | ||||||||||||||||
Purchased debt(1) | $ | 274,357 | $ | 658,676 | $ | — | $ | — | $ | 658,676 | ||||||||||
Line of credit(2) | 145,269 | 145,269 | — | 145,269 | — | |||||||||||||||
Senior Second Lien Notes, net of $2,350 unamortized discount(3) | 287,650 | 295,987 | 295,987 | — | — | |||||||||||||||
Other Notes Payable(4) | 1,764 | 1,764 | — | 1,764 | — |
(1) The Company's estimated fair value of purchased debt has been determined using our consolidated ERP discounted using a rate that approximates our weighted average cost of capital. Our ERP expectations are based on historical data as well as assumptions about future collection rates and customer behavior. The estimated fair value of purchased debt should not be construed to represent the underlying value of the Company.
(2) The Company has both a domestic and Canadian revolving credit facility. These instruments contain variable borrowing rates that are based in part on observed available market interest rates. As a result, the Company believes the carrying values of these instruments approximate fair value.
(3) The fair value of our Senior Second Lien Notes is based on recently observed available market trading metrics.
(4) We estimated the fair value of these notes to approximate carrying value, as the applicable interest rates of the notes approximate those of our other current borrowings, which are based in part on observable market rates.
The carrying values of cash and cash equivalents, accounts receivable and payable, accrued expenses, and notes receivable are considered to approximate fair value due to the short-term nature of these instruments.
8. Income Taxes
For financial statement reporting purposes, the Company is treated as a stand-alone entity, and therefore all components of the provision for, or benefit from income taxes as well as the deferred tax assets and liabilities recognized herein reflect only the financial results and position of SquareTwo. For income tax purposes, the Company is included in the consolidated return of Parent. Parent files income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. Parent's U.S. federal income tax returns were last examined for the tax year ended December 31, 2004, and Parent potentially remains subject to examination for all tax years ended on or after December 31, 2009.
For the three and six months ended June 30, 2014 the combined state, federal and Canadian tax expense from operations was $2.1 million and $3.1 million, respectively. These amounts are comprised of foreign taxes on Canadian operations based on an effective tax rate of approximately 26.5% as well as a $1.1 million expense in the U.S. recognized during the second quarter as a result of the Company’s pledge of its Canadian assets as collateral on U.S. borrowings in connection with Amendment No. 5 to the revolving credit agreement. Any tax benefits related to pretax losses generated by the Company’s ongoing U.S. operations during the first and second quarter of 2014 have been fully offset by a corresponding increase in the valuation allowance as the Company remains in a full valuation allowance position at June 30, 2014.
Under Section 956 of the U.S. Internal Revenue Code ("IRC"), the pledge of Canadian assets generates taxable income in the U.S. equal to the lesser of the outstanding amount of borrowings being guaranteed or the accumulated undistributed earnings and profits (“E&P”) of the Canadian entities that have pledged assets. In accordance with accounting for income taxes, the Company had previously asserted to permanently reinvest its Canadian E&P up through the year ended December 31, 2012, and accordingly, it had not accounted for those earnings as part of its provision for income taxes at December 31, 2013 or before. As a result of the foreign pledge of assets, the Company no longer asserts the permanent reinvestment criteria with respect to its Canadian earnings.
15
While virtually all of the IRC Section 956 income generated in the U.S. during the second quarter of 2014 can be offset by the Company’s net operating losses in the U.S., the $1.1 million expense relates specifically to withholding taxes on the amount of the deemed distribution under IRC Section 956, which would be payable in Canada upon an actual distribution in the future. Therefore, to the extent the amount of Canadian E&P deemed distributed is not actually repatriated to the U.S., the withholding tax will not be paid.
9. Commitments and Contingencies
Forward Commitments to Purchase Debt
The Company from time to time enters into forward flow purchase agreements with various debt sellers to purchase specified amounts of debt for designated prices. These contracts typically cover a year or less and can generally be canceled by the Company at its discretion with 30-60 days’ notice. At June 30, 2014 the Company did not have any significant non-cancelable forward flow purchase agreements.
Litigation
From time to time the Company is a defendant in ordinary routine litigation alleging violations of applicable state and federal laws by the Company or the branch offices acting on its behalf that is incidental to our business. These suits may include actions which may purport to be on behalf of a class of consumers. While the litigation and regulatory environment is challenging and continually changing, for the Company, our branch offices and our industry, in our opinion, such matters will not individually, or in the aggregate, result in a materially adverse effect on the Company's financial position, results of operations or cash flows. Management believes the range of reasonably possible loss for outstanding claims is between zero and $1.5 million. The Company accrues for loss contingencies as they become probable and estimable.
10. Segment Information
In its operation of the business, the chief operating decision maker ("CODM"), our Chief Executive Officer, reviews certain financial information, including segment statements of profitability prepared on a basis not consistent with GAAP. The segment information within this note is reported on that basis. The CODM evaluates this information in deciding how to allocate resources and in assessing performance. The Company has two reportable operating segments: Canada operations and Domestic operations, which have been determined based on the way our Board of Directors, the CODM, and our Senior Leadership Team review the Company's strategy and performance.
The accounting policies of our two segments are the same as those described in the summary of significant accounting policies in Note 2. Canadian purchases made on or after January 1, 2012 are being accounted for under the level yield method unless we are unable to reasonably forecast the timing and amount of cash proceeds. Purchases eligible for the level yield method are accumulated into static pools on a quarterly basis separately from U.S. purchases.
The following tables present the Company's operating segment results for the three and six months ended June 30, 2014 and June 30, 2013:
Cash Proceeds on Purchased Debt:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
Cash Proceeds on Purchased Debt | 2014 | 2013 | 2014 | 2013 | ||||||||||||
Domestic | $ | 100,352 | $ | 134,137 | $ | 202,338 | $ | 269,046 | ||||||||
Canada | 11,552 | 12,845 | 21,806 | 24,809 | ||||||||||||
Consolidated | $ | 111,904 | $ | 146,982 | $ | 224,144 | $ | 293,855 |
16
Total Revenues:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
Total Revenues | 2014 | 2013 | 2014 | 2013 | ||||||||||||
Domestic | $ | 59,845 | $ | 83,010 | $ | 125,204 | $ | 165,034 | ||||||||
Canada | 7,002 | 7,640 | 13,152 | 15,003 | ||||||||||||
Consolidated | $ | 66,847 | $ | 90,650 | $ | 138,356 | $ | 180,037 |
Adjusted EBITDA:
Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
Adjusted EBITDA(1) | 2014 | 2013 | 2014 | 2013 | ||||||||||||
Domestic | $ | 45,432 | $ | 69,449 | $ | 92,203 | $ | 140,972 | ||||||||
Canada | 8,378 | 9,503 | 15,799 | 16,756 | ||||||||||||
Consolidated | $ | 53,810 | $ | 78,952 | $ | 108,002 | $ | 157,728 |
(1) Segment Adjusted EBITDA is calculated consistently with the methodology used to report the Company's consolidated Adjusted EBITDA, except with regard to the costs of certain overhead items that may benefit both operating segments. The costs of these overhead items are included in the calculation of Domestic Adjusted EBITDA, but have not been allocated to Canada. This treatment of certain overhead costs is consistent with CODM review.
Segment net income or loss is not presented herein, which is consistent with the CODM's review of segment information. The table below reconciles consolidated net (loss) income to consolidated Adjusted EBITDA:
Reconciliation of Net (loss) Income to Adjusted EBITDA ($ in thousands) | Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
2014 | 2013 | 2014 | 2013 | |||||||||||||
Net (loss) income | $ | (7,517 | ) | $ | 4,374 | $ | (9,663 | ) | $ | 7,704 | ||||||
Interest expense | 11,075 | 11,605 | 22,084 | 23,383 | ||||||||||||
Interest income | (38 | ) | (21 | ) | (57 | ) | (36 | ) | ||||||||
Income tax expense | 2,071 | 1,940 | 3,108 | 2,590 | ||||||||||||
Depreciation and amortization | 1,706 | 1,997 | 3,348 | 3,911 | ||||||||||||
EBITDA | 7,297 | 19,895 | 18,820 | 37,552 | ||||||||||||
Adjustments related to purchased debt accounting | ||||||||||||||||
Proceeds applied to purchased debt principal(1) | 46,633 | 61,185 | 88,900 | 122,690 | ||||||||||||
Amortization of step-up of carrying value(2) | — | — | — | 107 | ||||||||||||
Purchased debt valuation allowance reversals(3) | (318 | ) | (2,367 | ) | (523 | ) | (3,751 | ) | ||||||||
Certain other or non-cash expenses | ||||||||||||||||
Stock option expense(4) | 25 | 33 | 49 | 67 | ||||||||||||
Other(5) | 173 | 206 | 756 | 1,063 | ||||||||||||
Adjusted EBITDA | $ | 53,810 | $ | 78,952 | $ | 108,002 | $ | 157,728 |
(1) Cash proceeds applied to purchased debt principal rather than recorded as revenue.
(2) Non-cash amortization of a step-up in the carrying value of certain purchased debt assets related to purchase accounting adjustments resulting from the 2005 acquisition of the Company by Parent.
(3) Represents non-cash valuation allowance reversals on purchased debt.
(4) Represents the non-cash expense related to option grants of Parent’s equity granted to certain employees, directors and branch office owners.
(5) Consistent with the covenant calculations within our revolving credit facility, other includes branch office note reserves, lease breakup costs, certain consulting fees, management fees paid to KRG, certain transaction expenses, recruiting expense, severance expense, and certain non-recurring items.
17
The table below reconciles net cash provided by operating activities to Adjusted EBITDA:
Reconciliation of Cash Flow from Operations to Adjusted EBITDA ($ in thousands) | Six Months Ended June 30, | |||||||
2014 | 2013 | |||||||
Net cash (used in) provided by operating activities | $ | (10,003 | ) | $ | 6,639 | |||
Proceeds applied to purchased debt principal(1) | 88,900 | 122,690 | ||||||
Interest expense to be paid in cash(2) | 20,618 | 21,691 | ||||||
Interest income | (57 | ) | (36 | ) | ||||
Amortization of prepaid and other non-cash expenses | (2,084 | ) | (2,241 | ) | ||||
Changes in operating assets and liabilities and deferred taxes: | ||||||||
Restricted cash(3) | 822 | 196 | ||||||
Other operating assets and liabilities and deferred taxes(4) | 5,942 | 5,136 | ||||||
Income tax expense | 3,108 | 2,590 | ||||||
Other(5) | 756 | 1,063 | ||||||
Adjusted EBITDA | $ | 108,002 | $ | 157,728 |
(1) Cash proceeds applied to purchased debt principal are shown in the investing activities section of the condensed consolidated statements of cash flows.
(2) Represents interest expense, excluding non-cash amortization of loan origination fees and debt discount.
(3) Represents the change in restricted cash balances for the period due to the timing of payments on our lines of credit and semi-annual interest payments on our Senior Second Lien Notes.
(4) The amount represents timing differences due to the recognition of certain expenses and revenue items on a cash versus accrual basis.
(5) Consistent with the covenant calculations within our revolving credit facility, other includes branch office note reserves, lease breakup costs, certain consulting fees, management fees paid to KRG, certain transaction expenses, recruiting expense, severance expense, and certain non-recurring items.
Segment assets were as follows as of June 30, 2014 and December 31, 2013:
Total Assets | June 30, 2014 | December 31, 2013 | ||||||
Domestic | $ | 455,245 | $ | 474,175 | ||||
Canada | 29,875 | 24,229 | ||||||
Consolidated | $ | 485,120 | $ | 498,404 |
Long-lived assets, excluding financial instruments and deferred taxes, of our Canada segment were not material at June 30, 2014 or December 31, 2013.
11. Supplemental Guarantor Information
The payment obligations under the Senior Second Lien Notes (see Note 5) are fully and unconditionally guaranteed, jointly and severally, on a senior secured basis by substantially all of SquareTwo Financial Corporation’s (the “Borrower”) 100% owned existing and future domestic subsidiaries (“Guarantor Subsidiaries”). The Senior Second Lien Notes are not guaranteed by Parent.
The consolidating financial information presented below reflects information regarding the Borrower, the issuer of the Senior Second Lien Notes, the Guarantor Subsidiaries, and all other subsidiaries of the Borrower (“Non-Guarantor Subsidiaries”). This basis of presentation is not intended to present the financial condition, results of operations or cash flows of the Company, the Borrower, the Guarantor Subsidiaries or the Non-Guarantor Subsidiaries for any purpose other than to comply with the specific requirements for subsidiary guarantor reporting. The consolidating information is prepared in accordance with the same accounting policies as are applied to the Company’s condensed consolidated financial statements except for accounting for income taxes of the Guarantor Subsidiaries, which is reflected entirely in the Borrower’s financial statements as all material Guarantor Subsidiaries are disregarded entities for tax purposes and are combined with the Borrower in the consolidated income tax return of Parent.
18
The presentation of the Borrower’s financial statements represents the equity method of accounting for the Guarantor and Non-Guarantor Subsidiaries. The results of operations of the Guarantor and Non-Guarantor Subsidiaries reflects certain expense allocations from the Borrower, which are made in relation to the intercompany balances and the intercompany usage of the Borrower’s assets.
19
Condensed Consolidating Balance Sheets
June 30, 2014 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Assets | ||||||||||||||||||||
Cash and cash equivalents | $ | 42 | $ | 104 | $ | 16,382 | $ | — | $ | 16,528 | ||||||||||
Restricted cash | (1,129 | ) | 8,435 | — | — | 7,306 | ||||||||||||||
Receivables: | ||||||||||||||||||||
Trade, net of allowance for doubtful accounts | 1,520 | 35 | 977 | — | 2,532 | |||||||||||||||
Notes receivable | 193 | — | 210 | — | 403 | |||||||||||||||
Purchased debt, net | — | 242,199 | 11,521 | — | 253,720 | |||||||||||||||
Property and equipment, net | 23,734 | 60 | 188 | — | 23,982 | |||||||||||||||
Goodwill and intangible assets | 170,779 | — | 569 | — | 171,348 | |||||||||||||||
Other assets | 7,251 | 1,225 | 825 | — | 9,301 | |||||||||||||||
Investment in subsidiaries | 277,369 | — | — | (277,369 | ) | — | ||||||||||||||
Total assets | $ | 479,759 | $ | 252,058 | $ | 30,672 | $ | (277,369 | ) | $ | 485,120 | |||||||||
Liabilities and equity (deficiency) | ||||||||||||||||||||
Payables: | ||||||||||||||||||||
Accounts payable, trade | $ | 2,432 | $ | 132 | $ | 24 | $ | — | $ | 2,588 | ||||||||||
Payable from trust accounts | 1,840 | 62 | 104 | — | 2,006 | |||||||||||||||
Payable to Borrower | — | 357,314 | 1,550 | (358,864 | ) | — | ||||||||||||||
Taxes payable | — | — | 67 | — | 67 | |||||||||||||||
Accrued interest and other liabilities | 23,580 | 221 | 869 | — | 24,670 | |||||||||||||||
Deferred tax liability (asset) | 11,036 | — | (8 | ) | — | 11,028 | ||||||||||||||
Line of credit | 144,785 | — | — | — | 144,785 | |||||||||||||||
Notes payable, net of discount | 289,397 | — | — | — | 289,397 | |||||||||||||||
Obligations under capital lease agreements | 3,285 | — | — | — | 3,285 | |||||||||||||||
Total liabilities | 476,355 | 357,729 | 2,606 | (358,864 | ) | 477,826 | ||||||||||||||
Equity (deficiency) | ||||||||||||||||||||
Common stock | — | — | — | — | — | |||||||||||||||
Additional paid-in capital | 190,161 | 1,277 | 1 | (1,278 | ) | 190,161 | ||||||||||||||
(Accumulated deficit) retained earnings | (186,757 | ) | (106,948 | ) | 24,175 | 82,773 | (186,757 | ) | ||||||||||||
Accumulated other comprehensive loss | — | — | (1,283 | ) | — | (1,283 | ) | |||||||||||||
Total equity (deficiency) before noncontrolling interest | 3,404 | (105,671 | ) | 22,893 | 81,495 | 2,121 | ||||||||||||||
Noncontrolling interest | — | — | 5,173 | — | 5,173 | |||||||||||||||
Total equity (deficiency) | 3,404 | (105,671 | ) | 28,066 | 81,495 | 7,294 | ||||||||||||||
Total liabilities and equity (deficiency) | $ | 479,759 | $ | 252,058 | $ | 30,672 | $ | (277,369 | ) | $ | 485,120 |
20
December 31, 2013 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Assets | ||||||||||||||||||||
Cash and cash equivalents | $ | — | $ | — | $ | 9,379 | $ | — | $ | 9,379 | ||||||||||
Restricted cash | (647 | ) | 7,131 | — | — | 6,484 | ||||||||||||||
Receivables: | ||||||||||||||||||||
Trade, net of allowance for doubtful accounts | 1,113 | 9 | 864 | — | 1,986 | |||||||||||||||
Notes receivable | — | — | 212 | — | 212 | |||||||||||||||
Taxes receivable | — | — | 275 | — | 275 | |||||||||||||||
Purchased debt, net | — | 261,714 | 12,643 | — | 274,357 | |||||||||||||||
Property and equipment, net | 24,092 | 53 | 211 | — | 24,356 | |||||||||||||||
Goodwill and intangible assets | 170,779 | — | 569 | — | 171,348 | |||||||||||||||
Other assets | 8,023 | 1,119 | 865 | — | 10,007 | |||||||||||||||
Investment in subsidiaries | 290,938 | — | — | (290,938 | ) | — | ||||||||||||||
Total assets | $ | 494,298 | $ | 270,026 | $ | 25,018 | $ | (290,938 | ) | $ | 498,404 | |||||||||
Liabilities and equity (deficiency) | ||||||||||||||||||||
Payables: | ||||||||||||||||||||
Accounts payable, trade | $ | 3,507 | $ | 39 | $ | (41 | ) | $ | — | $ | 3,505 | |||||||||
Payable from trust accounts | 1,807 | 61 | 65 | — | 1,933 | |||||||||||||||
Payable to Borrower | — | 367,463 | 337 | (367,800 | ) | — | ||||||||||||||
Taxes payable | 748 | — | — | — | 748 | |||||||||||||||
Accrued interest and other liabilities | 26,957 | 210 | 694 | — | 27,861 | |||||||||||||||
Deferred tax liability (asset) | 9,944 | — | (8 | ) | — | 9,936 | ||||||||||||||
Line of credit | 145,269 | — | — | — | 145,269 | |||||||||||||||
Notes payable, net of discount | 289,414 | — | — | — | 289,414 | |||||||||||||||
Obligations under capital lease agreements | 2,744 | — | — | — | 2,744 | |||||||||||||||
Total liabilities | 480,390 | 367,773 | 1,047 | (367,800 | ) | 481,410 | ||||||||||||||
Equity (deficiency) | ||||||||||||||||||||
Common stock | — | — | — | — | — | |||||||||||||||
Additional paid-in capital | 190,262 | 1,052 | 1 | (1,053 | ) | 190,262 | ||||||||||||||
(Accumulated deficit) retained earnings | (176,354 | ) | (98,799 | ) | 20,884 | 77,915 | (176,354 | ) | ||||||||||||
Accumulated other comprehensive loss | — | — | (1,347 | ) | — | (1,347 | ) | |||||||||||||
Total equity (deficiency) before noncontrolling interest | 13,908 | (97,747 | ) | 19,538 | 76,862 | 12,561 | ||||||||||||||
Noncontrolling interest | — | — | 4,433 | — | 4,433 | |||||||||||||||
Total equity (deficiency) | 13,908 | (97,747 | ) | 23,971 | 76,862 | 16,994 | ||||||||||||||
Total liabilities and equity (deficiency) | $ | 494,298 | $ | 270,026 | $ | 25,018 | $ | (290,938 | ) | $ | 498,404 |
21
Condensed Consolidating Statements of Operations
Three Months Ended June 30, 2014 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Revenues | ||||||||||||||||||||
Purchased debt revenue, net | $ | 1,689 | $ | 58,153 | $ | 6,996 | $ | — | $ | 66,838 | ||||||||||
Other revenue | 1 | 2 | 6 | — | 9 | |||||||||||||||
Total revenues | 1,690 | 58,155 | 7,002 | — | 66,847 | |||||||||||||||
Expenses | ||||||||||||||||||||
Purchased debt expense | — | 31,798 | 2,697 | — | 34,495 | |||||||||||||||
Court costs, net | — | 9,854 | 104 | — | 9,958 | |||||||||||||||
Other direct operating expense | 2 | 3,866 | 36 | — | 3,904 | |||||||||||||||
Salaries and payroll taxes | 1,275 | 6,092 | 163 | — | 7,530 | |||||||||||||||
General and administrative | 445 | 2,393 | 700 | — | 3,538 | |||||||||||||||
Depreciation and amortization | 546 | 1,149 | 11 | — | 1,706 | |||||||||||||||
Total operating expenses | 2,268 | 55,152 | 3,711 | — | 61,131 | |||||||||||||||
Operating (loss) income | (578 | ) | 3,003 | 3,291 | — | 5,716 | ||||||||||||||
Other expenses | ||||||||||||||||||||
Interest expense | 1,560 | 9,515 | — | — | 11,075 | |||||||||||||||
Other expense (income) | 121 | — | (34 | ) | — | 87 | ||||||||||||||
Total other expenses | 1,681 | 9,515 | (34 | ) | — | 11,162 | ||||||||||||||
(Loss) income before income taxes | (2,259 | ) | (6,512 | ) | 3,325 | — | (5,446 | ) | ||||||||||||
Income tax expense | (1,062 | ) | — | (1,009 | ) | — | (2,071 | ) | ||||||||||||
Loss from subsidiaries | (4,595 | ) | — | — | 4,595 | — | ||||||||||||||
Net (loss) income | (7,916 | ) | (6,512 | ) | 2,316 | 4,595 | (7,517 | ) | ||||||||||||
Less: Net income attributable to the noncontrolling interest | — | — | 399 | — | 399 | |||||||||||||||
Net (loss) income attributable to SquareTwo | $ | (7,916 | ) | $ | (6,512 | ) | $ | 1,917 | $ | 4,595 | $ | (7,916 | ) |
22
Three Months Ended June 30, 2013 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Revenues | ||||||||||||||||||||
Purchased debt revenue, net | $ | 2,834 | $ | 80,163 | $ | 7,502 | $ | — | $ | 90,499 | ||||||||||
Other revenue | 10 | 3 | 138 | — | 151 | |||||||||||||||
Total revenues | 2,844 | 80,166 | 7,640 | — | 90,650 | |||||||||||||||
Expenses | ||||||||||||||||||||
Purchased debt expense | — | 41,230 | 2,948 | — | 44,178 | |||||||||||||||
Court costs, net | — | 11,467 | 156 | — | 11,623 | |||||||||||||||
Other direct operating expense | 2 | 3,617 | 82 | — | 3,701 | |||||||||||||||
Salaries and payroll taxes | 824 | 6,191 | 143 | — | 7,158 | |||||||||||||||
General and administrative | 1,262 | 1,490 | 1,248 | — | 4,000 | |||||||||||||||
Depreciation and amortization | 1,139 | 845 | 13 | — | 1,997 | |||||||||||||||
Total operating expenses | 3,227 | 64,840 | 4,590 | — | 72,657 | |||||||||||||||
Operating (loss) income | (383 | ) | 15,326 | 3,050 | — | 17,993 | ||||||||||||||
Other expenses | ||||||||||||||||||||
Interest expense | 1,389 | 10,216 | — | — | 11,605 | |||||||||||||||
Other expense (income) | 89 | — | (15 | ) | — | 74 | ||||||||||||||
Total other expenses | 1,478 | 10,216 | (15 | ) | — | 11,679 | ||||||||||||||
(Loss) income before income taxes | (1,861 | ) | 5,110 | 3,065 | — | 6,314 | ||||||||||||||
Income tax expense | (903 | ) | — | (1,037 | ) | — | (1,940 | ) | ||||||||||||
Income from subsidiaries | 6,693 | — | — | (6,693 | ) | — | ||||||||||||||
Net income | 3,929 | 5,110 | 2,028 | (6,693 | ) | 4,374 | ||||||||||||||
Less: Net income attributable to the noncontrolling interest | — | — | 445 | — | 445 | |||||||||||||||
Net income attributable to SquareTwo | $ | 3,929 | $ | 5,110 | $ | 1,583 | $ | (6,693 | ) | $ | 3,929 |
23
Six Months Ended June 30, 2014 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Revenues | ||||||||||||||||||||
Purchased debt revenue, net | $ | 3,455 | $ | 121,736 | $ | 13,137 | $ | — | $ | 138,328 | ||||||||||
Other revenue | 7 | 6 | 15 | — | 28 | |||||||||||||||
Total revenues | 3,462 | 121,742 | 13,152 | — | 138,356 | |||||||||||||||
Expenses | ||||||||||||||||||||
Purchased debt expense | — | 64,551 | 5,116 | — | 69,667 | |||||||||||||||
Court costs, net | — | 18,969 | 172 | — | 19,141 | |||||||||||||||
Other direct operating expenses | 4 | 7,742 | 64 | — | 7,810 | |||||||||||||||
Salaries and payroll taxes | 2,596 | 12,137 | 354 | — | 15,087 | |||||||||||||||
General and administrative | 986 | 5,049 | 1,546 | — | 7,581 | |||||||||||||||
Depreciation and amortization | 1,102 | 2,224 | 22 | — | 3,348 | |||||||||||||||
Total operating expenses | 4,688 | 110,672 | 7,274 | — | 122,634 | |||||||||||||||
Operating (loss) income | (1,226 | ) | 11,070 | 5,878 | — | 15,722 | ||||||||||||||
Other expenses | ||||||||||||||||||||
Interest expense | 2,865 | 19,219 | — | — | 22,084 | |||||||||||||||
Other expense (income) | 249 | — | (56 | ) | — | 193 | ||||||||||||||
Total other expenses | 3,114 | 19,219 | (56 | ) | — | 22,277 | ||||||||||||||
(Loss) income before income taxes | (4,340 | ) | (8,149 | ) | 5,934 | — | (6,555 | ) | ||||||||||||
Income tax expense | (1,205 | ) | — | (1,903 | ) | — | (3,108 | ) | ||||||||||||
Loss from subsidiaries | (4,858 | ) | — | — | 4,858 | — | ||||||||||||||
Net (loss) income | (10,403 | ) | (8,149 | ) | 4,031 | 4,858 | (9,663 | ) | ||||||||||||
Less: Net income attributable to the noncontrolling interest | — | — | 740 | — | 740 | |||||||||||||||
Net (loss) income attributable to SquareTwo | $ | (10,403 | ) | $ | (8,149 | ) | $ | 3,291 | $ | 4,858 | $ | (10,403 | ) |
24
Six Months Ended June 30, 2013 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Revenues | ||||||||||||||||||||
Purchased debt revenue, net | $ | 5,730 | $ | 159,228 | $ | 14,688 | $ | — | $ | 179,646 | ||||||||||
Other revenue | 71 | 5 | 315 | — | 391 | |||||||||||||||
Total revenues | 5,801 | 159,233 | 15,003 | — | 180,037 | |||||||||||||||
Expenses | ||||||||||||||||||||
Purchased debt expense | — | 85,245 | 5,390 | — | 90,635 | |||||||||||||||
Court costs, net | — | 21,584 | 342 | — | 21,926 | |||||||||||||||
Other direct operating expenses | 3 | 6,004 | 85 | — | 6,092 | |||||||||||||||
Salaries and payroll taxes | 2,507 | 11,137 | 361 | — | 14,005 | |||||||||||||||
General and administrative | 2,217 | 3,189 | 2,042 | — | 7,448 | |||||||||||||||
Depreciation and amortization | 2,285 | 1,600 | 26 | — | 3,911 | |||||||||||||||
Total operating expenses | 7,012 | 128,759 | 8,246 | — | 144,017 | |||||||||||||||
Operating (loss) income | (1,211 | ) | 30,474 | 6,757 | — | 36,020 | ||||||||||||||
Other expenses | ||||||||||||||||||||
Interest expense | 2,836 | 20,547 | — | — | 23,383 | |||||||||||||||
Other expense | 199 | — | 2,144 | — | 2,343 | |||||||||||||||
Total other expenses | 3,035 | 20,547 | 2,144 | — | 25,726 | |||||||||||||||
(Loss) income before income taxes | (4,246 | ) | 9,927 | 4,613 | — | 10,294 | ||||||||||||||
Income tax expense | (963 | ) | — | (1,627 | ) | — | (2,590 | ) | ||||||||||||
Income from subsidiaries | 12,247 | — | — | (12,247 | ) | — | ||||||||||||||
Net income | 7,038 | 9,927 | 2,986 | (12,247 | ) | 7,704 | ||||||||||||||
Less: Net income attributable to the noncontrolling interest | — | — | 666 | — | 666 | |||||||||||||||
Net income attributable to SquareTwo | $ | 7,038 | $ | 9,927 | $ | 2,320 | $ | (12,247 | ) | $ | 7,038 |
25
Condensed Consolidating Statements of Comprehensive (Loss) Income
Three Months Ended June 30, 2014 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Net (loss) income | $ | (7,916 | ) | $ | (6,512 | ) | $ | 2,316 | $ | 4,595 | $ | (7,517 | ) | |||||||
Other comprehensive income, net of tax: | ||||||||||||||||||||
Currency translation adjustment | — | — | 898 | — | 898 | |||||||||||||||
Comprehensive (loss) income | (7,916 | ) | (6,512 | ) | 3,214 | 4,595 | (6,619 | ) | ||||||||||||
Less: Comprehensive income attributable to the noncontrolling interest | — | — | 399 | — | 399 | |||||||||||||||
Comprehensive (loss) income attributable to SquareTwo | $ | (7,916 | ) | $ | (6,512 | ) | $ | 2,815 | $ | 4,595 | $ | (7,018 | ) |
26
Three Months Ended June 30, 2013 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Net income | $ | 3,929 | $ | 5,110 | $ | 2,028 | $ | (6,693 | ) | $ | 4,374 | |||||||||
Other comprehensive loss, net of tax: | ||||||||||||||||||||
Currency translation adjustment | — | — | (742 | ) | — | (742 | ) | |||||||||||||
Comprehensive income | 3,929 | 5,110 | 1,286 | (6,693 | ) | 3,632 | ||||||||||||||
Less: Comprehensive income attributable to the noncontrolling interest | — | — | 445 | — | 445 | |||||||||||||||
Comprehensive income attributable to SquareTwo | $ | 3,929 | $ | 5,110 | $ | 841 | $ | (6,693 | ) | $ | 3,187 |
27
Six Months Ended June 30, 2014 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Net (loss) income | $ | (10,403 | ) | $ | (8,149 | ) | $ | 4,031 | $ | 4,858 | $ | (9,663 | ) | |||||||
Other comprehensive income, net of tax: | ||||||||||||||||||||
Currency translation adjustment | — | — | 64 | — | 64 | |||||||||||||||
Comprehensive (loss) income | (10,403 | ) | (8,149 | ) | 4,095 | 4,858 | (9,599 | ) | ||||||||||||
Less: Comprehensive income attributable to the noncontrolling interest | — | — | 740 | — | 740 | |||||||||||||||
Comprehensive (loss) income attributable to SquareTwo | $ | (10,403 | ) | $ | (8,149 | ) | $ | 3,355 | $ | 4,858 | $ | (10,339 | ) |
28
Six Months Ended June 30, 2013 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Net income | $ | 7,038 | $ | 9,927 | $ | 2,986 | $ | (12,247 | ) | $ | 7,704 | |||||||||
Other comprehensive loss, net of tax: | ||||||||||||||||||||
Currency translation adjustment | — | — | (1,129 | ) | — | (1,129 | ) | |||||||||||||
Comprehensive income | 7,038 | 9,927 | 1,857 | (12,247 | ) | 6,575 | ||||||||||||||
Less: Comprehensive income attributable to the noncontrolling interest | — | — | 666 | — | 666 | |||||||||||||||
Comprehensive income attributable to SquareTwo | $ | 7,038 | $ | 9,927 | $ | 1,191 | $ | (12,247 | ) | $ | 5,909 |
29
Condensed Consolidating Statements of Cash Flows
Six Months Ended June 30, 2014 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Operating activities | ||||||||||||||||||||
Net (loss) income | $ | (10,403 | ) | $ | (8,149 | ) | $ | 4,031 | $ | 4,858 | $ | (9,663 | ) | |||||||
Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: | ||||||||||||||||||||
Depreciation and amortization | 1,102 | 2,224 | 22 | — | 3,348 | |||||||||||||||
Amortization of loan origination fees and debt discount | 1,466 | — | — | — | 1,466 | |||||||||||||||
Purchased debt valuation allowance reversals | — | (523 | ) | — | — | (523 | ) | |||||||||||||
Stock option expense | 32 | 17 | — | — | 49 | |||||||||||||||
Amortization of prepaid and other non-cash expenses | 1,734 | 311 | 39 | — | 2,084 | |||||||||||||||
Deferred tax provision, net of valuation allowance | 1,092 | — | — | — | 1,092 | |||||||||||||||
Loss from subsidiaries | 4,858 | — | — | (4,858 | ) | — | ||||||||||||||
Changes in operating assets and liabilities: | ||||||||||||||||||||
Income tax payable/receivable | (748 | ) | — | 352 | — | (396 | ) | |||||||||||||
Restricted cash | 482 | (1,304 | ) | — | — | (822 | ) | |||||||||||||
Other assets | (2,253 | ) | (1,657 | ) | 1,112 | — | (2,798 | ) | ||||||||||||
Accounts payable and accrued liabilities | (4,025 | ) | 105 | 80 | — | (3,840 | ) | |||||||||||||
Net cash (used in) provided by operating activities | (6,663 | ) | (8,976 | ) | 5,636 | — | (10,003 | ) | ||||||||||||
Investing activities | ||||||||||||||||||||
Investment in purchased debt | — | (60,268 | ) | (7,548 | ) | — | (67,816 | ) | ||||||||||||
Proceeds applied to purchased debt principal | — | 80,306 | 8,594 | — | 88,900 | |||||||||||||||
Net investments in notes receivable | (193 | ) | — | — | — | (193 | ) | |||||||||||||
Investment in subsidiaries | 10,943 | — | — | (10,943 | ) | — | ||||||||||||||
Investment in property and equipment, including internally developed software | (2,048 | ) | (15 | ) | — | — | (2,063 | ) | ||||||||||||
Net cash provided by investing activities | 8,702 | 20,023 | 1,046 | (10,943 | ) | 18,828 | ||||||||||||||
Financing activities | ||||||||||||||||||||
Repayment of investment by parent, net | (150 | ) | (10,943 | ) | — | 10,943 | (150 | ) | ||||||||||||
Payments on notes payable, net | (377 | ) | — | — | — | (377 | ) | |||||||||||||
Proceeds from lines-of-credit | 229,236 | — | — | — | 229,236 | |||||||||||||||
Payments on lines-of-credit | (229,720 | ) | — | — | — | (229,720 | ) | |||||||||||||
Origination fees on lines-of-credit | (244 | ) | — | — | — | (244 | ) | |||||||||||||
Payments on capital lease obligations | (742 | ) | — | — | — | (742 | ) | |||||||||||||
Net cash used in financing activities | (1,997 | ) | (10,943 | ) | — | 10,943 | (1,997 | ) | ||||||||||||
Increase in cash and cash equivalents | 42 | 104 | 6,682 | — | 6,828 | |||||||||||||||
Impact of foreign currency translation on cash | — | — | 321 | — | 321 | |||||||||||||||
Cash and cash equivalents at beginning of period | — | — | 9,379 | — | 9,379 | |||||||||||||||
Cash and cash equivalents at end of period | $ | 42 | $ | 104 | $ | 16,382 | $ | — | $ | 16,528 | ||||||||||
Supplemental cash flow information | ||||||||||||||||||||
Cash paid for interest | $ | 20,673 | $ | — | $ | — | $ | — | $ | 20,673 | ||||||||||
Cash paid for income taxes | 861 | — | 1,570 | — | 2,431 | |||||||||||||||
Property and equipment financed with capital leases and notes payable | 1,282 | — | — | — | 1,282 |
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Six Months Ended June 30, 2013 | ||||||||||||||||||||
Borrower | Guarantor Subsidiaries | Non-Guarantor Subsidiaries | Eliminations | Total | ||||||||||||||||
Operating activities | ||||||||||||||||||||
Net income | $ | 7,038 | $ | 9,927 | $ | 2,986 | $ | (12,247 | ) | $ | 7,704 | |||||||||
Adjustments to reconcile net income to net cash (used in) provided by operating activities: | ||||||||||||||||||||
Depreciation and amortization | 2,285 | 1,600 | 26 | — | 3,911 | |||||||||||||||
Amortization of loan origination fees and debt discount | 1,692 | — | — | — | 1,692 | |||||||||||||||
Recovery of step-up in basis of purchased debt | 107 | — | — | — | 107 | |||||||||||||||
Purchased debt valuation allowance reversals | — | (3,733 | ) | (18 | ) | — | (3,751 | ) | ||||||||||||
Stock option expense | 42 | 25 | — | — | 67 | |||||||||||||||
Amortization of prepaid and other non-cash expenses | 1,848 | 73 | 320 | — | 2,241 | |||||||||||||||
Income from subsidiaries | (12,247 | ) | — | — | 12,247 | — | ||||||||||||||
Changes in operating assets and liabilities: | ||||||||||||||||||||
Income tax payable/receivable | 830 | — | (3,162 | ) | — | (2,332 | ) | |||||||||||||
Restricted cash | (1,060 | ) | 864 | — | — | (196 | ) | |||||||||||||
Other assets | (2,201 | ) | (1,442 | ) | 821 | — | (2,822 | ) | ||||||||||||
Accounts payable and accrued liabilities | (475 | ) | (664 | ) | 1,157 | — | 18 | |||||||||||||
Net cash (used in) provided by operating activities | (2,141 | ) | 6,650 | 2,130 | — | 6,639 | ||||||||||||||
Investing activities | ||||||||||||||||||||
Investment in purchased debt | — | (147,225 | ) | (10,026 | ) | — | (157,251 | ) | ||||||||||||
Proceeds applied to purchased debt principal | — | 112,704 | 9,986 | — | 122,690 | |||||||||||||||
Payments to branch offices related to asset purchase program | — | (297 | ) | — | — | (297 | ) | |||||||||||||
Net proceeds from notes receivable | 64 | — | — | 64 | ||||||||||||||||
Investment in subsidiaries | (28,168 | ) | — | — | 28,168 | — | ||||||||||||||
Investment in property and equipment including internally developed software | (2,818 | ) | — | — | — | (2,818 | ) | |||||||||||||
Net cash used in investing activities | (30,922 | ) | (34,818 | ) | (40 | ) | 28,168 | (37,612 | ) | |||||||||||
Financing activities | ||||||||||||||||||||
Repayments of investment by parent, net | — | 28,168 | — | (28,168 | ) | — | ||||||||||||||
Payments on notes payable, net | (224 | ) | — | — | — | (224 | ) | |||||||||||||
Proceeds from lines-of-credit | 309,655 | — | — | — | 309,655 | |||||||||||||||
Payments on lines-of-credit | (274,792 | ) | — | — | — | (274,792 | ) | |||||||||||||
Origination fees on lines-of-credit and notes payable | (856 | ) | — | — | — | (856 | ) | |||||||||||||
Payments on capital lease obligations | (720 | ) | — | — | — | (720 | ) | |||||||||||||
Net cash provided by financing activities | 33,063 | 28,168 | — | (28,168 | ) | 33,063 | ||||||||||||||
Increase in cash and cash equivalents | — | — | 2,090 | — | 2,090 | |||||||||||||||
Impact of foreign currency translation on cash | — | — | (796 | ) | — | (796 | ) | |||||||||||||
Cash and cash equivalents at beginning of period | — | — | 7,538 | — | 7,538 | |||||||||||||||
Cash and cash equivalents at end of period | $ | — | $ | — | $ | 8,832 | $ | — | $ | 8,832 | ||||||||||
Supplemental cash flow information | ||||||||||||||||||||
Cash paid for interest | $ | 21,271 | $ | 513 | $ | — | $ | — | $ | 21,784 | ||||||||||
Cash paid for income tax | 134 | — | 4,784 | — | 4,918 | |||||||||||||||
Property and equipment financed with capital leases and notes payable | 2,041 | — | — | — | 2,041 |
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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Some of the information in this Quarterly Report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts included in this Quarterly Report on Form 10-Q, including, without limitation, certain statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” may constitute forward-looking statements. In some cases you can identify these “forward-looking statements” by words like “may,” "will," “should,” “expect,” “intend,” “estimate,” “anticipate,” "plan," "foresee," “predict,” “believe,” “potential” or “continue” or, in each case, the negative or other variations or similar expressions. All forward-looking statements reflect our current beliefs and assumptions with respect to our future results, business plans and prospects, and are based on information currently available to us. Accordingly, these statements are subject to significant risks and uncertainties and our actual results, business plans and prospects could differ significantly from those expressed in, or implied by, these statements. Factors that could cause or contribute to such differences include, but are not limited to, those described under “Risk Factors” in our most recent Annual Report on Form 10-K (File No. 333- 170734). We undertake no obligation to update publicly or publicly revise any forward-looking statement, whether as a result of new information or otherwise.
Unless otherwise indicated, the terms (i) “SquareTwo,” “we,” “our,” “us” and the “Company” refer to SquareTwo Financial Corporation and all of its restricted subsidiaries on a consolidated basis, (ii) “SquareTwo Financial Corporation” refers to SquareTwo Financial Corporation and not to its parent company or any of its subsidiaries, and (iii) “Parent” refers to CA Holding, Inc. and not to any of its subsidiaries. You should read this discussion and analysis in conjunction with the condensed consolidated financial statements and notes that appear elsewhere in this Quarterly Report on Form 10-Q. Our financial information may not be indicative of our future performance and does not necessarily reflect what our financial condition and results of operations would have been had we operated as an independent, stand-alone entity during all periods presented.
Our Company
We are a leading purchaser of charged-off consumer and commercial receivables in the accounts receivable management industry. Our primary business is the acquisition, management and collection of charged-off consumer and commercial accounts receivable that we purchase from financial institutions, finance and leasing companies, and other issuers in the U.S. and Canada. We believe that we are one of the largest purchasers of "fresh" charged-off credit card and consumer loan receivables in the U.S. Fresh charged-off credit card and consumer loan receivables are generally 180-210 days past due at the time of sale and typically have not been subject to previous collection attempts by a third-party collection agency. The act of charging off an account is an action required by banking regulations and is an accounting action that does not release the obligor on the account from his/her responsibility to pay amounts due on the account. Because the credit issuer was unable to collect the charged-off receivables that we purchase, we are able to acquire these portfolios at a substantial discount to their face value.
Our business model leverages our analytical expertise, technology platform, operational experience and our network of branch offices, to purchase and then manage the recovery of charged-off receivables. Our focus throughout the recovery process is on the customer and helping the customer resolve their outstanding financial commitments, while ensuring that those customers who demonstrate a significant ability to pay their validly incurred contractual obligations actually satisfy their obligations. In accordance with the Fair Square Promise, we are dedicated to treating customers fairly and ethically and maintaining stringent compliance standards, which we believe in turn allows us to liquidate more effectively. From 1999, our first full year of purchasing debt, to June 30, 2014, we have invested approximately $2.5 billion in the acquisition of charged-off receivables, representing over $37.2 billion in face value of accounts. The combination of our historical and future recovery efforts is expected to result in cumulative gross cash proceeds of approximately 2.1x our invested capital.
Based on our proprietary analytical models, which utilize historical and current account level data, as well as economic, pricing and collection trends, we expect that our U.S. owned charged-off receivables as of June 30, 2014 of $8.1 billion (active face value) will generate approximately $673.7 million in estimated remaining proceeds ("ERP") over the next nine years. In addition, we expect our Canadian owned charged-off receivables of $1.2 billion (active face value) to generate approximately $58.3 million in additional ERP. Therefore, the total ERP for both our U.S. and Canadian owned charged-off receivables was $732.0 million as of June 30, 2014. These expectations are based on historical data as well as assumptions about future collection rates, account sales activity and consumer behavior. We cannot guarantee that we will achieve such proceeds.
In the U.S. we primarily utilize our branch offices, which provide nationwide coverage. These offices use eAGLE, an integrated account management system that we have developed and maintain, to liquidate accounts. Each of our branch offices
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has an executed detailed agreement that provides the legal structure for the relationship with SquareTwo, including their right to use eAGLE. Also, to a much lesser extent, we currently utilize specialized third party non-legal and legal collection firms in the U.S. and employ a small number of collectors focused exclusively on commercial collections.
In Canada, we utilize internal collectors and third-party non-legal and legal collection firms which exclusively service our Canadian customers.
Our Branch Offices
Collection efforts on our U.S. purchased debt are primarily handled by our branch offices. Under the terms of our contractual arrangements, our offices license our proprietary technology and perform recovery work on our behalf in accordance with our required policies. We are under no obligation to provide accounts to any branch office. We pay our offices a fee, which varies based upon their performance against our return assumptions and is subject to adjustment based upon the performance against our operational requirements. These include providing a positive customer experience within the context of the collections industry and conformance with legal and regulatory requirements. We allocate accounts to our offices based on capacity, geographic coverage, their performance against our return expectations, and adherence to the aforementioned operational requirements.
We believe that our competitive account placement model and our variable fee structure are critical to our performance as they motivate each office to optimize its efforts on its allocated accounts, while at the same time providing for tight focus on both compliance with applicable laws and regulations and a positive customer experience. We believe that our law firm model promotes the highest ethical standards in the industry as our branch offices maintain both SquareTwo’s commitment to the Fair Square Promise which embodies our stringent compliance standards as well as the obligations imposed by membership in the bar associations of the respective states in which their attorneys are licensed to practice law. In addition to these compliance and collections benefits, we believe that law firms generally provide a more professional environment than traditional call centers, helping our offices to more effectively attract and retain quality collectors. Additionally, SquareTwo provides branch offices with training and comprehensive business and operational support to ensure that their relationship with our customers reflects our desire to help customers resolve their financial obligations in a respectful manner.
Underwriting and Purchasing
The success of our business depends heavily on our ability to find charged-off receivables for purchase, evaluate these assets accurately and acquire them at the appropriate pricing. We have a dedicated Business Development team that generates portfolio acquisition opportunities in the markets in which we operate and works with our Decision Science team to prepare pricing models and perform account-level analysis. Historically, we have purchased charged-off receivables from seven of the ten largest U.S. credit card issuers, as well as from super-regional and regional banks and other issuers of credit. Potential purchasing opportunities are reviewed in detail by our Decision Science department, which is responsible for preparing forecasted cash flows from each purchase based on our proprietary statistical models and our experience with similar purchases. These models and related assumptions are reviewed by our investment committee, which includes members of our senior leadership team and representatives from each key business function, to determine the appropriate purchase price for the available portfolios. We target purchases that meet return thresholds determined by our investment committee. In times of increased pricing in the market, we may accept a lower return, while still maintaining our yield-based purchasing strategy. In addition to the credit card and consumer loan business, we are actively engaged in the development of business opportunities in purchasing other forms of charged-off domestic and Canadian financial obligations.
Sources of Revenue and Expense
Sources of Revenue
Our primary sources of revenue are revenues recognized on our portfolio base of purchased debt assets which are driven by cash proceeds from voluntary, non-legal collections, legal collections, court cost recoveries, sales, recourse and bankruptcy. Generally, we earn royalties from our branch offices ranging from 2% to 4% of each dollar collected in the non-legal channels for the use of our proprietary collection platform, eAGLE.
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Expenses
Purchased Debt Expense
Purchased debt expense represents the direct costs of collections related to our purchased debt. The majority of our direct expenses represent the fees that we pay to our branch offices based on their collections on our purchased debt. The fee we pay to our offices varies depending on the age and type of purchased debt and certain network performance targets and other operational factors. In Canada, purchased debt expense includes the cost of our collectors as well as fees paid to outside agencies with whom we place certain accounts.
Court Costs, Net
Court costs represent court costs and related fees on accounts placed for legal action. Court costs are expensed as incurred and are reduced by court cost recoveries for purchased debt accounted for under the cost recovery method. Court cost recoveries for purchased debt accounted for under the level yield method are included in level yield proceeds which drive purchased debt revenue, net. We estimate that we recover in excess of one-third of all court costs expended.
Other Direct Operating Expense
Other direct operating expense represents other costs of collections, primarily on purchased debt. Included in other direct operating expense is direct legal compliance and certain other operating and branch office costs. Additionally, other direct operating expense includes the amounts paid to our commercial debt collectors employed by SquareTwo Commercial Funding.
Costs to Collect
We consider our true costs to collect on our purchased debt accounts to include purchased debt expense, gross court costs, and other direct operating expense. We measure our costs to collect in relation to total collections rather than revenue due to the timing differences between revenue and expense recognition for GAAP purposes.
Salaries and Payroll Taxes
Salaries and payroll taxes include employment-related expenses, including salaries, wages, bonuses, insurance, payroll taxes and benefits.
General and Administrative
General and administrative expenses consist of rent, utilities, marketing, information technology, property and other miscellaneous taxes, office, travel and entertainment, accounting and payroll services, consulting fees, licenses, and general insurance.
Depreciation and Amortization
We incur depreciation related to our property and equipment. We incur amortization on the value of our internally developed proprietary collection platform eAGLE, which is used by our branch offices.
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Results of Operations
We have two reportable operating segments, as defined by the Financial Accounting Standards Board's ("FASB") Accounting Standards Codification Topic 280, Segment Reporting ("ASC 280"): Domestic and Canada.
A reporting segment's operating results are regularly reviewed by the Company's Chief Operating Decision Maker ("CODM"), our Chief Executive Officer, to make decisions about resources to be allocated to the segment and assess its performance. Consistent with how the Board of Directors, the CODM, and the leadership team review the Company's results, the following discussion and analysis is primarily around consolidated results. Segment specific information reviewed by the CODM and Company directors is discussed later in this section under the heading "Segment Performance Summary".
Three and Six Months Ended June 30, 2014 Compared to Three and Six Months Ended June 30, 2013
Purchasing Activity
The following table summarizes the purchasing activity for the three and six months ended June 30, 2014 compared to the three and six months ended June 30, 2013:
Three Months Ended | Six Months Ended | |||||||||||||||||||||||||||||
Purchasing Activity ($ in thousands) | June 30, | June 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Variance | % Variance | 2014 | 2013 | $ Variance | % Variance | |||||||||||||||||||||||
Credit Card/Consumer Loan - Fresh(1) | ||||||||||||||||||||||||||||||
Face | $ | 246,781 | $ | 526,154 | $ | (279,373 | ) | (53.1 | )% | $ | 421,592 | $ | 929,437 | $ | (507,845 | ) | (54.6 | )% | ||||||||||||
Price | 36,882 | 65,640 | (28,758 | ) | (43.8 | )% | 61,054 | 110,274 | (49,220 | ) | (44.6 | )% | ||||||||||||||||||
Price (%) | 14.9 | % | 12.5 | % | 14.5 | % | 11.9 | % | ||||||||||||||||||||||
Credit Card/Consumer Loan - Non-Fresh(1) | ||||||||||||||||||||||||||||||
Face | 40,006 | 448,970 | (408,964 | ) | (91.1 | )% | 49,612 | 651,110 | (601,498 | ) | (92.4 | )% | ||||||||||||||||||
Price | 2,735 | 25,940 | (23,205 | ) | (89.5 | )% | 3,308 | 32,821 | (29,513 | ) | (89.9 | )% | ||||||||||||||||||
Price (%) | 6.8 | % | 5.8 | % | 6.7 | % | 5.0 | % | ||||||||||||||||||||||
Other(2) | ||||||||||||||||||||||||||||||
Face | 54,020 | 75,272 | (21,252 | ) | (28.2 | )% | 90,400 | 263,840 | (173,440 | ) | (65.7 | )% | ||||||||||||||||||
Price | 2,435 | 3,401 | (966 | ) | (28.4 | )% | 3,454 | 14,156 | (10,702 | ) | (75.6 | )% | ||||||||||||||||||
Price (%) | 4.5 | % | 4.5 | % | 3.8 | % | 5.4 | % | ||||||||||||||||||||||
Purchased Debt - Total | ||||||||||||||||||||||||||||||
Face | $ | 340,807 | $ | 1,050,396 | $ | (709,589 | ) | (67.6 | )% | $ | 561,604 | $ | 1,844,387 | $ | (1,282,783 | ) | (69.6 | )% | ||||||||||||
Price | 42,052 | 94,981 | (52,929 | ) | (55.7 | )% | 67,816 | 157,251 | (89,435 | ) | (56.9 | )% | ||||||||||||||||||
Price (%) | 12.3 | % | 9.0 | % | 12.1 | % | 8.5 | % |
(2) Other includes commercial, student loan, medical, and other purchased debt assets.
Credit Card/Consumer Loan - Fresh
Credit card and consumer loan - fresh purchases were $246.8 million of face value receivables at a price of $36.9 million during the three months ended June 30, 2014, compared to $526.2 million of face value receivables at a price of $65.6 million during the three months ended June 30, 2013, a decrease of 53.1% in face value and 43.8% in capital deployed. During the six months ended June 30, 2014 credit card and consumer loan - fresh purchases were $421.6 million of face value at a price of $61.1 million compared to $929.4 million of face value at a price of $110.3 million during six months ended June 30, 2013, a decrease of 54.6% in face value and 44.6% in capital deployed. These decreases were due to a reduction in the supply of charged-off receivables and increased competition in the market. Our average price for credit card/consumer loan - fresh purchases increased from 12.5% to 14.9% and from 11.9% to 14.5% for the three and six months ended June 30, 2014, respectively, generally without a corresponding increase in the quality of the offered portfolios. We attribute this price increase primarily to decreased supply from financial institutions as a result of the uncertainty stemming from the Consumer Financial Protection Bureau’s expressed intention to issue new regulations. Certain selling financial institutions, which had ceased selling
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during 2013, continued their absence from debt sales. While we believe this to be temporary, it remains unclear when these market participants will reenter the debt sales market.
During the three and six months ended June 30, 2014, we accepted lower returns on certain purchases relative to prior years. Refer to the Supplemental Performance Data for further information regarding purchases made during the three and six months ended June 30, 2014.
Credit Card/Consumer Loan - Non-Fresh
Credit card and consumer loan - non-fresh purchases consist of charged-off receivables that have been worked by an external agency or other party external to the originating financial institution. Credit card and consumer loan - non-fresh purchases were $40.0 million of face value receivables at a price of $2.7 million during the three months ended June 30, 2014, compared to $449.0 million of face value receivables at a price of $25.9 million during the three months ended June 30, 2013. During the six months ended June 30, 2014 credit card and consumer loan - non-fresh purchases were $49.6 million of face value at a price of $3.3 million compared to $651.1 million of face value at a price of $32.8 million during the six months ended June 30, 2013. These decreases of 91.1% and 92.4% in face value and 89.5% and 89.9% in capital deployed, for the three and six months ended June 30, 2014, respectively, were due to a reduction in the supply of charged-off receivables similar to credit card/consumer loan - fresh.
Other
Other purchases consist of commercial, student loan, medical, and other various asset classes. Other purchases were $54.0 million in face value at a price of $2.4 million during the three months ended June 30, 2014, compared to $75.3 million in face value at a price of $3.4 million during the three months ended June 30, 2013. Other purchases were $90.4 million in face at a price of $3.5 million during the six months ended June 30, 2014, compared to $263.8 million in face at a price of $14.2 million during the six months ended June 30, 2013. The decrease in capital deployed was driven by a 66.0% decrease in commercial purchases and zero student loan purchases during the six months ended June 30, 2014. These decreases were the result of reduction in the supply of charged-off receivables and increased competition in the market, similar to credit card/consumer loan - fresh. In addition, the Company is no longer actively pursuing purchases of medical accounts and has not purchased any medical portfolios since the first quarter of 2013. The decrease in price paid from 5.4% to 3.8% for the six months ended June 30, 2014 was due primarily to a change in product mix purchased.
Cash Proceeds on Purchased Debt
A key driver to our performance, and one of the primary metrics monitored by our management team, is cash proceeds received from our purchased debt. This measurement, and our focus on cash proceeds, is important because proceeds drive our business operations. Included in cash proceeds are voluntary non-legal collections, legal collections, the reimbursement of court costs, sales of accounts, returns of non-conforming accounts (which we refer to as recourse), and bankruptcy.
The following table summarizes the cash proceeds activity for the three and six months ended June 30, 2014 compared to the three and six months ended June 30, 2013:
Three Months Ended | Six Months Ended | |||||||||||||||||||||||||||||
June 30, | June 30, | |||||||||||||||||||||||||||||
Cash Proceeds ($ in thousands) | 2014 | 2013 | $ Variance | % Variance | 2014 | 2013 | $ Variance | % Variance | ||||||||||||||||||||||
Credit card/consumer loan collections | ||||||||||||||||||||||||||||||
Voluntary, non-legal collections | $ | 50,658 | $ | 80,679 | $ | (30,021 | ) | (37.2 | )% | $ | 102,911 | $ | 164,005 | $ | (61,094 | ) | (37.3 | )% | ||||||||||||
Legal collections | 54,388 | 53,502 | 886 | 1.7 | % | 107,263 | 107,005 | 258 | 0.2 | % | ||||||||||||||||||||
Other collections(1) | 4,965 | 5,873 | (908 | ) | (15.5 | )% | 10,247 | 11,352 | (1,105 | ) | (9.7 | )% | ||||||||||||||||||
Total collections | 110,011 | 140,054 | (30,043 | ) | (21.5 | )% | 220,421 | 282,362 | (61,941 | ) | (21.9 | )% | ||||||||||||||||||
Sales, recourse & bankruptcy proceeds | 1,893 | 6,928 | (5,035 | ) | (72.7 | )% | 3,723 | 11,493 | (7,770 | ) | (67.6 | )% | ||||||||||||||||||
Total cash proceeds on purchased debt | $ | 111,904 | $ | 146,982 | $ | (35,078 | ) | (23.9 | )% | $ | 224,144 | $ | 293,855 | $ | (69,711 | ) | (23.7 | )% |
(1) Other includes collections and court cost recoveries on commercial, student loan, medical, and other accounts.
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Credit Card/Consumer Loan Collections
Voluntary, Non-legal Collections
Credit card and consumer loan voluntary, non-legal collections were $50.7 million during the three months ended June 30, 2014 compared to $80.7 million during the three months ended June 30, 2013, a decrease of 37.2%. During the six months ended June 30, 2014 credit card and consumer loan voluntary, non-legal collections were $102.9 million compared to $164.0 million during the six months ended June 30, 2013, a decrease of 37.3%. These decreases were driven primarily by lower face value of purchases during late 2013 and early 2014 and therefore less inventory in the voluntary, non-legal channel. Credit card/consumer loan non-legal collections represented 45.3% and 54.9% of total cash proceeds on purchased debt during three months ended June 30, 2014 and 2013, respectively. Credit card/consumer loan non-legal collections represented 45.9% and 55.8% of total cash proceeds on purchased debt during the six months ended June 30, 2014 and 2013, respectively.
Legal Collections
Credit card and consumer loan legal collections were $54.4 million during the three months ended June 30, 2014 compared to $53.5 million during the three months ended June 30, 2013, an increase of 1.7%. Credit card and consumer loan legal collections were $107.3 million during the six months ended June 30, 2014 compared to $107.0 million during the six months ended June 30, 2013, an increase of 0.2%. Legal collections were largely unaffected by the lower purchases over the last year due to the time lag between when portfolios are acquired versus when legal action, which is our strategy of last resort, is commenced. Credit card/consumer loan legal collections represented 48.6% and 36.4% of total cash proceeds on purchased debt during three months ended June 30, 2014 and 2013, respectively. Credit card/consumer loan legal collections represented 47.9% and 36.4% of total cash proceeds on purchased debt during the six months ended June 30, 2014 and 2013, respectively.
Other Collections
Other collections were $5.0 million during the three months ended June 30, 2014 compared to $5.9 million during the three months ended June 30, 2013, a decrease of 15.5%. Other collections were $10.2 million during the six months ended June 30, 2014 compared to $11.4 million during the six months ended June 30, 2013, a decrease of 9.7%.
Sales, Recourse, and Bankruptcy Proceeds
Sales, recourse, and bankruptcy proceeds were $1.9 million during the three months ended June 30, 2014 compared to $6.9 million during the three months ended June 30, 2013. Sales, recourse, and bankruptcy proceeds were $3.7 million during the six months ended June 30, 2014 compared to $11.5 million during the six months ended June 30, 2013. The decrease is directly attributable to a shift in the Company's strategy away from account re-sales. Concurrent with the shift away from account re-sales, the Company made operational improvements to enhance internal bankruptcy processing capabilities and began tracking bankruptcy proceeds in 2014.
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Consolidated Results
The following table summarizes the results of our operations for the three months ended June 30, 2014 compared to the three months ended June 30, 2013:
Three Months Ended | |||||||||||||||
June 30, | |||||||||||||||
Consolidated Results ($ in thousands) | 2014 | 2013 | $ Variance | % Variance | |||||||||||
Revenues | |||||||||||||||
Purchased debt revenue, net | $ | 66,838 | $ | 90,499 | $ | (23,661 | ) | (26.1 | )% | ||||||
Other revenue | 9 | 151 | (142 | ) | (94.0 | )% | |||||||||
Total revenues | 66,847 | 90,650 | (23,803 | ) | (26.3 | )% | |||||||||
Expenses | |||||||||||||||
Purchased debt expense | 34,495 | 44,178 | (9,683 | ) | (21.9 | )% | |||||||||
Court costs, net | 9,958 | 11,623 | (1,665 | ) | (14.3 | )% | |||||||||
Other direct operating expense | 3,904 | 3,701 | 203 | 5.5 | % | ||||||||||
Salaries and payroll taxes | 7,530 | 7,158 | 372 | 5.2 | % | ||||||||||
General and administrative | 3,538 | 4,000 | (462 | ) | (11.6 | )% | |||||||||
Depreciation and amortization | 1,706 | 1,997 | (291 | ) | (14.6 | )% | |||||||||
Total operating expenses | 61,131 | 72,657 | (11,526 | ) | (15.9 | )% | |||||||||
Operating income | 5,716 | 17,993 | (12,277 | ) | (68.2 | )% | |||||||||
Other expenses | |||||||||||||||
Interest expense | 11,075 | 11,605 | (530 | ) | (4.6 | )% | |||||||||
Other expense | 87 | 74 | 13 | 17.6 | % | ||||||||||
Total other expenses | 11,162 | 11,679 | (517 | ) | (4.4 | )% | |||||||||
(Loss) income before income taxes | (5,446 | ) | 6,314 | (11,760 | ) | (1) | |||||||||
Income tax expense | (2,071 | ) | (1,940 | ) | (131 | ) | (6.8 | )% | |||||||
Net (loss) income | $ | (7,517 | ) | $ | 4,374 | $ | (11,891 | ) | (1) |
(1) Not meaningful.
Purchased Debt Revenue, Net
Purchased debt revenue, net was $66.8 million during the three months ended June 30, 2014 compared to $90.5 million during the three months ended June 30, 2013, a decrease of $23.7 million or 26.1%. This change was predominantly driven by a $18.6 million decrease in gross revenue on level yield assets. Increased purchase prices led to lower return expectations on the 2013 and 2014 purchases, which resulted in a lower overall weighted average IRR. Also impacting gross revenue on purchased debt was a decrease in the average carrying value of level yield purchased debt assets from $246.6 million to $238.6 million. Gross revenue on cost recovery assets decreased $1.8 million which was in line with the decrease in cost recovery proceeds due to an older base of existing assets accounted for under the cost recovery method of accounting.
Also contributing to the overall decrease in purchased debt revenue, net was a decrease in net valuation allowance reversals which directly impact purchased debt revenue. During the three months ended June 30, 2014, we recorded $0.3 million in net reversals of non-cash valuation allowances on our level yield assets. The net reversal of non-cash valuation allowance related to overperformance on certain 2007 - 2009 level yield pools, which was partially offset by a non-cash valuation allowance charge on one 2013 level yield pool. During the three months ended June 30, 2013, we recorded $5.3 million in reversals of non-cash valuation allowances on our level yield assets related to overperformance on certain 2007 - 2009 level yield pools, which was partially offset by non-cash valuation allowance charges of $2.9 million on our cost recovery assets.
In addition, purchased debt royalties decreased $1.2 million, which was in line with the decrease in non-legal collections.
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Purchased Debt Expense
Purchased debt expense was $34.5 million during the three months ended June 30, 2014 compared to $44.2 million during the three months ended June 30, 2013. Purchased debt expense decreased 21.9%, which was primarily attributable to a decrease of 21.5% in total collections on purchased debt.
Court Costs, Net
Court costs, net were $10.0 million during the three months ended June 30, 2014, compared to $11.6 million during the three months ended June 30, 2013. Court costs are expensed as incurred; however, partial recovery of these costs occurs over several periods. We estimate that we recover in excess of one-third of all court costs expended.
Other Direct Operating Expense
Other direct operating expense was $3.9 million during the three months ended June 30, 2014, which represented an increase of $0.2 million from the three months ended June 30, 2013.
Costs to Collect
We refer to the costs directly related to the collection of purchased debt as our "costs to collect", which includes purchased debt expense, gross court costs, and other direct operating expense. We measure our costs to collect in relation to total collections rather than revenue due to the timing differences between revenue and expense recognition for GAAP purposes. For the purpose of this metric, we use gross court costs in the numerator because court cost recoveries are included in total collections.
The following table summarizes our costs to collect and our costs to collect excluding court costs as a % of total collections for the three months ended June 30, 2014 compared to the three months ended June 30, 2013:
Three Months Ended | |||||||||||||
June 30, | |||||||||||||
Costs to Collect ($ in thousands) | 2014 | 2013 | $ Variance | % Variance | |||||||||
Total collections | 110,011 | 140,054 | $ | (30,043 | ) | (21.5 | )% | ||||||
Costs to collect(1) | 48,671 | 59,875 | (11,204 | ) | (18.7 | )% | |||||||
Costs to collect as a % of collections | 44.2 | % | 42.8 | % | |||||||||
Costs to collect excluding court costs | 38,399 | 47,879 | (9,480 | ) | (19.8 | )% | |||||||
Costs to collect excluding court costs as a % of collections | 34.9 | % | 34.2 | % |
(1) Excludes court cost recoveries of $0.3 million and $0.4 million, respectively, to arrive at gross court costs.
The increase in costs to collect as a % of collections was attributable to an increase in court costs as a percentage of collections. Excluding court costs, costs to collect as a % of collections were slightly higher due primarily to other direct operating expenses.
Income Tax Expense
For the three months ended June 30, 2014 the combined state, federal and Canadian tax expense from operations was $2.1 million compared to income tax expense of $1.9 million for the same period in 2013. The increase was attributable to a $1.1 million expense recognized in the U.S. under IRC Section 956 of the tax law as a result of the Company’s pledge of its Canadian assets as collateral on U.S. borrowings in connection with Amendment No. 5 to the revolving credit agreement. The increase was partially offset by a decrease in estimated quarterly provision for the Company’s Canadian and US operations for the quarter ended June 30, 2014.
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The following table summarizes the results of our operations for the six months ended June 30, 2014 compared to the six months ended June 30, 2013:
Six Months Ended | |||||||||||||||
June 30, | |||||||||||||||
Consolidated Results ($ in thousands) | 2014 | 2013 | $ Variance | % Variance | |||||||||||
Revenues | |||||||||||||||
Purchased debt revenue, net | $ | 138,328 | $ | 179,646 | $ | (41,318 | ) | (23.0 | )% | ||||||
Other revenue | 28 | 391 | (363 | ) | (92.8 | )% | |||||||||
Total revenues | 138,356 | 180,037 | (41,681 | ) | (23.2 | )% | |||||||||
Expenses | |||||||||||||||
Purchased debt expense | 69,667 | 90,635 | (20,968 | ) | (23.1 | )% | |||||||||
Court costs, net | 19,141 | 21,926 | (2,785 | ) | (12.7 | )% | |||||||||
Other direct operating expense | 7,810 | 6,092 | 1,718 | 28.2 | % | ||||||||||
Salaries and payroll taxes | 15,087 | 14,005 | 1,082 | 7.7 | % | ||||||||||
General and administrative | 7,581 | 7,448 | 133 | 1.8 | % | ||||||||||
Depreciation and amortization | 3,348 | 3,911 | (563 | ) | (14.4 | )% | |||||||||
Total operating expenses | 122,634 | 144,017 | (21,383 | ) | (14.8 | )% | |||||||||
Operating income | 15,722 | 36,020 | (20,298 | ) | (56.4 | )% | |||||||||
Other expenses | |||||||||||||||
Interest expense | 22,084 | 23,383 | (1,299 | ) | (5.6 | )% | |||||||||
Other expense | 193 | 2,343 | (2,150 | ) | (91.8 | )% | |||||||||
Total other expenses | 22,277 | 25,726 | (3,449 | ) | (13.4 | )% | |||||||||
(Loss) income before income taxes | (6,555 | ) | 10,294 | (16,849 | ) | (1) | |||||||||
Income tax expense | (3,108 | ) | (2,590 | ) | (518 | ) | (20.0 | )% | |||||||
Net (loss) income | $ | (9,663 | ) | $ | 7,704 | $ | (17,367 | ) | (1) |
(1) Not meaningful.
Purchased Debt Revenue, Net
Purchased debt revenue, net was $138.3 million during the six months ended June 30, 2014 compared to $179.6 million during the six months ended June 30, 2013, a decrease of $41.3 million or 23.0%. This change was predominantly driven by a $31.4 million decrease in gross revenue on level yield assets due to a decrease in the weighted average level yield portfolio IRR. Increased purchase prices led to lower return expectations on the 2013 and 2014 purchases, which resulted in a lower overall weighted average IRR. Gross revenue on cost recovery assets decreased $4.4 million which was in line with the decrease in cost recovery proceeds due to an older base of existing assets accounted for under the cost recovery method of accounting.
During the six months ended June 30, 2014, we recorded $0.5 million in net reversals of non-cash valuation allowances on our level yield assets. Reversals of non-cash valuation allowance related to overperformance on certain 2007 - 2009 level yield pools, and partially offset by a non-cash valuation allowance charge on one 2013 level yield pool. During the six months ended June 30, 2013, we recorded $6.6 million in reversals of non-cash valuation allowances on our level yield assets related to overperformance on certain 2007 - 2009 level yield pools, which was partially offset by non-cash valuation allowance charges of $2.9 million on our cost recovery assets.
In addition, purchased debt royalties decreased $2.3 million, which was in line with the decrease in non-legal collections.
Purchased Debt Expense
Purchased debt expense was $69.7 million during the six months ended June 30, 2014 compared to $90.6 million during the six months ended June 30, 2013. Purchased debt expense decreased 23.1%, which was primarily attributable to a decrease of 21.9% in total collections on purchased debt.
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Court Costs, Net
Court costs, net were $19.1 million during the six months ended June 30, 2014, compared to $21.9 million during the six months ended June 30, 2013. Court costs are expensed as incurred; however, partial recovery of these costs occurs over several periods. We estimate that we recover in excess of one-third of all court costs expended.
Other Direct Operating Expense
Other direct operating expense was $7.8 million during the six months ended June 30, 2014, which represented an increase of $1.7 million from the six months ended June 30, 2013. This increase was attributable to certain branch office, legal, and operational expenses, including ongoing investments in operational improvements. As part of the operational improvements, SquareTwo centralized certain operating costs during the second quarter of 2013 which were previously paid for by the branch offices.
Costs to Collect
We refer to the costs directly related to the collection of purchased debt as our "costs to collect", which includes purchased debt expense, gross court costs, and other direct operating expense. We measure our costs to collect in relation to total collections rather than revenue due to the timing differences between revenue and expense recognition for GAAP purposes. For the purpose of this metric, we use gross court costs in the numerator because court cost recoveries are included in total collections.
The following table summarizes our costs to collect and our costs to collect excluding court costs as a % of total collections for the six months ended June 30, 2014 compared to the six months ended June 30, 2013:
Six Months Ended | |||||||||||||
June 30, | |||||||||||||
Costs to Collect ($ in thousands) | 2014 | 2013 | $ Variance | % Variance | |||||||||
Total collections | 220,421 | 282,362 | $ | (61,941 | ) | (21.9 | )% | ||||||
Costs to collect(1) | 97,254 | 119,389 | (22,135 | ) | (18.5 | )% | |||||||
Costs to collect as a % of collections | 44.1 | % | 42.3 | % | |||||||||
Costs to collect excluding court costs | 77,477 | 96,727 | (19,250 | ) | (19.9 | )% | |||||||
Costs to collect excluding court costs as a % of collections | 35.1 | % | 34.3 | % |
(1) Excludes court cost recoveries of $0.6 million and $0.7 million, respectively, to arrive at gross court costs.
The increase in costs to collect as a % of collections was attributable to an increase in court costs as a percentage of collections. Excluding court costs, costs to collect as a % of collections were slightly higher due primarily to other direct operating expenses.
Income Tax Expense
Income tax expense was $3.1 million for the six months ended June 30, 2014 compared to income tax expense of $2.6 million for the same period in 2013. The increase was primarily attributable to a $1.1 million expense recognized in the U.S. under IRC Section 956 of the tax law as a result of the Company’s pledge of its Canadian assets as collateral on U.S. borrowings in connection with Amendment No. 5 to the revolving credit agreement. The remainder of the expense recognized in both quarters was almost entirely attributable to the Canadian operations based on an effective tax rate of approximately 26.5% as any tax expense or benefit attributable to the pre-tax income or loss in the U.S. was entirely offset by a corresponding change in the valuation allowance.
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Adjusted EBITDA
Adjusted EBITDA is calculated as income before interest, taxes, depreciation and amortization (including amortization of the carrying value on our purchased debt), as adjusted by several items. Adjusted EBITDA generally represents cash proceeds on our owned charged-off receivables plus the contributions of our other business activities less operating expenses (other than non-cash expenses, such as depreciation and amortization) as adjusted. Adjusted EBITDA, which is a non-GAAP financial measure, should not be considered an alternative to, or more meaningful than, net income prepared on a GAAP basis. We present Adjusted EBITDA because we consider it to be an important supplemental measure of our performance. We believe Adjusted EBITDA is representative of our cash flow generation that can be used to purchase charged-off receivables, pay down or service debt, pay income taxes, and for other uses. We believe that Adjusted EBITDA is frequently used by investors and other interested parties in the evaluation of companies in our industry. In addition, the instruments governing our indebtedness use Adjusted EBITDA to measure our compliance with certain covenants and, in certain circumstances, our ability to make certain borrowings. The following table summarizes our Adjusted EBITDA for the three and six months ended June 30, 2014 compared to the three and six months ended June 30, 2013:
Three Months Ended | Six Months Ended | |||||||||||||||||||||||||||||
June 30, | June 30, | |||||||||||||||||||||||||||||
Adjusted EBITDA ($ in thousands) | 2014 | 2013 | $ Variance | % Variance | 2014 | 2013 | $ Variance | % Variance | ||||||||||||||||||||||
Voluntary, non-legal collections | $ | 50,658 | $ | 80,679 | $ | (30,021 | ) | (37.2 | )% | $ | 102,911 | $ | 164,005 | $ | (61,094 | ) | (37.3 | )% | ||||||||||||
Legal collections | 54,388 | 53,502 | 886 | 1.7 | % | 107,263 | 107,005 | 258 | 0.2 | % | ||||||||||||||||||||
Other collections(1) | 4,965 | 5,873 | (908 | ) | (15.5 | )% | 10,247 | 11,352 | (1,105 | ) | (9.7 | )% | ||||||||||||||||||
Sales, recourse & bankruptcy proceeds | 1,893 | 6,928 | (5,035 | ) | (72.7 | )% | 3,723 | 11,493 | (7,770 | ) | (67.6 | )% | ||||||||||||||||||
Contribution of other business activities(2) | 1,615 | 2,921 | (1,306 | ) | (44.7 | )% | 3,314 | 6,022 | (2,708 | ) | (45.0 | )% | ||||||||||||||||||
Total inflows | 113,519 | 149,903 | (36,384 | ) | (24.3 | )% | 227,458 | 299,877 | (72,419 | ) | (24.1 | )% | ||||||||||||||||||
Purchased debt expense | 34,495 | 44,178 | (9,683 | ) | (21.9 | )% | 69,667 | 90,635 | (20,968 | ) | (23.1 | )% | ||||||||||||||||||
Court costs, net | 9,958 | 11,623 | (1,665 | ) | (14.3 | )% | 19,141 | 21,926 | (2,785 | ) | (12.7 | )% | ||||||||||||||||||
Other direct operating expense | 3,904 | 3,701 | 203 | 5.5 | % | 7,810 | 6,092 | 1,718 | 28.2 | % | ||||||||||||||||||||
Salaries, general and administrative expenses | 11,068 | 11,158 | (90 | ) | (0.8 | )% | 22,668 | 21,453 | 1,215 | 5.7 | % | |||||||||||||||||||
Other(3) | 482 | 530 | (48 | ) | (9.1 | )% | 975 | 3,173 | (2,198 | ) | (69.3 | )% | ||||||||||||||||||
Total outflows | 59,907 | 71,190 | (11,283 | ) | (15.8 | )% | 120,261 | 143,279 | (23,018 | ) | (16.1 | )% | ||||||||||||||||||
Adjustments(4) | 198 | 239 | (41 | ) | (17.2 | )% | 805 | 1,130 | (325 | ) | (28.8 | )% | ||||||||||||||||||
Adjusted EBITDA | $ | 53,810 | $ | 78,952 | $ | (25,142 | ) | (31.8 | )% | $ | 108,002 | $ | 157,728 | $ | (49,726 | ) | (31.5 | )% |
(1) Other includes collections and court cost recoveries on commercial, student loan, and medical accounts.
(2) Includes royalties on purchased debt and other revenue.
(3) Represents certain other items consistent with our debt covenant calculation.
(4) Consistent with the covenant calculations within our revolving credit facility, adjustments include the non-cash expense related to option grants of Parent’s equity granted to our employees, directors and branch office owners, branch office note reserves, lease breakup costs, certain consulting fees, management fees paid to KRG, certain transaction expenses, recruiting expense, severance expense, and certain non-recurring items.
The table above represents cash generated by collecting debt, selling debt and other business activities, less operating and other cash expenses, resulting in Adjusted EBITDA. The table below reconciles net income to EBITDA and adjusts for certain purchasing items and other non-cash items to reconcile to Adjusted EBITDA:
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Three Months Ended | Six Months Ended | |||||||||||||||||||||||||||||
Reconciliation of Net (Loss) Income to Adjusted EBITDA ($ in thousands) | June 30, | June 30, | ||||||||||||||||||||||||||||
2014 | 2013 | $ Variance | % Variance | 2014 | 2013 | $ Variance | % Variance | |||||||||||||||||||||||
Net (loss) income | $ | (7,517 | ) | $ | 4,374 | $ | (11,891 | ) | (6) | $ | (9,663 | ) | $ | 7,704 | $ | (17,367 | ) | (6) | ||||||||||||
Interest expense | 11,075 | 11,605 | (530 | ) | (4.6 | )% | 22,084 | 23,383 | (1,299 | ) | (5.6 | )% | ||||||||||||||||||
Interest income | (38 | ) | (21 | ) | (17 | ) | (81.0 | )% | (57 | ) | (36 | ) | (21 | ) | (58.3 | )% | ||||||||||||||
Income tax expense | 2,071 | 1,940 | 131 | 6.8 | % | 3,108 | 2,590 | 518 | 20.0 | % | ||||||||||||||||||||
Depreciation and amortization | 1,706 | 1,997 | (291 | ) | (14.6 | )% | 3,348 | 3,911 | (563 | ) | (14.4 | )% | ||||||||||||||||||
EBITDA | 7,297 | 19,895 | (12,598 | ) | (63.3 | )% | 18,820 | 37,552 | (18,732 | ) | (49.9 | )% | ||||||||||||||||||
Adjustments related to purchased debt accounting | ||||||||||||||||||||||||||||||
Proceeds applied to purchased debt principal(1) | 46,633 | 61,185 | (14,552 | ) | (23.8 | )% | 88,900 | 122,690 | (33,790 | ) | (27.5 | )% | ||||||||||||||||||
Amortization of step-up of carrying value(2) | — | — | — | — | % | — | 107 | (107 | ) | (100.0 | )% | |||||||||||||||||||
Purchased debt valuation allowance reversals(3) | (318 | ) | (2,367 | ) | 2,049 | 86.6 | % | (523 | ) | (3,751 | ) | 3,228 | 86.1 | % | ||||||||||||||||
Certain other or non-cash expenses | ||||||||||||||||||||||||||||||
Stock option expense(4) | 25 | 33 | (8 | ) | (24.2 | )% | 49 | 67 | (18 | ) | (26.9 | )% | ||||||||||||||||||
Other(5) | 173 | 206 | (33 | ) | (16.0 | )% | 756 | 1,063 | (307 | ) | (28.9 | )% | ||||||||||||||||||
Adjusted EBITDA | $ | 53,810 | $ | 78,952 | $ | (25,142 | ) | (31.8 | )% | $ | 108,002 | $ | 157,728 | $ | (49,726 | ) | (31.5 | )% |
(1) Cash proceeds applied to purchased debt principal rather than recorded as revenue.
(2) Non-cash amortization of a step-up in the carrying value of certain purchased debt assets related to purchase accounting adjustments resulting from the 2005 acquisition of the Company by Parent.
(3) Represents non-cash valuation allowance reversals on purchased debt.
(4) Represents the non-cash expense related to option grants of Parent’s equity granted to certain employees, directors and branch office owners.
(5) Consistent with the covenant calculations within our revolving credit facility, other includes branch office note reserves, lease breakup costs, certain consulting fees, management fees paid to KRG, certain transaction expenses, recruiting expense, severance expense, and certain non-recurring items.
(6) Not meaningful.
The table below reconciles net cash used in operating activities to Adjusted EBITDA:
Six Months Ended | |||||||||||||||
Reconciliation of Cash Flow from Operations to Adjusted EBITDA ($ in thousands) | June 30, | ||||||||||||||
2014 | 2013 | $ Variance | % Variance | ||||||||||||
Net cash (used in) provided by operating activities | $ | (10,003 | ) | $ | 6,639 | $ | (16,642 | ) | (6) | ||||||
Proceeds applied to purchased debt principal(1) | 88,900 | 122,690 | (33,790 | ) | (27.5 | )% | |||||||||
Interest expense to be paid in cash(2) | 20,618 | 21,691 | (1,073 | ) | (4.9 | )% | |||||||||
Interest income | (57 | ) | (36 | ) | (21 | ) | (58.3 | )% | |||||||
Amortization of prepaid and other non-cash expenses | (2,084 | ) | (2,241 | ) | 157 | 7.0 | % | ||||||||
Changes in operating assets and liabilities and deferred taxes: | |||||||||||||||
Restricted cash(3) | 822 | 196 | 626 | (6) | |||||||||||
Other operating assets and liabilities and deferred taxes(4) | 5,942 | 5,136 | 806 | 15.7 | % | ||||||||||
Income tax expense | 3,108 | 2,590 | 518 | 20.0 | % | ||||||||||
Other(5) | 756 | 1,063 | (307 | ) | (28.9 | )% | |||||||||
Adjusted EBITDA | $ | 108,002 | $ | 157,728 | $ | (49,726 | ) | (31.5 | )% |
(1) Cash proceeds applied to purchased debt principal are shown in the investing activities section of the condensed consolidated statements of cash flows.
(2) Represents interest expense, excluding non-cash amortization of loan origination fees and debt discount.
(3) Represents the change in restricted cash balances for the period due to the timing of payments on our lines of credit and semi-annual interest payments on our Senior Second Lien Notes.
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(4) The amount represents timing differences due to the recognition of certain expenses and revenue items on a cash versus accrual basis.
(5) Consistent with the covenant calculations within our revolving credit facility, other includes branch office note reserves, lease breakup costs, certain consulting fees, management fees paid to KRG, certain transaction expenses, recruiting expense, severance expense, and certain non-recurring items.
(6) Not meaningful.
Segment Performance Summary
We have two reportable segments in accordance with the GAAP criteria for segment reporting: Domestic and Canada. A reporting segment's operating results are regularly reviewed by the CODM to make decisions about resources to be allocated to the segment and assess its performance. The segment operating results discussed in this section are presented on a basis consistent with our current management reporting being reviewed by our Board of Directors and the CODM.
Domestic Performance Summary
The following table presents selected financial data for our Domestic operating segment for the following periods:
Domestic Segment Performance Summary | Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | |||||||||||||||||||||||||||||
($ in thousands) | 2014 | 2013 | $ Variance | % Variance | 2014 | 2013 | $ Variance | % Variance | ||||||||||||||||||||||
Purchases - face | $ | 288,215 | $ | 985,482 | $ | (697,267 | ) | (70.8 | )% | $ | 480,747 | $ | 1,725,476 | $ | (1,244,729 | ) | (72.1 | )% | ||||||||||||
Purchases - price | 37,479 | 89,786 | (52,307 | ) | (58.3 | )% | 60,269 | 147,225 | (86,956 | ) | (59.1 | )% | ||||||||||||||||||
Purchases - price (%) | 13.0 | % | 9.1 | % | 12.5 | % | 8.5 | % | ||||||||||||||||||||||
Cash proceeds on purchased debt | 100,352 | 134,137 | (33,785 | ) | (25.2 | )% | 202,338 | 269,046 | (66,708 | ) | (24.8 | )% | ||||||||||||||||||
Total revenues | 59,845 | 83,010 | (23,165 | ) | (27.9 | )% | 125,204 | 165,034 | (39,830 | ) | (24.1 | )% | ||||||||||||||||||
Adjusted EBITDA(1) | 45,432 | 69,449 | (24,017 | ) | (34.6 | )% | 92,203 | 140,972 | (48,769 | ) | (34.6 | )% |
(1) Segment Adjusted EBITDA is calculated consistently with the methodology used to report the Company's consolidated Adjusted EBITDA, except with regard to the costs of certain overhead items that may benefit both operating segments. The costs of these overhead items are included in the calculation of Domestic Adjusted EBITDA, but have not been allocated to Canada. This treatment of certain overhead costs is consistent with CODM review.
Purchases
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Total domestic purchases decreased $697.3 million or 70.8% in face value and $52.3 million or 58.3% in capital deployed. Capital deployed for credit card/consumer loan - fresh debt decreased $28.6 million and our average price increased from 12.6% to 15.5%. In addition, capital deployed for credit card/consumer loan - non-fresh debt decreased $22.8 million. We generally attribute the decrease in domestic purchasing to decreased supply from financial institutions as a result of the uncertainty in the current regulatory environment.
Six months ended June 30, 2014 compared with six months ended June 30, 2013
Total domestic purchases decreased $1.2 billion or 72.1% in face value and $87.0 million or 59.1% in capital deployed. Capital deployed for credit card/consumer loan - fresh debt decreased $47.9 million and our average price increased from 12.0% to 15.1%. In addition, capital deployed for credit card/consumer loan - non-fresh debt decreased $28.3 million and purchases of commercial accounts decreased $6.3 million. We generally attribute the decrease in domestic purchasing to decreased supply from financial institutions as a result of the uncertainty in the current regulatory environment.
Cash Proceeds
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Domestic cash proceeds on purchased debt decreased $33.8 million or 25.2%. The largest driver was a decrease of $28.6 million or 41.2% in credit card and consumer loan voluntary, non-legal collections, due to lower face value of purchases in late 2013 and early 2014 and therefore less inventory in the voluntary, non-legal channel. In addition, sales decreased $5.7 million due to a shift in the Company's strategy away from account re-sales.
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Six months ended June 30, 2014 compared with six months ended June 30, 2013
Domestic cash proceeds on purchased debt decreased $66.7 million or 24.8%. The largest driver was a decrease of $57.9 million or 40.8%in credit card and consumer loan voluntary, non-legal collections, due to lower face value of purchases in late 2013 and early 2014 and therefore less inventory in the voluntary, non-legal channel. In addition, sales decreased $9.0 million due to a shift in the Company's strategy away from account re-sales.
Total Revenues
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Total revenues attributable to our Domestic segment decreased $23.2 million or 27.9%. Gross revenue on level yield assets decreased by $19.2 million due to a decrease in the weighted average level yield portfolio IRR. Due to higher prices for domestic level yield assets purchased during 2013 and the first half of 2014, our return expectations are lower, resulting in a lower IRR on those portfolios. In addition, gross revenue on cost recovery assets decreased $0.7 million, which was in line with the decrease in cost recovery proceeds. Non-cash valuation allowance reversals on level yield assets were $0.3 million during the three months ended June 30, 2014, compared to $5.3 million during three months ended June 30, 2013. There were no non-cash valuation allowance charges on cost recovery assets during the three months ended June 30, 2014, compared to $2.9 million during three months ended June 30, 2013. The remaining difference was a $1.2 million decrease in purchased debt royalties, which was in line with the decrease in domestic voluntary, non-legal collections.
Six months ended June 30, 2014 compared with six months ended June 30, 2013
Total revenues attributable to our Domestic segment decreased $39.8 million or 24.1%. Gross revenue on level yield assets decreased by $32.1 million due to a decrease in the weighted average level yield portfolio IRR. Due to higher prices for domestic level yield assets purchased during 2013 and the first half of 2014, our return expectations are lower, resulting in a lower IRR on those portfolios. In addition, gross revenue on cost recovery assets decreased $2.2 million, which was in line with the decrease in cost recovery proceeds. Non-cash valuation allowance reversals on level yield assets were $0.5 million during the six months ended June 30, 2014, compared to $6.6 million during the six months ended June 30, 2013. There were no non-cash valuation allowance charges on cost recovery assets during the six months ended June 30, 2014, compared to $2.9 million during the six months ended June 30, 2013. The remaining difference was a $2.3 million decrease in purchased debt royalties, which was in line with the decrease in domestic voluntary, non-legal collections.
Adjusted EBITDA
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Domestic Adjusted EBITDA decreased $24.0 million or 34.6%. This was due primarily to a decrease in cash proceeds on purchased debt of $33.8 million, which resulted in a partially offsetting $10.8 million decrease in costs to collect.
Six months ended June 30, 2014 compared with six months ended June 30, 2013
Domestic Adjusted EBITDA decreased $48.8 million or 34.6%. This was due primarily to a decrease in cash proceeds on purchased debt of $66.7 million, which resulted in a partially offsetting $21.6 million decrease in costs to collect.
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Canada Performance Summary
The following table presents selected financial data for our Canada operating segment for the following periods:
Canada Segment Performance Summary | Three Months Ended | Six Months Ended | ||||||||||||||||||||||||||||
June 30, | June 30, | |||||||||||||||||||||||||||||
($ in thousands) | 2014 | 2013 | $ Variance | % Variance | 2014 | 2013 | $ Variance | % Variance | ||||||||||||||||||||||
Purchases - face | $ | 52,592 | $ | 64,914 | $ | (12,322 | ) | (19.0 | )% | $ | 80,857 | $ | 118,911 | $ | (38,054 | ) | (32.0 | )% | ||||||||||||
Purchases - price | 4,573 | 5,195 | (622 | ) | (12.0 | )% | 7,547 | 10,026 | (2,479 | ) | (24.7 | )% | ||||||||||||||||||
Purchases - price (%) | 8.7 | % | 8.0 | % | 9.3 | % | 8.4 | % | ||||||||||||||||||||||
Cash proceeds on purchased debt | 11,552 | 12,845 | (1,293 | ) | (10.1 | )% | 21,806 | 24,809 | (3,003 | ) | (12.1 | )% | ||||||||||||||||||
Total revenues | 7,002 | 7,640 | (638 | ) | (8.4 | )% | 13,152 | 15,003 | (1,851 | ) | (12.3 | )% | ||||||||||||||||||
Adjusted EBITDA(1) | 8,378 | 9,503 | (1,125 | ) | (11.8 | )% | 15,799 | 16,756 | (957 | ) | (5.7 | )% |
(1) Segment Adjusted EBITDA is calculated consistently with the methodology used to report the Company's consolidated Adjusted EBITDA, except with regard to the costs of certain overhead items that may benefit both operating segments. The costs of these overhead items are included in the calculation of Domestic Adjusted EBITDA, but have not been allocated to Canada. This treatment of certain overhead costs is consistent with CODM review.
Purchases
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Purchases by our Canada segment decreased $12.3 million in terms of face value and $0.6 million in capital deployed, due to fewer acquisition opportunities that met our return criteria. Credit card/consumer loan - fresh purchases decreased $1.9 million in face value and $0.2 million in capital deployed and credit card/consumer loan - non-fresh purchases decreased $10.5 million in face value and $0.4 million in capital deployed. While the price of our Canadian credit card/consumer loan - fresh purchases remained consistent, the price of credit card/consumer loan - non-fresh increased slightly.
Six months ended June 30, 2014 compared with six months ended June 30, 2013
Purchases by our Canada segment decreased $38.1 million in terms of face value and $2.5 million in capital deployed, due to fewer acquisition opportunities that met our return criteria. Credit card/consumer loan - fresh purchases decreased $12.5 million in face value and $1.3 million in capital deployed and credit card/consumer loan - non-fresh purchases decreased $25.6 million in face value and $1.2 million in capital deployed. While the price of our Canadian credit card/consumer loan - fresh purchases remained consistent, the price of credit card/consumer loan - non-fresh increased.
Cash Proceeds
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Canada cash proceeds on purchased debt decreased $1.3 million or 10.1%, primarily driven by a $1.4 million decrease in voluntary, non-legal collections, due to lower face value of purchases in late 2013 and early 2014 and therefore less inventory in the voluntary, non-legal channel. Partially offsetting this decrease is a $0.1 million increase in legal collections.
Six months ended June 30, 2014 compared with six months ended June 30, 2013
Canada cash proceeds on purchased debt decreased $3.0 million or 12.1%, primarily driven by a $3.2 million decrease in voluntary, non-legal collections, due to lower face value of purchases in late 2013 and early 2014 and therefore less inventory in the voluntary, non-legal channel. Partially offsetting this decrease is a $0.2 million increase in legal collections.
Total Revenues
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Total revenues from our Canada segment decreased $0.6 million or 8.4%. The decrease was due primarily to a $1.1 million decrease in gross revenue on cost recovery assets, which was in line with the decrease in cost recovery proceeds and our cost recovery asset base, as we started placing our Canadian asset purchases on level yield accounting in January 2012. The decrease in gross revenues on cost recovery assets was partially offset by a $0.6 million increase in level yield revenue.
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Six months ended June 30, 2014 compared with six months ended June 30, 2013
Total revenues from our Canada segment decreased $1.9 million or 12.3%. The decrease was due primarily to a $2.2 million decrease in gross revenue on cost recovery assets, which was in line with the decrease in cost recovery proceeds and our cost recovery asset base, as we started placing our Canadian asset purchases on level yield accounting in January 2012. The decrease in gross revenues on cost recovery assets was partially offset by a $0.7 million increase in level yield revenue.
Adjusted EBITDA
Three months ended June 30, 2014 compared with three months ended June 30, 2013
Adjusted EBITDA decreased $1.1 million or 11.8%. Cash proceeds on purchased debt decreased $1.3 million, which resulted in an offsetting $0.4 million decrease in costs to collect.
Six months ended June 30, 2014 compared with six months ended June 30, 2013
Adjusted EBITDA decreased $1.0 million or 5.7%. Cash proceeds on purchased debt decreased $3.0 million, which resulted in an offsetting $0.5 million decrease in costs to collect.
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Supplemental Performance Data
Our Owned Portfolios
As of June 30, 2014, our active owned charged-off receivables in the U.S. and Canada totaled $9.4 billion in face value and consisted of approximately 2.3 million accounts. We believe that these accounts will represent a significant base of cash flows for us over the next nine years. The following table sets forth summary information on our active owned charged-off receivables as of June 30, 2014.
Account Type | # of Active Accts (in thousands) | Avg. Bal. per Acct. | Active Face Value ($ in millions) | Active Face Value (% of Total) | Capital Deployed(1) ($ in millions) | Capital Deployed(1) (% of Total) | |||||||||||||||
Credit Card/Consumer Loan - Fresh | 1,487 | $ | 4,009 | $ | 5,962 | 63.6 | % | $ | 2,057 | 81.5 | % | ||||||||||
Credit Card/Consumer Loan - Non-Fresh | 707 | 3,304 | 2,336 | 24.9 | % | 336 | 13.3 | % | |||||||||||||
Other(2) | 120 | 9,017 | 1,082 | 11.5 | % | 132 | 5.2 | % | |||||||||||||
Total/Average | 2,314 | $ | 4,054 | $ | 9,380 | 100.0 | % | $ | 2,525 | 100.0 | % |
(1) Capital Deployed is an aggregate life-to-date total by account type. It is a representation of resource allocation and includes active and inactive accounts.
(2) Other includes commercial, student loan, and medical purchased debt assets.
Owned Portfolio Performance
The following tables show certain data related to our purchased debt portfolios. These tables describe purchase price, cash proceeds received to date, estimated remaining cash proceeds, and related gross return on investment.
The gross ROIs for 2007 and 2008 shown below are lower in comparison to most of our historical multiples. These lower ROIs were generally caused by increased market pricing and an overall deterioration in the macroeconomic environment. The gross ROIs for 2013 and 2014 purchases are also lower in comparison to most of our historical returns, primarily due to lower supply that has resulted in increased market competition and rising prices.
U.S. Purchased Debt Portfolio as of June 30, 2014 ($ in thousands)
Purchase Period | Purchase Price(1) | Valuation Allowance (2) | Purchased Debt, net Carrying Value(3) | % of Carrying Value Unamortized(4) | Actual Proceeds Life to Date | Estimated Remaining Proceeds(5) | Total Estimated Proceeds(6) | Gross ROI(7) | |||||||||||||||||||||
2006 and prior | $ | 896,340 | $ | (4,235 | ) | $ | 1,849 | — | % | $ | 2,099,477 | $ | 1,755 | $ | 2,101,232 | 2.34x | |||||||||||||
2007 | 236,005 | (58,969 | ) | 4,074 | 2 | % | 347,986 | 6,156 | 354,142 | 1.50x | |||||||||||||||||||
2008 | 226,030 | (68,058 | ) | 7,468 | 3 | % | 335,228 | 13,879 | 349,107 | 1.54x | |||||||||||||||||||
2009 | 105,157 | (1,112 | ) | 2,776 | 3 | % | 208,066 | 15,670 | 223,736 | 2.13x | |||||||||||||||||||
2010 | 164,117 | (1,975 | ) | 1,712 | 1 | % | 383,616 | 54,880 | 438,496 | 2.67x | |||||||||||||||||||
2011 | 244,959 | (2,917 | ) | 12,223 | 5 | % | 514,474 | 109,156 | 623,630 | 2.55x | |||||||||||||||||||
2012 | 246,011 | (3,843 | ) | 42,265 | 17 | % | 389,193 | 159,411 | 548,604 | 2.23x | |||||||||||||||||||
2013 | 240,595 | (2,036 | ) | 122,397 | 51 | % | 190,289 | 237,798 | 428,087 | 1.78x | |||||||||||||||||||
2014 | 60,269 | — | 48,569 | 81 | % | 14,137 | 75,015 | 89,152 | 1.48x | ||||||||||||||||||||
Total | $ | 2,419,483 | $ | (143,145 | ) | $ | 243,333 | $ | 4,482,466 | $ | 673,720 | $ | 5,156,186 | 2.13x |
(1) Purchase price represents cost of each purchase.
(2) Valuation allowance represents the total valuation allowance on our purchased debt, net of reversals.
(3) Portfolio carrying value represents the net book value of our purchased debt portfolios excluding the impact of the branch office asset purchase program (discontinued).
(4) Percentage of carrying value unamortized represents the carrying value divided by the purchase price.
(5) Although we receive cash proceeds related to purchases with an age greater than 108 months, we do not forecast cash proceeds for these purchases beyond 108 months due to the unpredictable nature of those cash proceeds.
(6) Total estimated proceeds represent actual proceeds life to date plus the estimated remaining proceeds.
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(7) Gross ROI represents the total estimated proceeds divided by purchase price.
Canada Purchased Debt Portfolio as of June 30, 2014 (U.S. dollars in thousands)
Purchase Period | Purchase Price(1) | Valuation Allowance | Purchased Debt, net Carrying Value | % of Carrying Value Unamortized | Actual Proceeds Life to Date(1) | Estimated Remaining Proceeds(2) | Total Estimated Proceeds | Gross ROI | |||||||||||||||||||||
2006 and prior | $ | 5,885 | $ | — | $ | — | — | % | $ | 9,396 | $ | 51 | $ | 9,447 | 1.61x | ||||||||||||||
2007 | 7,889 | — | — | — | % | 14,774 | 227 | 15,001 | 1.90x | ||||||||||||||||||||
2008 | 6,282 | — | — | — | % | 9,240 | 306 | 9,546 | 1.52x | ||||||||||||||||||||
2009 | 3,350 | — | — | — | % | 9,035 | 852 | 9,887 | 2.95x | ||||||||||||||||||||
2010 | 7,706 | — | — | — | % | 27,862 | 4,083 | 31,945 | 4.15x | ||||||||||||||||||||
2011 | 22,745 | — | 238 | 1 | % | 55,136 | 9,051 | 64,187 | 2.82x | ||||||||||||||||||||
2012 | 26,746 | — | 1,978 | 7 | % | 43,974 | 12,024 | 55,998 | 2.09x | ||||||||||||||||||||
2013 | 17,515 | — | 4,371 | 25 | % | 19,042 | 20,054 | 39,096 | 2.23x | ||||||||||||||||||||
2014 | 7,547 | 4,934 | 65 | % | 3,561 | 11,660 | 15,221 | 2.02x | |||||||||||||||||||||
Total | $ | 105,665 | $ | — | $ | 11,521 | $ | 192,020 | $ | 58,308 | $ | 250,328 | 2.37x |
(1) Converted to U.S. dollars using average historical exchange rates effective in the month of activity.
(2) Converted to U.S. dollars using the exchange rate as of June 30, 2014.
Consolidated Purchased Debt Portfolio as of June 30, 2014 (U.S. dollars in thousands)
Purchase Period | Purchase Price(1) | Valuation Allowance | Purchased Debt, net Carrying Value(3) | % of Carrying Value Unamortized | Actual Proceeds Life to Date(1) | Estimated Remaining Proceeds(2) | Total Estimated Proceeds | Gross ROI | |||||||||||||||||||||
2006 and prior | $ | 902,225 | $ | (4,235 | ) | $ | 1,849 | — | % | $ | 2,108,873 | $ | 1,806 | $ | 2,110,679 | 2.34x | |||||||||||||
2007 | 243,894 | (58,969 | ) | 4,074 | 2 | % | 362,760 | 6,383 | 369,143 | 1.51x | |||||||||||||||||||
2008 | 232,312 | (68,058 | ) | 7,468 | 3 | % | 344,468 | 14,185 | 358,653 | 1.54x | |||||||||||||||||||
2009 | 108,507 | (1,112 | ) | 2,776 | 3 | % | 217,101 | 16,522 | 233,623 | 2.15x | |||||||||||||||||||
2010 | 171,823 | (1,975 | ) | 1,712 | 1 | % | 411,478 | 58,963 | 470,441 | 2.74x | |||||||||||||||||||
2011 | 267,704 | (2,917 | ) | 12,461 | 5 | % | 569,610 | 118,207 | 687,817 | 2.57x | |||||||||||||||||||
2012 | 272,757 | (3,843 | ) | 44,243 | 16 | % | 433,167 | 171,435 | 604,602 | 2.22x | |||||||||||||||||||
2013 | 258,110 | (2,036 | ) | 126,768 | 49 | % | 209,331 | 257,852 | 467,183 | 1.81x | |||||||||||||||||||
2014 | 67,816 | — | 53,503 | 79 | % | 17,698 | 86,675 | 104,373 | 1.54x | ||||||||||||||||||||
Total | $ | 2,525,148 | $ | (143,145 | ) | $ | 254,854 | $ | 4,674,486 | $ | 732,028 | $ | 5,406,514 | 2.14x |
(1) Canadian amounts converted to U.S. dollars using average historical exchange rates effective in the month of activity.
(2) Canadian amounts converted to U.S. dollars using the exchange rate as of June 30, 2014.
(3) Portfolio carrying value represents the net book value of our purchased debt portfolios excluding the impact of the branch office asset purchase program (discontinued).
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Estimated Remaining Proceeds
Based on our proprietary models and analytics, we have developed detailed cash flow forecasts for our charged-off receivables. As outlined in the tables below, we anticipate that our U.S. owned charged-off receivables as of June 30, 2014 will generate a total of approximately $673.7 million of gross cash proceeds over the next nine years. Our ERP expectations are based on historical data as well as assumptions about future collection rates and consumer behavior and are subject to a variety of factors that are beyond our control, and we cannot guarantee that we will achieve these results.
U.S. Purchased Debt Calendar Year Estimated Remaining Proceeds by Year of Purchase ($ in thousands)
Purchase Year | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 and thereafter | Total | |||||||||||||||||||||||||||
2006 and prior(1) | $ | 1,293 | $ | 462 | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — | $ | 1,755 | ||||||||||||||||||
2007 | 2,718 | 3,009 | 429 | — | — | — | — | — | 6,156 | |||||||||||||||||||||||||||
2008 | 4,974 | 6,681 | 1,969 | 255 | — | — | — | — | 13,879 | |||||||||||||||||||||||||||
2009 | 3,543 | 5,833 | 3,943 | 2,007 | 344 | — | — | — | 15,670 | |||||||||||||||||||||||||||
2010 | 11,279 | 17,513 | 12,706 | 8,472 | 4,221 | 689 | — | — | 54,880 | |||||||||||||||||||||||||||
2011 | 25,089 | 31,231 | 21,321 | 15,701 | 10,319 | 4,861 | 634 | — | 109,156 | |||||||||||||||||||||||||||
2012 | 40,260 | 48,689 | 26,372 | 17,673 | 13,189 | 8,686 | 4,041 | 501 | 159,411 | |||||||||||||||||||||||||||
2013 | 54,162 | 81,289 | 42,640 | 22,097 | 15,810 | 11,107 | 7,181 | 3,512 | 237,798 | |||||||||||||||||||||||||||
2014 | 15,533 | 24,043 | 15,327 | 8,230 | 4,246 | 2,616 | 1,836 | 3,184 | 75,015 | |||||||||||||||||||||||||||
Total | $158,851 | $218,750 | $124,707 | $74,435 | $48,129 | $27,959 | $13,692 | $7,197 | $673,720 | |||||||||||||||||||||||||||
Cumulative Percent | 23.6 | % | 56.0 | % | 74.6 | % | 85.6 | % | 92.7 | % | 96.9 | % | 98.9 | % | 100.0 | % |
U.S. Purchased Debt Rolling Twelve Months Estimated Remaining Proceeds by Year of Purchase ($ in thousands)
Purchase Year | 0 - 12 Months | 13 - 24 Months | 25 - 36 Months | 37 - 48 Months | 49 - 60 Months | 61 - 72 Months | 73 - 84 Months | 85 - 108 Months | Total | |||||||||||||||||||||||||||
2006 and prior(1) | $ | 1,715 | $ | 40 | $ | — | $ | — | $ | — | $ | — | $ | — | $ | — | $ | 1,755 | ||||||||||||||||||
2007 | 4,628 | 1,489 | 39 | — | — | — | — | — | 6,156 | |||||||||||||||||||||||||||
2008 | 8,974 | 4,016 | 865 | 24 | — | — | — | — | 13,879 | |||||||||||||||||||||||||||
2009 | 6,698 | 4,892 | 2,975 | 1,077 | 28 | — | — | — | 15,670 | |||||||||||||||||||||||||||
2010 | 20,846 | 14,877 | 10,543 | 6,346 | 2,194 | 74 | — | — | 54,880 | |||||||||||||||||||||||||||
2011 | 42,967 | 24,799 | 18,385 | 13,033 | 7,590 | 2,326 | 56 | — | 109,156 | |||||||||||||||||||||||||||
2012 | 68,968 | 34,881 | 20,930 | 15,409 | 10,918 | 6,363 | 1,895 | 47 | 159,411 | |||||||||||||||||||||||||||
2013 | 101,011 | 59,666 | 29,946 | 18,070 | 13,344 | 9,153 | 5,201 | 1,407 | 237,798 | |||||||||||||||||||||||||||
2014 | 27,829 | 20,720 | 11,110 | 5,914 | 3,245 | 2,159 | 1,626 | 2,412 | 75,015 | |||||||||||||||||||||||||||
Total | $283,636 | $165,380 | $94,793 | $59,873 | $37,319 | $20,075 | $8,778 | $3,866 | $673,720 | |||||||||||||||||||||||||||
Cumulative Percent | 42.1 | % | 66.6 | % | 80.7 | % | 89.6 | % | 95.1 | % | 98.1 | % | 99.4 | % | 100.0 | % |
(1) Represents estimated remaining proceeds for purchased debt acquired during the years 2004-2006.
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Historical Proceeds
The following table demonstrates our ability to realize continuing cash flow streams on our purchased debt, showing our cash proceeds by year, and year of purchase.
U.S. Period of Proceeds ($ in thousands)
Purchase Year | 2006 & Prior(2) | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | Total | ||||||||||||||||||||
2006 & Prior(1) | $ | 1,329,748 | $ | 338,808 | $ | 180,830 | $ | 96,778 | $ | 61,165 | $ | 40,410 | $ | 26,238 | $ | 18,207 | $ | 7,293 | $ | 2,099,477 | ||||||||||
2007 | — | 98,929 | 111,049 | 54,363 | 34,500 | 21,178 | 14,424 | 9,919 | 3,624 | 347,986 | ||||||||||||||||||||
2008 | — | — | 98,025 | 88,017 | 65,471 | 38,416 | 24,983 | 15,024 | 5,292 | 335,228 | ||||||||||||||||||||
2009 | — | — | — | 49,074 | 71,698 | 41,300 | 27,948 | 13,681 | 4,365 | 208,066 | ||||||||||||||||||||
2010 | — | — | — | — | 90,429 | 130,132 | 94,374 | 53,213 | 15,468 | 383,616 | ||||||||||||||||||||
2011 | — | — | — | — | — | 163,304 | 196,236 | 120,068 | 34,866 | 514,474 | ||||||||||||||||||||
2012 | — | — | — | — | — | — | 176,605 | 163,096 | 49,492 | 389,193 | ||||||||||||||||||||
2013 | — | — | — | — | — | — | — | 122,488 | 67,801 | 190,289 | ||||||||||||||||||||
2014 | — | — | — | — | — | — | — | — | 14,137 | 14,137 | ||||||||||||||||||||
Total | $ | 1,329,748 | $ | 437,737 | $ | 389,904 | $ | 288,232 | $ | 323,263 | $ | 434,740 | $ | 560,808 | $ | 515,696 | $ | 202,338 | $ | 4,482,466 |
(1) Represents purchase vintage years 1998-2006.
(2) Represents proceeds from purchased debt during the years 1998-2006.
The following chart represents our historical proceeds on owned debt by quarter, with collections shown in black and sales, recourse & bankruptcy proceeds in gray.
Quarterly Cash Proceeds ($ in millions)
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Liquidity and Capital Resources
Working Capital
Our primary sources of working capital are cash flows from operations, excess cash balances and bank borrowings. Our working capital levels fluctuate throughout the year based on purchasing volumes and are generally positively affected by first and second quarter collections each year when we historically tend to have higher collections. Generally, these higher first and second quarter collections are driven by tax refunds, patterns of seasonal employment, and the impact of reductions in consumer spending following the holiday season. We use our working capital to purchase charged-off receivables, service our indebtedness, and fund our operations to generate long-term growth.
Under our current borrowing structure, our lines of credit are managed separately within our domestic and Canadian operations. Our domestic operation sweeps all cash proceeds obtained to pay down our domestic line of credit daily. As a result, we maintain minimal domestic cash balances on hand, excluding our restricted cash. Domestically and in Canada, we borrow from our line of credit only as needed to reduce overall interest costs on our outstanding borrowings. Our line of credit, in total for both domestic and Canadian operations, is subject to a borrowing base and is described further in our condensed consolidated financial statements. To the extent our Canadian cash flow exceeds the cash flow needs of our Canadian operation including purchasing new assets, the excess Canadian cash flow, after paying down the Canadian line of credit to zero, is held in our Canadian bank accounts or used to pay down our domestic line of credit.
The Company from time to time enters into forward flow purchase agreements with various debt sellers to purchase specified amounts of debt for designated prices. These contracts typically cover a year or less and can generally be canceled by the Company at its discretion with 30-60 days’ notice. At June 30, 2014, the Company did not have any significant non-cancelable forward flow purchase agreements.
Based on our current level of operations, we have ample liquidity to fund our operations through the next twelve months. Our purchasing volumes and proceeds in any period fluctuate based on pricing and other macro-economic factors. We view our liquidity as our availability to borrow on our domestic and Canadian line of credit, plus our domestic and Canadian non-restricted cash balances, which primarily includes excess Canadian cash on hand. As of June 30, 2014, our total availability under our line of credit was $75.3 million based on our borrowing base calculation, and our non-restricted cash balances were $16.5 million, resulting in liquidity as of June 30, 2014 of $91.8 million.
Cash Flows
Our primary sources of liquidity are cash proceeds from purchased debt, cash from operations, excess cash balances, and borrowings on our senior revolving credit facility. Our primary uses of liquidity are to purchase additional charged-off receivables, fund operating expenses, and service our indebtedness. Our total indebtedness, net of discount, at June 30, 2014 and December 31, 2013 was $437.5 million and $437.4 million, respectively, including obligations under capital leases. Our ability to service our debt and to fund planned purchases of charged-off receivables will depend on our ability to generate cash proceeds in the future, which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors beyond our control.
The following table provides a summary of the components of cash flow for the six months ended June 30, 2014 and 2013:
Six Months Ended | ||||||||
June 30, | ||||||||
$ in thousands | 2014 | 2013 | ||||||
Net cash (used in) provided by operating activities | $ | (10,003 | ) | $ | 6,639 | |||
Net cash provided by (used in) investing activities | 18,828 | (37,612 | ) | |||||
Net cash (used in) provided by financing activities | (1,997 | ) | 33,063 | |||||
Increase in cash and cash equivalents (1) | $ | 6,828 | $ | 2,090 |
(1) Before the impact of foreign currency translation on cash of $321 and $(796), respectively.
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Operating Activities
Cash generated from operations is dependent upon our ability to generate proceeds on our purchased debt. Many factors, including the economy and our branch offices' ability to maintain low collector turnover and adequate liquidation rates, are essential to our ability to generate cash proceeds. Fluctuations in these factors that cause volatility in our business could have a material impact on our expected future cash flows. Proceeds on purchased debt recorded as revenue are included in the operating activities, while proceeds recorded as amortization of purchased debt principal are included in the investing activities. See the reconciliation of cash flow from operations to Adjusted EBITDA in the Results of Operations section herein.
Our operating activities used net cash of $10.0 million and provided $6.6 million during the six months ended June 30, 2014 and 2013, respectively, resulting in a net increase in cash used in operating activities of $16.6 million. The increase in cash used was primarily due to a $35.8 million decrease in gross revenue recognized on purchased debt assets. This was partially offset by a corresponding decrease in costs to collect including court costs of $22.1 million The remaining change in net cash provided by operating activities was due to normal changes in operating assets and liabilities.
Investing Activities
Our investing activities provided net cash of $18.8 million and used $37.6 million during the six months ended June 30, 2014 and 2013, respectively. Cash used in investing activities is primarily driven by investments in charged-off receivables offset by cash proceeds applied to the carrying value of our purchased debt. The increase in cash provided by investing activities of $56.4 million was due primarily to a $89.4 million decrease in investments in purchased debt, partially offset by a $33.8 million decrease in cash proceeds recorded as a reduction of our purchased debt carrying value.
Financing Activities
Financing activities used net cash of $2.0 million and provided $33.1 million during the six months ended June 30, 2014 and 2013, respectively. Financing activities are primarily driven by purchasing volume (which drives our incremental borrowing), payments on our revolving credit facility, capital lease obligations, and payments of origination fees on our revolving line of credit. Cash is provided by draws on our revolving credit facility and proceeds are used to pay down the revolving credit facility. The increase in cash used by financing activities of $35.1 million was due to a decrease of $80.4 million in draws on our revolving credit facility used to fund purchases and overhead costs. Lower purchasing resulted in lower collections which led to a $45.1 million decrease in payments on our revolving credit facility.
Long-term Financing
Senior Revolving Credit Facility and Senior Second Lien Notes
On May 21, 2014, SquareTwo Financial Corporation and certain of SquareTwo Financial Corporations' subsidiaries entered into Amendment No. 5 to its Loan Agreement ("Amendment No. 5") for the senior revolving credit facility. Pursuant to the terms of Amendment No. 5, the following adjustments have been made to the Loan Agreement: (i) the formula which determines the maximum amount of borrowings has been modified to include Canadian Estimated Remaining Proceeds and (ii) the collateral pool securing the loan has been modified to include Canadian assets. The remaining terms of the Loan Agreement were not impacted by Amendment No. 5.
There were no other material changes to the Company's revolving credit facility or its Senior Second Lien Notes from the information previously disclosed in the Company's most recent Annual Report on Form 10-K except for additional draws and repayments on the revolving credit facility. The balance of the outstanding line of credit under the revolving facility was $144.8 million and $145.3 million at June 30, 2014 and December 31, 2013, respectively; a decrease of $0.5 million. At June 30, 2014, our availability under the line of credit was $75.3 million based on our borrowing base calculation.
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Company Debt Outstanding as a Multiple of TTM Adjusted EBITDA
We believe the metric of debt outstanding as a multiple of TTM Adjusted EBITDA is representative of the Company's business model operating leverage. The ratio increased from 1.4x at June 30, 2013 to 1.7x at June 30, 2014 as a result of a 19.4% decrease in our TTM Adjusted EBITDA and a 4.9% decrease in our total debt. Adjusted EBITDA declined primarily due to lower cash proceeds on purchased debt.
Covenants
The senior revolving credit facility and the Senior Second Lien Notes have certain covenants and restrictions, as is customary for such facilities, with which the Company must comply. Some of the financial covenants under the revolving credit facility include: minimum Adjusted EBITDA, capital expenditures limits, and maximum operating lease obligations. The minimum Adjusted EBITDA covenant, as defined in detail in the revolving credit facility agreement is $200 million for each of the trailing twelve month periods following the fiscal quarter ending March 31, 2012. The maximum capital expenditures covenant for any fiscal year, as further described in the revolving credit facility agreement, is $8 million and is subject to provisions set forth in the agreement. Maximum aggregate rent expense and certain other operating lease obligations, excluding a certain operating lease, are $3 million in any fiscal year.
As of June 30, 2014, the Company was in compliance with all covenants and restrictions of the revolving credit facility and Senior Second Lien Notes.
Capital Leases
We had outstanding capital lease obligations relating to computer and office equipment of $2.3 million and software agreements of $1.0 million as of June 30, 2014.
Related Party Loans
During 2001, we entered into two promissory notes with two individuals related to a co-founder and member of our Board of Directors, P. Scott Lowery. The notes were issued to repurchase common stock of SquareTwo held by these related parties. These notes bear interest at a fixed rate of 8.0% and require us to make monthly principal and interest payments of less than $0.1 million. As of June 30, 2014, these notes had outstanding balances of $0.4 million and $0.3 million, respectively. The notes mature on January 15, 2016, and August 15, 2021, respectively.
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Off-Balance Sheet Arrangements
As of June 30, 2014, we did not have any off balance sheet arrangements as defined by Item 303(a)(4) of Regulation S-K.
Critical Accounting Policies
The preparation of financial statements and related disclosures in conformity with GAAP and our discussion and analysis of our financial condition and results of operations require our management to make judgments, assumptions and estimates that affect the amounts reported in our condensed consolidated financial statements and accompanying notes. We base our estimates on historical experience and on various other assumptions we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and such differences may be material.
Management believes our critical accounting policies and estimates are those related to revenue recognition, accounting estimates, valuation of acquired intangibles and goodwill and income taxes. Management believes these policies to be critical because they are both important to the portrayal of our financial condition and results, and they require management to make judgments and estimates about matters that are inherently uncertain.
Revenue
We account for our purchased debt under the guidance of ASC Topic 310-30, “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (“ASC 310-30”). Under ASC 310-30, static pools of purchased debt, aggregated based on certain common risk criteria, can be accounted for under either the interest method of accounting or the cost recovery method of accounting. Revenue recognition under ASC 310-30 is based in part on life-to-date performance of our static pools as well as our forecasts of future proceeds on those pools, which reflect our judgments and various assumptions and estimates made quarterly. See accounting for income recognized on purchased debt discussed in detail in "Management's Discussion and Analysis of Financial Condition and Results of Operations" as well as Note 2 to the condensed consolidated financial statements.
Accounting Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. Our condensed consolidated financial statements are based on a number of significant estimates, including the collectability of purchased debt and the timing of such proceeds. Due to the uncertainties inherent in the estimation process, it is at least reasonably possible that our estimates in connection with these items could be materially revised within the near term.
Goodwill and Intangible Assets
Goodwill represents the cost of acquired businesses in excess of the fair value assigned to the net tangible and identifiable intangible assets acquired. As prescribed by ASC Topic 350, "Intangibles-Goodwill and Other", goodwill is not amortized. We review goodwill for impairment annually, or more frequently, if indicators of possible impairment arise. Potential impairment is indicated when the book value of a reporting unit, including goodwill, exceeds its fair value. Significant judgments are required to estimate the fair value of reporting units and intangible assets including estimating future cash flows, and determining appropriate discount rates, growth rates, and other assumptions. If potential impairment exists, the fair value of the reporting unit is compared to the fair value of its assets and liabilities, excluding goodwill, to estimate the implied value of the reporting unit's goodwill. An impairment loss is recognized for any excess of the book value of the reporting unit's goodwill over the implied fair value.
In connection with the Acquisition, certain intangible assets were identified. The branch office intangible, with a value of $24.9 million, was deemed to have an indefinite life and, therefore, is not being amortized. We perform an impairment test annually, or more frequently, if events or changes in circumstances indicate impairment of intangible assets. Our judgments regarding the existence of impairment indicators and future cash flows related to intangible assets are based on operational performance of our businesses, market conditions and other factors.
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Income Taxes
The Company uses the liability method of accounting for income taxes in accordance with the authoritative guidance for income taxes. When the Company prepares its consolidated financial statements, it estimates income taxes based on the various jurisdictions where it conducts business. This requires the Company to estimate current tax exposure and to assess temporary differences that result from differing treatments of certain items for tax and accounting purposes. Deferred income taxes are recognized based on the difference between the financial statements and income tax bases of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. The Company then assesses the likelihood that deferred tax assets will be realized. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. When the Company establishes a valuation allowance or increases this allowance in an accounting period, it records a corresponding tax expense in the consolidated statements of operations. The Company includes interest and penalties related to the income taxes within its provision for income taxes. See Note 8 for additional discussion of income taxes.
Management must make significant judgments to determine the provision for income taxes, deferred tax assets and liabilities, and any valuation allowance to be recorded against the deferred tax assets.
Item 3. Quantitative and Qualitative Disclosure About Market Risk.
Market Risk
We are exposed to various types of market risk in the normal course of business, including the impact of interest rate changes, foreign currency exchange rate fluctuations, changes in corporate tax rates, and inflation. From time to time, we employ risk management strategies that may include the use of derivatives, such as interest rate swap agreements. We do not enter into derivatives for trading purposes.
For additional discussion of market risks affecting SquareTwo Financial, see "Quantitative and Qualitative Disclosure About Market Risk" in our Annual Report on Form 10-K. Our exposure to market risk has not changed materially since the filing of our most recent Annual Report on Form 10-K.
Item 4. Controls and Procedures.
Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rules 13a-15(e) and 13d-15(e) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal control over financial reporting during the three months ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II
Item 1. Legal Proceedings.
From time to time the Company is a defendant in ordinary routine litigation alleging violations of applicable state and federal laws by the Company or the branch offices acting on its behalf that is incidental to our business. These suits may include actions which may purport to be on behalf of a class of consumers. While the litigation and regulatory environment is challenging and continually changing, for the Company, our branch offices and our industry, in our opinion, such matters will not individually, or in the aggregate, result in a materially adverse effect on the Company's financial position, results of operations or cash flows. Management believes the range of reasonably possible loss for outstanding claims is between zero and $1.5 million. The Company accrues for loss contingencies as they become probable and estimable.
Item 1A. Risk Factors.
In addition to the other information set forth in this report, you should carefully consider the factors discussed in the section entitled "Risk Factors" in our most recent Annual Report on Form 10-K.
There have been no material changes to risk factors previously disclosed in our most recent Annual Report on Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Mine Safety Disclosures.
Not applicable.
Item 5. Other Information.
None.
Item 6. Exhibits.
Exhibit No. | Description |
31.1 | Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002 |
31.2 | Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002 |
32.1 | Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes Oxley Act of 2002 |
101.INS | XBRL Instance Document |
101.SCH | XBRL Taxonomy Extension Schema Document |
101.CAL | XBRL Taxonomy Extension Calculation Linkbase Document |
101.LAB | XBRL Taxonomy Extension Label Linkbase Document |
101.PRE | XBRL Taxonomy Extension Presentation Linkbase Document |
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
SQUARETWO FINANCIAL CORPORATION | ||
August 14, 2014 | By: | /s/ Paul A. Larkins |
Name: | Paul A. Larkins | |
Title: | Chief Executive Officer | |
(Principal Executive Officer) | ||
August 14, 2014 | By: | /s/ John D. Lowe |
Name: | John D. Lowe | |
Title: | Senior Vice President and Chief Financial Officer | |
(Principal Financial and Accounting Officer) |
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