UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2007 or
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number 000-26489
ENCORE CAPITAL GROUP, INC.
(Exact name of registrant as specified in its charter)
| Delaware | 48-1090909 | |
| (State or Other Jurisdiction of Incorporation or Organization) |
(I.R.S. Employer Identification No.) | |
| 8875 Aero Drive, Suite 200, San Diego, CA | 92123 | |
| (Address of Principal Executive Offices) | (Zip Code) | |
(877) 445-4581
(Registrant’s Telephone Number, Including Area Code)
Securities registered pursuant to Section 12(b) of the Act:
| Title of Each Class |
Name of Each Exchange on Which Registered | |
| Common Stock, $.01 Par Value Per Share | The NASDAQ Stock Market LLC |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer ¨ | Accelerated filer x | Non-accelerated filer ¨ | Smaller reporting company ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
The aggregate market value of the voting stock held by non-affiliates of the registrant totaling 9,770,383 shares was $121,934,380 at June 30, 2007, based on the closing price of the common stock of $12.48 per share on such date, as reported by the NASDAQ Global Select Market.
The number of shares of our Common Stock outstanding at February 5, 2008, was 22,991,810.
Documents Incorporated by Reference
Portions of the registrant’s proxy statement in connection with its annual meeting of shareholder to be held in 2008 are incorporated by reference in Items 10, 11, 12, 13, and 14 of Part III of this Form 10-K.
TABLE OF CONTENTS
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An Overview of Our Business
Nature of Business
We are a systems-driven purchaser and manager of charged-off consumer receivable portfolios and, through our wholly owned subsidiary Ascension Capital Group, Inc. (“Ascension”), a provider of bankruptcy services to the finance industry. We acquire receivable portfolios at deep discounts from their face values using our proprietary valuation process that is based upon an analysis of the individual consumer attributes of the underlying accounts. Based upon our ongoing analysis of these accounts, we employ a dynamic mix of collection strategies to maximize our return on investment. The receivable portfolios we purchase consist primarily of unsecured, charged-off domestic consumer credit card, auto loan deficiency and telecom receivables purchased from national financial institutions, major retail credit corporations, telecom companies and resellers of such portfolios. From 2006 through August 2007, we also purchased healthcare receivables from hospitals and resellers of healthcare receivables. In September 2007, we exited our healthcare purchasing and internal collection activities, although we are still receiving collections from certain healthcare portfolios that we purchased. Acquisitions of receivable portfolios are financed from operating cash flows and by borrowings from third parties. See Note 8 to our consolidated financial statements for further discussion of our debt. Encore is a Delaware holding company whose assets consist of investments in its subsidiaries.
We have been in the collection business for 54 years and started purchasing portfolios for our own account approximately 17 years ago. From our inception through December 31, 2007, we have invested over $936.2 million to acquire 22.3 million consumer accounts with a face value of approximately $32.7 billion.
We have established certain relationships with credit card issuers, other lenders and resellers that allow us to purchase portfolios directly through negotiated transactions, and we participate in the auction-style purchase processes that typify our industry. In addition, we enter into “forward flow” arrangements in which we agree to buy receivables that meet agreed upon parameters over the course of the contract term.
We evaluate each portfolio for purchase using the proprietary valuation and underwriting processes developed by our in-house team of statisticians. Unlike many of our competitors, which we believe often base their purchase decisions primarily on numerous aggregated portfolio-level factors, including the lender/originator, the type of receivables to be purchased, or the number of collection agencies the accounts have been placed with previously, we base our purchase decisions primarily on our analysis of the specific accounts included in a portfolio. Based upon this analysis, we determine a value for each account, which we aggregate to produce a valuation of the entire portfolio. We believe this capability allows us to perform more accurate valuations of receivable portfolios. We have successfully applied this methodology to receivables across multiple asset classes.
After we purchase a portfolio, we continuously refine our analysis of the accounts to determine the best strategy for collection. As with our purchase decisions, our collection strategies are based on account level criteria. Our collection strategies include:
| • | the use of a nationwide network of collection attorneys to pursue legal action where appropriate; |
| • | outbound calling, driven by proprietary predictive software, by our own collection workforce located at our three domestic call centers and our international call center in India; |
| • | the use of multiple third party collection agencies; |
| • | direct mail campaigns coordinated by our in-house marketing group; |
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| • | the transfer of accounts to a credit card provider, generating a payment to us; and |
| • | the sale of accounts where appropriate. |
Investors wishing to obtain more information about Encore Capital Group, Inc. may access our Internet site (www.encorecapitalgroup.com) that allows access to relevant investor related information, free of charge, such as Security and Exchange Commission (“SEC”) filings, analyst coverage and earnings estimates, press releases, featured articles, an event calendar, and frequently asked questions. SEC filings are available on our website as soon as reasonably practicable after being filed with, or furnished to, the SEC. The contents of our Internet site are not incorporated by reference in this Annual Report on Form 10-K.
Our Strengths
Empirically Based and Technology-Driven Business Processes. We have assembled a team of statisticians, business analysts and software programmers that have developed and continually enhance proprietary valuation models, software and other business systems that guide our portfolio purchases and collection efforts. Our information technology department has developed and continually updates sophisticated software that manages the movement of data, accounts and information throughout the company. These proprietary systems give us the flexibility, speed and control to capitalize on business opportunities.
Account—Based Portfolio Valuation. We analyze each account within a portfolio presented to us for purchase to determine the likelihood and expected amount of payment. We utilize an internally-developed valuation process based on a set of proprietary statistical models that predict behavior at the consumer level. Individual consumer characteristics are weighted, account-level payment expectations are determined, the expectations for each account are then aggregated to arrive at a portfolio-level liquidation assessment and a valuation for the entire portfolio is made. Our valuations are derived in large part from information accumulated on approximately 19.8 million accounts acquired since mid-2000, supplemented by external data purchased from providers.
Dynamic Collections Approach. Over the past several years, we have dramatically reduced our dependence on general outbound calling by expanding our collection strategies. Moreover, because the status of individual debtors changes continually, once each quarter we re-analyze all of our accounts with refreshed external data, which we supplement with information gleaned from our own collection efforts. We modify our collection method for each account if warranted.
Experienced Management Team. Our management team has considerable experience in finance, banking, consumer collections and other industries. We believe that the expertise of our executives obtained by managing businesses across numerous other industries has been critical to the enhancement of our operations. Our management team has created a culture of new ideas and progressive thinking, coupled with the increased use of technology and statistical analysis.
Our Strategy
To enhance our position in the industry, we have implemented a business strategy that emphasizes the following elements:
Implement and Refine New and Existing Collection Channels. We continually refine our collection processes, and evaluate new collection strategies, such as strategic outsourcing, to further supplement our traditional call center approach. We believe that our multiple and dynamic approach to collections increases our opportunity to achieve enhanced returns on our investments.
Leverage Expertise in New Markets. We believe that our internally developed underwriting and collection processes can be extended to a variety of charged-off consumer receivables in addition to charged-off credit card
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receivables. We intend to continue to leverage our valuation, underwriting and collection processes to other charged-off receivable markets, including auto loan deficiencies, telecom and general consumer loans. To date, our purchases in other charged-off receivable markets have generally performed to expectations.
Continue to Build Our Data Management and Analysis Capabilities. We are continually improving our technology platform and our pricing, underwriting and collection processes through software development, statistical analysis and experience.
Consider Complementary Acquisitions. We will actively pursue acquisitions of complementary companies to expand into new markets, add capacity in our current business, or leverage our knowledge of the distressed consumer.
Acquisition of Receivables
Typically, receivable portfolios are offered for sale through a general auction, “forward flow” contract or direct negotiation. A “forward flow” contract is a commitment to purchase a defined volume of accounts from a seller for a period of typically 3 to 12 months, though such commitments can extend up to several years. We believe long-term success is achieved by combining a diverse sourcing approach with an account level scoring methodology and a disciplined evaluation process.
Identify purchase opportunities. We employ a team of professionals who maintain relationships with the largest credit grantors in the United States. Their role is to identify purchase opportunities and secure, if possible, exclusive negotiation rights for Encore.
Analyze paper—account level analytics. Once a portfolio acquisition is identified, our internal modeling team analyzes information provided by the seller and other external sources, if appropriate, to determine the expected value of each potential new consumer. The expected value of each individual consumer is aggregated into a total portfolio value. We will remain focused on making purchasing decisions based on sound quantitative and qualitative analysis.
Collection Strategies
We expand upon the insights created during our purchasing process when building account collection strategies. Our proprietary consumer-level collectability analysis is the primary determinant of whether an account is actively worked post-purchase. Throughout our ownership period, we continuously refine this analysis to determine the most effective collection strategy to pursue for each account. These strategies consist of:
| • | Legal Action. We generally outsource those accounts where it appears the debtor is able, but is unwilling to pay. We utilize lawyers that specialize in collection matters, paying them a contingency fee on amounts collected. This process is managed by our Legal Outsourcing Department. Prior to sending accounts to a law firm, a specialized internal group of collectors, or “Recovery Collectors,” communicates to the debtor our intention to have a lawyer evaluate the suitability of the account for litigation if payment arrangements cannot be established. |
| • | Call Centers. We maintain domestic collection call centers in San Diego, CA, Phoenix, AZ and St. Cloud, MN and an international call center in Gurgaon, India. Each site location consists of multiple collection departments, which are divided by specialties, each consisting of Group Managers supervising Account Managers. Account Managers are trained to use a friendly, but firm approach to assess the willingness of the customer to pay. They attempt to work with customers to evaluate sources and means of repayment to achieve a full or negotiated lump sum settlement or develop payment programs customized to the individual’s ability to pay. In some cases, collectors advise the debtors of alternative sources of financing to pay off their debt. In cases where a payment plan is developed, collectors encourage debtors to pay through automatic payment arrangements. |
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| • | Third Party Collection Agencies. We selectively employ a strategy that uses collection agencies, which receive a contingency fee for each dollar collected. Generally, we use these agencies where we believe they can liquidate better or less expensively on certain accounts than we can in our internal call centers. These include, among others, accounts that generally have low liquidation expectations, such as accounts with small balances or with limited consumer contact information. We also use agencies to initially provide us a way to scale quickly when large purchases are made and as a challenge to our internal call center collection teams. |
| • | Direct Mail. We have an in-house marketing team that develops innovative mail campaigns. The mail campaigns generally offer debtors targeted discounts on their balances owed to encourage settlement of their accounts and to provide us with a low cost recovery method. |
| • | Sale. We believe our ability to analyze portfolios enables us to periodically sell a portion of such portfolios to buyers at a favorable price. We may consider selling certain accounts if we believe the current market price exceeds our estimate of the net present value of remaining collections or determine that additional recovery efforts are not warranted. In addition, under contractual obligations with Jefferson Capital, LLC (“Jefferson Capital”), we sell, on a forward flow basis, all accounts for which the debtor has filed for protection under the United States Bankruptcy Code. This agreement expires concurrently with our forward flow purchase agreement with Jefferson Capital, which expires the earlier of June 2010 or upon our purchase of $3.0 billion of face value in specified portfolio receivables from Jefferson Capital. See Note 12 to our consolidated financial statements for a further discussion of our forward flow purchase agreement. |
| • | Account Balance Transfer. We may transfer to our credit card partners accounts for which this approach offers the highest opportunity for success. The credit card partners may offer the debtor the opportunity to establish new credit and to transfer the balance onto a new credit card. If the account is transferred we receive an agreed-upon payment. |
| • | Skip Tracing. If a debtor’s phone number proves inaccurate when a collector calls an account, or if current contact information for a debtor is not available at the time of account purchase, then the account is automatically routed to our database skip tracing process. We currently use a number of different companies to provide phone numbers and addresses. |
| • | Inactive. We use our collection resources judiciously and efficiently by not deploying resources on accounts where the prospects of collection are remote. For example, for accounts where the debtor is currently unemployed, overburdened by debt, incarcerated, or deceased, no collection method of any sort is assigned. |
Competition
The consumer credit recovery industry is highly competitive and fragmented. We compete with a wide range of collection companies, financial services companies and a number of well-funded, newer entrants with limited experience in our industry. We also compete with traditional contingency collection agencies and in-house recovery departments. Competitive pressures affect the availability and pricing of receivable portfolios, as well as the availability and cost of qualified recovery personnel. In addition, some of our competitors may have signed forward flow contracts under which originating institutions have agreed to transfer charged-off receivables to them in the future, which could restrict those originating institutions from selling receivables to us. We believe some of our major competitors, which include companies that focus primarily on the purchase of charged-off receivable portfolios, have continued to diversify into third-party agency collections and into offering credit card and other financial services as part of their recovery strategy.
When purchasing receivables, we compete primarily on the basis of the price paid for receivable portfolios, the ease of negotiating and closing the prospective portfolio purchases with us, including our ability to obtain funding and our reputation with respect to the quality of services that we provide. There continues to be
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consolidation of issuers of credit cards, which have been a principal source of receivable purchases. This consolidation has limited the sellers in the market and has correspondingly given the remaining sellers increasing market strength in establishing the price and terms of the sale of credit card accounts.
Government Regulation
In a number of states we must maintain licenses to perform debt recovery services and must satisfy related bonding requirements. We believe that we have satisfied all material licensing and bonding requirements, and are in compliance with all material government regulations. Adoption of new licensing requirements, or changing interpretations of existing requirements, could restrict our ability to collect in states, subject us to increased regulatory regulations, increase our costs, or adversely affect our ability to enforce our receivables.
The Fair Debt Collection Practices Act (“FDCPA”) and comparable state statutes establish specific guidelines and procedures which debt collectors must follow when communicating with customers, including the time, place and manner of the communications. It is our policy to comply with the provisions of the FDCPA and comparable state statutes in all of our recovery activities, even though we may not be specifically subject to these laws. Our failure to comply with these laws could have a material adverse effect on us if they apply to some or all of our recovery activities. In addition to the FDCPA, significant federal laws applicable to our business include the following:
| • Truth-In-Lending Act; |
• U.S. Bankruptcy Code; | |
| • Fair Credit Billing Act; |
• Gramm-Leach-Bliley Act; | |
| • Equal Credit Opportunity Act; |
• Health Insurance Portability and Accountability Act; and | |
| • Fair Credit Reporting Act; |
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| • Electronic Funds Transfer Act; |
• Regulations that relate to these Acts |
Additionally, there may be comparable statutes in those states in which our customers reside or in which the originating institutions are located. State laws may also limit the interest rate and the fees that a credit originator may impose on its customers, and also limit the time in which we may file legal actions to enforce consumer accounts.
The relationship between a customer and a credit card issuer is extensively regulated by federal and state consumer protection and related laws and regulations. While we do not issue credit cards, these laws affect some of our operations because the majority of our receivables were originated through credit card transactions. The laws and regulations applicable to credit card issuers, among other things, impose disclosure requirements when a credit card account is advertised, when it is applied for and when it is opened, at the end of monthly billing cycles, and at year-end. Federal law requires, among other things, that credit card issuers disclose to consumers the interest rates, fees, grace periods and balance calculation methods associated with their credit card accounts. Some laws prohibit discriminatory practices in connection with the extension of credit. If the originating institution fails to comply with applicable statutes, rules, and regulations, it could create claims and rights for the debtors that would reduce or eliminate their obligations under their receivables, and have a possible material adverse effect on us. When we acquire receivables, we generally require the originating institution to contractually indemnify us against losses caused by its failure to comply with applicable statutes, rules and regulations relating to the receivables before they are sold to us.
Federal statutes further provide that, in some cases, consumers cannot be held liable for, or their liability is limited with respect to, charges to their credit card accounts that resulted from unauthorized use of their credit cards. These laws, among others, may give consumers a legal cause of action against us, or may limit our liability to recover amounts owing with respect to the receivables, whether or not we committed any wrongful act or omission in connection with the account.
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State and federal laws concerning identity theft, privacy, data security, the use of automated dialing equipment and other laws related to debtors and consumer protection, as well as laws applicable to specific types of debt, impose requirements or restrictions on collection methods or our ability to enforce and recover certain debts. These requirements or restrictions could adversely affect our ability to enforce the collection of the receivables.
The laws described above, among others, as well as any new laws, rules or regulations, may adversely affect our ability to recover amounts owing with respect to the receivables.
Employees
As of December 31, 2007, we had approximately 1,000 employees. None of our employees are represented by a labor union. We believe that our relations with our employees are good.
Risk Factors
Recent instability in the financial markets may have an impact on our business.
Recently, the residential real estate market in the U.S. has experienced a significant downturn due to declining real estate values, substantially reducing mortgage loan originations and securitizations, and precipitating more generalized credit market dislocations and a significant contraction in available liquidity globally. These factors, combined with rising oil prices, declining business and consumer confidence and increased unemployment, have precipitated an economic slowdown and fears of a possible recession. Individual consumers are experiencing higher delinquency rates on various consumer loans and defaults on indebtedness of all kinds has increased. Further declines in real estate values in the U.S. or elsewhere and continuing credit and liquidity concerns could further reduce our ability to collect on our purchased consumer receivable portfolios while adversely affecting their value. In addition, continued or further credit market dislocations or sustained market downturns may reduce the ability of lenders to originate new credit, limiting our ability to purchase consumer receivable portfolios in the future. Further, increased financial pressure on the distressed consumer may result in additional regulatory restrictions on our operations and increased litigation filed against us.
Our quarterly operating results may fluctuate and cause the prices of our common stock and convertible notes to decrease.
Our quarterly operating results will likely vary in the future due to a variety of factors that could affect our revenues and operating expenses in any particular quarter. We expect that our operating expenses as a percentage of collections will fluctuate in the future as we expand into new markets, increase our new business development efforts, hire additional personnel and incur increased insurance and regulatory compliance costs. In addition, our operating results have fluctuated and may continue to fluctuate as the result of the factors described below and elsewhere in this Annual Report on Form 10-K:
| • | the timing and amount of collections on our receivable portfolios, including the effects of seasonality; |
| • | any charge to earnings resulting from an impairment in the carrying value of our receivable portfolios; |
| • | increases in operating expenses associated with the growth or change of our operations; |
| • | the cost of credit to finance our purchases of receivable portfolios; and |
| • | the timing and terms of our purchases of receivable portfolios. |
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Due to rising prices for consumer receivable portfolios, there has been considerable variation in our purchasing volume from quarter to quarter and we expect that to continue. The volume of our portfolio purchases will be limited while prices are high. Because we recognize revenue on the basis of projected collections on purchased portfolios, we may experience variations in quarterly revenue and earnings due to the timing of portfolio purchases.
Accordingly, results for any one quarter are not necessarily indicative of results to be expected for any other quarter or for any year, and revenues and earnings for any particular future period may decrease. In the future, if operating results fall below the expectations of securities analysts and investors, the price of our common stock and convertible notes likely would decrease.
We may not be able to purchase receivables at sufficiently favorable prices or terms, or at all.
Our ability to continue to operate profitably depends upon the continued availability of receivable portfolios that meet our purchasing standards and are cost-effective based upon projected collections exceeding our costs. The market for acquiring receivable portfolios has become more competitive. Our industry has attracted a large amount of investment capital. With this inflow of capital, we have seen a significant increase in the pricing of receivable portfolios to levels that we believe will generate reduced returns on investment and which will negatively affect our results of operations.
In addition to the competitive factors discussed above, the availability of consumer receivable portfolios at favorable prices and on favorable terms depends on a number of factors, within and outside of our control, including:
| • | the continuation of the current growth and charge-off trends in consumer debt; |
| • | the continued sale of receivable portfolios by originating institutions; |
| • | our ability to develop and maintain long-term relationships with key major credit originators; |
| • | our ability to obtain adequate data from credit originators or portfolio resellers to appropriately evaluate the collectability of, and estimate the value of, portfolios; and |
| • | changes in laws and regulations governing consumer lending, bankruptcy and collections |
In addition, because of the length of time involved in collecting charged-off consumer receivables on acquired portfolios and the volatility in the timing our collections, we may not be able to identify trends and make changes in our purchasing strategies in a timely manner. Ultimately, if we are unable to continually purchase and collect on a sufficient volume of receivables to generate cash collections that exceed our costs, our business will be materially and adversely affected.
We may not be successful in acquiring and collecting on portfolios consisting of new types of receivables.
We may pursue the acquisition of portfolios consisting of assets with which we have little collection experience. We may not be successful in completing any of these acquisitions. Our lack of experience with new types of receivables may cause us to pay too much for these receivable portfolios, which may substantially hinder our ability to generate profits from such portfolios. Even if we successfully acquire such new types of receivables, our existing methods of collections may prove ineffective for such new receivables and our inexperience may materially and adversely affect our financial condition.
We may not be able to collect sufficient amounts on our receivable portfolios to recover our costs and fund our operations.
We acquire and service receivables that the obligors have failed to pay and the sellers have deemed uncollectible and written off. The originating institutions generally make numerous attempts to recover on their
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nonperforming receivables, often using a combination of their in-house collection and legal departments as well as third-party collection agencies. In order to operate profitably over the long term, we must continually purchase and collect on a sufficient volume of receivables to generate revenue that exceeds our costs. These receivables are difficult to collect, and we may not be successful in collecting amounts sufficient to cover the costs associated with purchasing the receivables and funding our operations. If we are not able to collect on these receivables or collect sufficient amounts to cover our costs, this may materially and adversely affect our financial condition.
We may purchase portfolios that contain unprofitable accounts.
In the normal course of our portfolio acquisitions, some receivables may be included in the portfolios that fail to conform to the terms of the purchase agreements and we may seek to return these receivables to the seller for payment or replacement. However, we cannot guarantee that such sellers will be able to meet their obligations to us. Accounts that we are unable to return to sellers may yield no return. If we purchase portfolios containing too many accounts that do not conform to the terms of the purchase contracts or contain accounts that are otherwise uncollectible, we may be unable to collect a sufficient amount and the portfolio purchase could be unprofitable, which would have an adverse effect on our cash flows. If cash flows from operations are less than anticipated, our ability to satisfy our debt obligations, purchase new portfolios and our future growth and profitability may be materially and adversely affected.
The statistical model we use to project remaining cash flows from our receivable portfolios may prove to be inaccurate, which could result in reduced revenues or the recording of an impairment charge if we do not achieve the collections forecasted by our model.
We use our internally developed Unified Collection Score, or UCS model, to project the remaining cash flows from our receivable portfolios. Our UCS model considers known data about our customers’ accounts, including, among other things, our collection experience and changes in external customer factors, in addition to all data known when we acquired the accounts. There can be no assurance, however, that we will be able to achieve the collections forecasted by our UCS model. If we are not able to achieve these levels of forcasted collection, our revenues will be reduced or we may be required to record an impairment charge, which results in a reduction of our earnings.
We may not be successful in recovering court costs we anticipate recovering.
We contract with a nationwide network of attorneys that specialize in collection matters. We generally refer charged-off accounts to our contracted attorneys when we believe the related debtor has sufficient assets to repay the indebtedness and has, to date, been unwilling to pay. In connection with our agreements with our contracted attorneys, we advance certain out-of-pocket court costs (“Deferred Court Costs”). Deferred Court Costs represent amounts we believe we will recover from the obligors in addition to the amounts owed on their accounts. These court costs may bedifficult to collect, and we may not be successful in collecting amounts sufficient to cover the amounts deferred in our financial statements. If we are not able to recover these court costs, this may materially and adversely affect our financial condition.
Our industry is highly competitive, and we may be unable to continue to compete successfully with businesses that may have greater resources than we have.
We face competition from a wide range of collection and financial services companies that may have substantially greater financial, personnel and other resources, greater adaptability to changing market needs and more established relationships in our industry than we currently have. We also compete with traditional contingency collection agencies and in-house recovery departments. Competitive pressures adversely affect the availability and pricing of charged-off receivable portfolios, as well as the availability and cost of qualified recovery personnel. Because there are few significant barriers to entry for new purchasers of charged-off
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receivable portfolios, there is a risk that additional competitors with greater resources than ours, including competitors that have historically focused on the acquisition of different asset types, will enter our market. If we are unable to develop and expand our business or adapt to changing market needs as well as our current or future competitors, we may experience reduced access to charged-off receivable portfolios at acceptable prices, which could reduce our profitability.
Moreover, we cannot assure you that we will be able to offer competitive bids for charged-off receivable portfolios. We face bidding competition in our acquisition of charged-off receivable portfolios. In our industry, successful bids generally are awarded on a combination of price, service and relationships with the debt sellers. Some of our current and future competitors may have more effective pricing and collection models, greater adaptability to changing market needs and more established relationships in our industry. They also may pay prices for portfolios that we determine are not reasonable. We cannot assurethat we will be able to offer competitive bids for charged-off consumer receivable portfolios. In addition, there continues to be consolidation of issuers of credit cards, which have been a principal source of receivable purchases. This consolidation has limited the number of sellers in the market and has correspondingly given the remaining sellers increasing market strength in the price and terms of the sale of credit card accounts.
In addition, we believe that issuers of credit cards are increasingly using outsourced, off-shore alternatives in connection with their collection of delinquent accounts in an effort to reduce costs. If these off-shore efforts are successful, these issuers may decrease the number of portfolios available for sale and increase the purchase price for portfolios available for sale.
Our failure to purchase sufficient quantities of receivable portfolios may necessitate workforce reductions, which may harm our business.
Because fixed costs, such as certain personnel costs and lease or other facilities costs, constitute a significant portion of our overhead, we may be required to reduce the number of employees in our collection operations if we do not continually augment the receivable portfolios we service with additional receivable portfolios or collect sufficient amounts on receivables owned or serviced by us. Reducing the number of employees can affect our business adversely and lead to:
| • | lower employee morale, higher employee attrition rates, fewer experienced employees and higher recruiting and training costs; |
| • | disruptions in our operations and loss of efficiency in collection functions; and |
| • | excess costs associated with unused space in collection facilities. |
A significant portion of our portfolio purchases during any period may be concentrated with a small number of sellers.
We expect that a significant percentage of our portfolio purchases for any given fiscal year may be concentrated with a few large sellers, some of which also may involve forward flow arrangements. We cannot be certain that any of our significant sellers will continue to sell charged-off receivables to us on terms or in quantities acceptable to us, or that we would be able to replace such purchases with purchases from other sellers.
A significant decrease in the volume of purchases from any of our principal sellers would force us to seek alternative sources of charged-off receivables. We may be unable to find alternative sources from which to purchase charged-off receivables, and even if we could successfully replace such purchases, the search could take time, the receivables could be of lower quality, cost more, or both, any of which could materially adversely affect our financial performance.
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We may be unable to meet our future liquidity requirements.
We depend on both internal and external sources of financing to fund our purchases of receivable portfolios and our operations. Our need for additional financing and capital resources increases dramatically as our business grows. Our inability to obtain financing and capital as needed or on terms acceptable to us would limit our ability to acquire additional receivable portfolios and to operate our business.
We may not be able to continue to satisfy the restrictive covenants in our debt agreements.
All of our receivable portfolios are pledged to secure amounts owed to our lenders. Our debt agreement imposes a number of restrictive covenants on how we operate our business. Failure to satisfy any one of these covenants could result in all or any of the following consequences, each of which could have a materially adverse effect on our ability to conduct business:
| • | acceleration of outstanding indebtedness; |
| • | our inability to continue to purchase receivables needed to operate our business; or |
| • | our inability to secure alternative financing on favorable terms, if at all. |
We use estimates in our revenue recognition and our earnings will be reduced if actual results are less than estimated.
We utilize the interest method to determine revenue recognized on substantially all of our receivable portfolios. Under this method, each pool of receivables is modeled based upon its projected cash flows. A yield is then established which, when applied to the outstanding balance of the pool of receivables, results in the recognition of revenue at a constant yield relative to the remaining balance in the pool . The actual amount recovered by us may substantially differ from our projections and may be lower than initially projected. If differences are material, we may take an impairment charge on all or on a portion of our investment, which would negatively affect our earnings.
We may incur impairment charges based on the provisions of American Institute of Certified Public Accountants Statement of Position 03-03.
In October 2003, the American Institute of Certified Public Accountants, or AICPA, issued Statement of Position, or SOP, 03-03, “Accounting for Loans or Certain Securities Acquired in a Transfer.” The SOP provides guidance on accounting for differences between contractual and expected cash flows from an investor’s initial investment in loans or debt securities acquired in a transfer if those differences are attributable, at least in part, to credit quality. The SOP is effective for receivable portfolios acquired in fiscal years beginning after December 15, 2004 and was adopted by us on January 1, 2005. The SOP limits the revenue that may be accrued to the excess of the estimate of expected future cash flows over a portfolio’s initial cost of accounts receivable acquired. The SOP requires that the excess of the contractual cash flows over expected cash flows not be recognized as an adjustment of revenue, expense, or on the balance sheet. The SOP freezes the internal rate of return (“IRR”) originally estimated when the accounts receivable are purchased for subsequent impairment testing. Rather than lower the estimated IRR if the expected future cash flow estimates are decreased, the carrying value of our receivable portfolios would be written down to maintain the then-current IRR. The SOP also amends AICPA Practice Bulletin 6 in a similar manner and applies to all loans acquired prior to January 1, 2005. Increases in expected future cash flows would be recognized prospectively through an upward adjustment of the IRR over a portfolio’s remaining life. Any increased yield then becomes the new benchmark for impairment testing. The SOP provides that previously issued annual financial statements do not need to be restated. Historically, as we have applied the guidance of AICPA Practice Bulletin 6, we have moved yields upward and downward, as appropriate under that guidance. However, since the SOP guidance does not permit yields to be lowered, there is an increased probability of our having to incur impairment charges in the future, which would negatively impact our profitability.
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Government regulation may limit our ability to recover and enforce the collection of receivables.
Federal and state laws and regulations may limit our ability to recover and enforce the collection of receivables regardless of any act or omission on our part. Laws relating to debt collections also directly apply to our business. Additional consumer protection or privacy laws and regulations may be enacted that impose additional restrictions on the collection of receivables. Such new laws may materially adversely affect our ability to collect on our receivables, which could materially and adversely affect our earnings. Our failure or the failure of third party agencies and attorneys or the originators of our receivables to comply with existing or new laws, rules or regulations could limit our ability to recover on receivables or cause us to pay damages to the original debtors, which could reduce our revenues and harm our business.
Some laws and regulations applicable to credit card issuers or other debt originators may preclude us from collecting on receivables we purchase where the card issuer or originator failed to comply with applicable federal or state laws in generating or servicing the receivables that we have acquired. Because our receivables generally are originated and serviced nationwide, we cannot assure that the originating lenders have complied with applicable laws and regulations. While receivable acquisition contracts typically contain provisions indemnifying us for losses owing to the originating institution’s failure to comply with applicable laws and other events, we cannot assure that any indemnities received from originating institutions will be adequate to protect us from losses on the receivables or liabilities to customers.
We purchase accounts in asset classes that are subject to industry-specific restrictions that limit the collections methods that we can use on those accounts. Our inability to collect sufficient amounts from these accounts through available collections methods could materially and adversely affect our financial performance.
Failure to comply with government regulation could result in the suspension or termination of our ability to conduct business.
The collections industry is regulated under various federal and state laws and regulations. Many states and several cities require that we be licensed as a debt collection company. The Federal Trade Commission, state Attorneys General and other regulatory bodies have the authority to investigate consumer complaints against debt collection companies and to recommend enforcement actions and seek monetary penalties. If we fail to comply with applicable laws and regulations, it could result in the suspension or termination of our ability to conduct collection operations, which would materially adversely affect us. In addition, new federal, state or local laws or regulations, or changes in the ways these rules or laws are interpreted or enforced, could limit our activities in the future or significantly increase the cost of regulatory compliance.
We rely on the court system for a significant portion of our collections.
We generate a significant portion of our revenue by collecting on judgments that are granted by courts in lawsuits filed against debtors. A decrease in the willingness of courts to grant such judgments or a change in the requirements for filing such cases or obtaining such judgments could have a material adverse effect on our operations and financial results.
We are subject to ongoing risks of litigation, including individual and class actions under consumer credit, collections, employment, securities and other laws.
We operate in an extremely litigious climate and currently are, and may in the future, be named as defendants in litigation, including individual and class actions under consumer credit, collections, employment, securities and other laws.
In the past, securities class-action litigation has often been filed against a company after a period of volatility in the market price of its stock. Our industry experiences a high volume of litigation, and legal precedents have not been clearly established in many areas applicable to our business. Additionally,
13
employment-related litigation is increasing throughout the country. Defending a lawsuit, regardless of its merit, could be costly and divert management’s attention from the operation of our business. Damage awards or settlements could be significant. The use of certain collection strategies could be restricted if class-action plaintiffs were to prevail in their claims. All of these factors could have an adverse effect on our consolidated financial condition and results of operations.
We may make acquisitions that prove unsuccessful or strain or divert our resources.
From time to time, we consider acquisitions of other companies that could complement our business, including the acquisition of entities in diverse geographic regions and entities offering greater access to businesses and markets that we do not currently serve. For instance, during 2005 we aquired Ascension Capital Group and certain assets of Jefferson Capital. See Note 2 to the consolidated financial statements for a further discussion of “Acquisition of Businesses.” We may not be able to successfully acquire other businesses or, if we do, the acquisition may be unprofitable. In addition, we may not successfully operate the businesses, or may not successfully integrate such businesses with our own, which may result in our inability to maintain our goals, objectives, standards, controls, policies or culture. In addition, through acquisitions, we may enter markets in which we have limited or no experience. The occurrence of one or more of these events may place additional constraints on our resources such as diverting the attention of our management from other business concerns, which can materially adversely affect our operations and financial condition. Moreover, any acquisition may result in a potentially dilutive issuance of equity securities, incurrence of additional debt and amortization of identifiable intangible assets, all of which could reduce our profitability.
We are dependent on our management team for the adoption and implementation of our strategies and the loss of their services could have a material adverse effect on our business.
Our management team has considerable experience in finance, banking, consumer collections and other industries. We believe that the expertise of our executives obtained by managing businesses across numerous other industries has been critical to the enhancement of our operations. Our management team has created a culture of new ideas and progressive thinking, coupled with increased use of technology and statistical analysis. The loss of the services of one or more of our key executive officers could disrupt our operations and seriously impair our ability to continue to acquire or collect on portfolios of charged-off consumer receivables and to manage and expand our business. Our success depends on the continued service and performance of our management team, and we cannot guarantee that we will be able to retain such individuals.
We may not be able to hire and retain enough sufficiently trained employees to support our operations, and/or we may experience high rates of personnel turnover.
Our industry is very labor-intensive, and companies in our industry typically experience a high rate of employee turnover. We generally compete for qualified collections personnel with companies in our business and in the collection agency, teleservices and telemarketing industries and we compete for qualified non-collections personnel with companies in many industries. We will not be able to service our receivables effectively, continue our growth or operate profitably if we cannot hire and retain qualified collection personnel. Further, high turnover rate among our employees increases our recruiting and training costs and may limit the number of experienced collection personnel available to service our receivables. Our newer employees tend to be less productive and generally produce the greatest rate of personnel turnover. If the turnover rate among our employees increases, we will have fewer experienced employees available to service our receivables, which could reduce collections and therefore result in lower revenues and earnings.
Exposure to regulatory and economic conditions in India exposes us to risks or loss of business.
A significant element of our business strategy is to continue to develop and expand offshore operations in India. While wage costs in India are significantly lower than in the U.S. and other industrialized countries for comparably skilled workers, wages in India are increasing at a faster rate than in the U.S., and we experience
14
higher employee turnover in our India site. The continuation of these trends could result in the loss of the cost savings we sought to achieve by moving a portion of our collection operations to India. In the past, India has experienced significant inflation and shortages of foreign exchange, and has been subject to civil unrest. We may be adversely affected by changes in inflation, exchange rate fluctuations, interest rates, tax provisions, social stability or other political, economic or diplomatic developments in or affecting India in the future. In addition, the infrastructure of the Indian economy is relatively poor. Further, the Indian government is significantly involved in and exerts considerable influence over its economy through its complicated tax code and pervasive bureaucracy. In the recent past, the Indian government has provided significant tax incentives and relaxed certain regulatory restrictions in order to encourage foreign investment in certain sectors of the economy, including the technology industry. Changes in the business or regulatory climate of India could have a material adverse effect on our business, results of operations and financial condition.
India has also experienced persistent though declining mass poverty, civil unrest and terrorism and has been involved in conflicts with neighboring countries. In recent years, there have been military confrontations between India and Pakistan that have occurred in the region of Kashmir and along the Indian-Pakistan border. The potential for hostilities between the two countries has been high in light of tensions related to recent terrorist incidents in India and the unsettled nature of the regional geopolitical environment, including events in and related to Afghanistan and Iraq. Additionally, India’s recent nuclear activity could expose it to increased political scrutiny, exclusion, or sanctions. Changes in the political stability of India could have a material adverse effect on our business, results of operations and financial condition.
We may not be able to manage our growth effectively.
We have expanded significantly in recent years. However, future growth will place additional demands on our resources, and we cannot be sure that we will be able to manage our growth effectively. Continued growth could place a strain on our management, operations and financial resources. We cannot assure you that our infrastructure, facilities and personnel will be adequate to support our future operations or to effectively adapt to future growth. If we cannot manage our growth effectively, our results of operations may be materially adversely affected.
The failure of our technology and telecommunications systems could have an adverse effect on our operations.
Our success depends in large part on sophisticated computer and telecommunications systems. The temporary or permanent loss of our computer and telecommunications equipment and software systems, through casualty, operating malfunction, software virus, or service provider failure, could disrupt our operations. In the normal course of our business, we must record and process significant amounts of data quickly and accurately to properly bid on prospective acquisitions of receivable portfolios and to access, maintain and expand the databases we use for our collection activities. Any simultaneous failure of our information systems and their backup systems would interrupt our business operations.
Our business depends heavily on services provided by various local and long-distance telephone companies. A significant increase in telephone service costs or any significant interruption in telephone services could negatively affect our operating results or disrupt our operations.
We may not be able to successfully anticipate, invest in or adopt technological advances within our industry.
Our business relies on computer and telecommunications technologies, and our ability to integrate new technologies into our business is essential to our competitive position and our success. We may not be successful in anticipating, managing, or adopting technological changes on a timely basis. Computer and telecommunications technologies are evolving rapidly and are characterized by short product life cycles.
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We are making significant modifications to our information systems to ensure that they continue to meet our current and foreseeable demands and continued expansion, and our future growth may require additional investment in these systems. These system modifications may exceed our cost or time estimates for completion or may be unsuccessful. If we cannot update our information systems effectively, our results of operations may be materially adversely affected.
We depend on having the capital resources necessary to invest in new technologies to acquire and service receivables. We cannot assure you that adequate capital resources will be available to us.
We may not be able to adequately protect the intellectual property rights upon which we rely.
We rely on proprietary software programs and valuation and collection processes and techniques, and we believe that these assets provide us with a competitive advantage. We consider our proprietary software, processes and techniques to be trade secrets, but they are not protected by patent or registered copyright. We may not be able to adequately protect our technology and data resources, which may materially diminish our competitive advantage.
Our results of operations may be materially adversely affected if bankruptcy filings increase or if bankruptcy or other debt collection laws change.
Our business model may be uniquely vulnerable to an economic recession which typically results in an increase in the amount of defaulted consumer receivables, thereby contributing to an increase in the amount of personal bankruptcy filings. Under certain bankruptcy filings, a debtor’s assets are sold to repay credit originators, with priority given to holders of secured debt. Since the defaulted consumer receivables we often purchase are generally unsecured, we often would not be able to collect on those receivables. In addition, since we purchase receivables that are seriously delinquent, this is often an indication that many of the consumer debtors from whom we collect would be unable to service their debts going forward and are more likely to file for bankruptcy in an economic recession. We cannot assure you that our collection experience would not decline with an increase in bankruptcy filings. If our actual collection experience with respect to a defaulted consumer receivable portfolio is significantly lower than we projected when we purchased the portfolio, our earnings could be negatively affected.
In 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (the “Protection Act”) was enacted which made significant changes in the treatment of consumer filers for bankruptcy protection. Since the Protection Act was enacted, the number of bankruptcy filings has decreased, and the volume of business at Ascension has decreased as a result. We cannot determine the impact of the Protection Act on the number of bankruptcy filings, on a prospective basis, and its impact on the collectability of consumer debt.
Item 1B—Unresolved Staff Comments
None.
16
At December 31, 2007, we occupied the indicated square footage in the leased facilities described below:
| Location |
Square Footage |
Lease Expiration Date | Primary Use | |||
| San Diego, California |
51,000 | April 2015 | Corporate headquarters, call center, and strategic outsourcing activities | |||
| Phoenix, Arizona |
63,000 | September 20081 | Call center | |||
| St. Cloud, Minnesota |
43,000 | June 20082 | Call center | |||
| Arlington, Texas |
28,600 | December 2010 | Bankruptcy servicing center | |||
| Gurgaon, India |
29,000 | November 2010 | Call center |
| 1 |
This lease expires in September 2008 and we are currently renegotiating the lease to reduce the leased premises to 33,000 square feet at the same location. |
| 2 |
This lease expires in June 2008 and we are currently renegotiating the lease to increase the leased premises to 49,000 square feet at the same location. We anticipate the new lease will have a five-year term expiring in June 2013. |
We believe that our leased facilities are generally well maintained and in good operating condition. We believe that these facilities are suitable and sufficient for our present operation needs.
On October 18, 2004, Timothy W. Moser, one of our former officers, filed an action in the United States District Court for the Southern District of California against us, and certain individuals, including several of our officers and directors. On February 14, 2005, we were served with an amended complaint in this action alleging defamation, intentional interference with contractual relations, breach of contract, breach of the covenant of good faith and fair dealing, intentional and negligent infliction of emotional distress and civil conspiracy arising out of certain statements in our Registration Statement on Form S-1 originally filed in September 2003 and alleged to be included in our Registration Statement on Form S-3 originally filed in May 2004. The amended complaint seeks injunctive relief, economic and punitive damages in an unspecified amount plus an award of profits allegedly earned by the defendants and alleged co-conspirators as a result of the alleged conduct, in addition to attorney’s fees and costs. On May 2, 2006, the court denied our special motion to strike pursuant to California’s anti-SLAPP statute, denied in part and granted in part our motion to dismiss, denied a variety of ex parte motions and applications filed by the plaintiff and denied the plaintiff’s motion for leave to conduct discovery or file supplemental briefing. The court granted the plaintiff 30 days in which to further amend his complaint, and on September 1, 2006, the plaintiff filed a second amended complaint in which he amended his claim for negligent infliction of emotional distress. On May 25, 2006, we filed a notice of appeal of the court’s order denying the anti-SLAPP motion, which is pending. On September 16, 2006, we filed a motion to stay the case pending the outcome of the appeal. This motion was granted on March 27, 2007. On April 9, 2007, the plaintiff filed a motion requesting an accelerated early neutral evaluation conference, which the court denied on April 16, 2007. Our management believes the claims are without merit and intends to vigorously defend the action. Although the outcome of this matter cannot be predicted with certainty, management does not currently believe that this matter will have a material adverse effect on our consolidated financial position or results of operations.
On September 7, 2005, Mr. Moser filed a related action in the United States District Court for the Southern District of California against Triarc Companies, Inc. (“Triarc”), which at the time, was a significant stockholder of ours, alleging intentional interference with contractual relations and intentional infliction of emotional distress. The case arises out of the same statements made or alleged to have been made in our Registration Statements mentioned above. On January 7, 2006, Triarc was served with an amended complaint seeking injunctive relief, an order directing Triarc to issue a statement of retraction or correction of the allegedly false statements, economic and punitive damages in an unspecified amount and attorney’s fees and costs. Triarc tendered the defense of this
17
action to us, and we accepted the defense and will indemnify Triarc, pursuant to the indemnification provisions of the Registration Rights Agreements dated as of October 31, 2000 and February 21, 2002, and the Underwriting Agreements dated September 25, 2004 and January 20, 2005 to which Triarc is a party. Although the outcome of this matter cannot be predicted with certainty, management does not currently believe that this matter will have a material adverse effect on our consolidated financial position or results of operations.
Claims based on the Fair Debt Collection Practices Act (“FDCPA”) and comparable state statutes may result in class action lawsuits, which can be material to us due to the remedies available under these statutes, including punitive damages. A number of cases styled as class actions have been filed against us. To date, a class has been certified in several of these cases. Several of these cases present novel issues on which there is no legal precedent. As a result, we are unable to predict the range of possible outcomes. There are a number of other lawsuits or claims pending or threatened against us. In general, these lawsuits, claims and counterclaims have arisen in the ordinary course of business and involve claims for actual damages arising from alleged misconduct or improper reporting of credit information by our employees or us. Although litigation is inherently uncertain, based on past experience, established reserves, the information currently available and the possible availability of insurance and/or indemnification from originating institutions in some cases, our management does not believe that the currently pending and threatened litigation or claims will have a material adverse effect on our consolidated financial position or results of operations. However, future events or circumstances, currently unknown to management, will determine whether the resolution of pending or threatened litigation or claims will ultimately have a material effect on our consolidated financial position, liquidity or results of operations in any future reporting periods.
Item 4—Submission of Matters to a Vote of Security Holders
On October 30, 2007, we held our annual meeting of stockholders. At the annual meeting, J. Brandon Black, Carl C. Gregory, III, Timothy J. Hanford, George Lund, Richard A. Mandell, Willem Mesdag, John J. Oros, J. Christopher Teets and Warren Wilcox were elected to serve as directors. The votes for the election of directors are set forth below:
| Name of Nominee |
Votes For | Votes Withheld | ||
| J. Brandon Black |
21,568,201 | 285,400 | ||
| Carl C. Gregory, III |
18,716,164 | 3,137,437 | ||
| Timothy J. Hanford |
21,512,917 | 340,684 | ||
| George Lund |
21,569,401 | 284,200 | ||
| Richard A. Mandell |
21,567,961 | 285,640 | ||
| Willem Mesdag |
21,567,461 | 286,140 | ||
| John J. Oros |
21,569,401 | 284,200 | ||
| J. Christopher Teets |
21,569,401 | 284,200 | ||
| Warren Wilcox |
21,569,401 | 284,200 |
At the annual meeting, the stockholders also approved Proposal 2, ratifying the appointment of BDO Seidman, LLP as our independent registered public accounting firm for fiscal year 2007. The votes for Proposal 2 were as follows:
| Votes For |
Votes Against |
Abstentions |
Broker Non-votes | |||
| 21,797,958 | 52,242 | 3,400 | 0 |
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Item 5—Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchase of Equity Securities
Our common stock is traded on the NASDAQ Global Select Market under the symbol “ECPG.”
The high and low sales prices of our common stock, as reported by NASDAQ Global Select Market for each quarter during our two most recent fiscal years, are reported below:
| Market Price | ||||||
| High | Low | |||||
| Fiscal Year 2007 |
||||||
| First Quarter |
$ | 12.66 | $ | 9.24 | ||
| Second Quarter |
$ | 12.64 | $ | 9.47 | ||
| Third Quarter |
$ | 12.81 | $ | 9.34 | ||
| Fourth Quarter |
$ | 12.23 | $ | 8.94 | ||
| Fiscal Year 2006 |
||||||
| First Quarter |
$ | 19.07 | $ | 14.52 | ||
| Second Quarter |
$ | 14.97 | $ | 8.87 | ||
| Third Quarter |
$ | 13.25 | $ | 11.30 | ||
| Fourth Quarter |
$ | 14.49 | $ | 12.33 | ||
The closing price of our common stock on February 5, 2008, was $7.67 per share and there were 125 holders of record, including 108 NASD registered broker/dealers.
The following Performance Graph and related information shall not be deemed “soliciting material” or “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that the Company specifically incorporates it by reference into such filing.
The following graph compares the total cumulative stockholder return on our common stock for the period December 31, 2002, through December 31, 2007, with the cumulative total return of (a) the NASDAQ Index and (b) Asset Acceptance Capital Corp. (following its initial public offering in January 2004), Asta Funding, Inc. and Portfolio Recovery Associates, Inc. (following its initial public offering in September 2002), which we believe are comparable companies. The comparison assumes that $100 was invested on December 31, 2002, in our common stock and in each of the comparison indices.
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| 12/02 | 12/03 | 12/04 | 12/05 | 12/06 | 12/07 | |||||||||||||
| Encore Capital Group, Inc. |
$ | 100.00 | $ | 1,372.73 | $ | 2,161.82 | $ | 1,577.27 | $ | 1,145.45 | $ | 880.00 | ||||||
| NASDAQ Composite |
$ | 100.00 | $ | 149.75 | $ | 164.64 | $ | 168.60 | $ | 187.83 | $ | 205.22 | ||||||
| Peer Group |
$ | 100.00 | $ | 171.83 | $ | 268.34 | $ | 288.19 | $ | 264.75 | $ | 216.47 | ||||||
Dividend Policy
As a public company, we have never declared or paid dividends on our common stock. However, the declaration, payment and amount of future dividends, if any, is subject to the discretion of our board of directors, which may review our dividend policy from time to time in light of the then existing relevant facts and circumstances. Under the terms of our Revolving Credit Facility, we are permitted to declare and pay dividends in an amount not to exceed, during any fiscal year, 20% of our audited consolidated net income for the then most recently completed fiscal year, so long as no default or unmatured default under the facility has occurred and is continuing or would arise as the result of the dividend payment. We may also be subject to additional dividend restrictions under future financing facilities.
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Item 6—Selected Financial Data
This table presents selected historical financial data of Encore and its consolidated subsidiaries. This information should be carefully considered in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this report. The selected data in this section are not intended to replace the consolidated financial statements. The selected financial data (except for “Selected Operating Data”) in the table below, as of December 31, 2005, 2004, and 2003 and for the years ended December 31, 2004 and 2003, were derived from our audited consolidated financial statements not included in this report. The selected financial data as of December 31, 2007, and 2006 and for the years ended December 31, 2007, 2006, and 2005, were derived from our audited consolidated financial statements included elsewhere in this report. The Selected Operating Data was derived from the books and records of the Company. (in thousands, except per share, and personnel data):
| As of and For The Years Ended December 31, | ||||||||||||||||||||
| 2007 | 2006 | 2005 | 2004 | 2003 | ||||||||||||||||
| Revenues |
||||||||||||||||||||
| Revenue from receivable portfolios, net(1) |
$ | 241,402 | $ | 239,340 | $ | 215,931 | $ | 177,783 | $ | 115,882 | ||||||||||
| Servicing fees and related revenues(2) |
12,609 | 15,800 | 5,904 | 692 | 1,620 | |||||||||||||||
| Total revenues |
254,011 | 255,140 | 221,835 | 178,475 | 117,502 | |||||||||||||||
| Operating expenses |
||||||||||||||||||||
| Salaries and employee benefits |
64,153 | 63,962 | 52,410 | 47,193 | 39,286 | |||||||||||||||
| Stock-based compensation expense |
4,287 | 5,669 | — | — | — | |||||||||||||||
| Cost of legal collections |
78,636 | 52,079 | 35,090 | 28,202 | 15,827 | |||||||||||||||
| Other operating expenses |
21,533 | 22,585 | 16,973 | 13,645 | 11,335 | |||||||||||||||
| Collection agency commissions |
12,411 | 18,030 | 17,287 | 4,786 | — | |||||||||||||||
| General and administrative expenses |
17,478 | 17,310 | 13,375 | 9,212 | 6,509 | |||||||||||||||
| Depreciation and amortization |
3,351 | 3,894 | 2,686 | 1,951 | 2,023 | |||||||||||||||
| Total operating expenses |
201,849 | 183,529 | 137,821 | 104,989 | 74,980 | |||||||||||||||
| Income before other (expense) income and income taxes |
52,162 | 71,611 | 84,014 | 73,486 | 42,522 | |||||||||||||||
| Other (expense) income |
||||||||||||||||||||
| Interest expense |
(13,904 | ) | (12,512 | ) | (9,530 | ) | (3,069 | ) | (4,456 | ) | ||||||||||
| Contingent interest expense |
(4,123 | ) | (18,520 | ) | (23,187 | ) | (32,261 | ) | (16,023 | ) | ||||||||||
| Pay-off of future contingent interest |
(11,733 | ) | — | — | — | — | ||||||||||||||
| Other income, net |
1,071 | 609 | 929 | 690 | 7,380 | (3) | ||||||||||||||
| Total other expense |
(28,689 | ) | (30,423 | ) | (31,788 | ) | (34,640 | ) | (13,099 | ) | ||||||||||
| Income before income taxes |
23,473 | 41,188 | 52,226 | 38,846 | 29,423 | |||||||||||||||
| Provision for income taxes |
(8,431 | ) | (17,180 | ) | (21,135 | ) | (15,670 | ) | (11,003 | ) | ||||||||||
| Net income |
15,042 | 24,008 | 31,091 | 23,176 | 18,420 | |||||||||||||||
| Preferred stock dividends |
— | — | — | — | (374 | ) | ||||||||||||||
| Net income available to common stockholders |
$ | 15,042 | $ | 24,008 | $ | 31,091 | $ | 23,176 | $ | 18,046 | ||||||||||
| Earnings per common share: |
||||||||||||||||||||
| Basic |
$ | 0.66 | $ | 1.06 | $ | 1.39 | $ | 1.05 | $ | 1.65 | ||||||||||
| Diluted |
$ | 0.64 | $ | 1.03 | $ | 1.30 | $ | 0.99 | $ | 0.88 | ||||||||||
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| As of and For The Years Ended December 31, | ||||||||||||||||||||
| 2007 | 2006 | 2005 | 2004 | 2003 | ||||||||||||||||
| Weighted-average shares outstanding: |
||||||||||||||||||||
| Basic |
22,876 | 22,754 | 22,299 | 22,072 | 10,965 | |||||||||||||||
| Diluted |
23,386 | 23,390 | 23,998 | 23,481 | 20,873 | |||||||||||||||
| Cash flow data: |
||||||||||||||||||||
| Cash flows provided by (used in): |
||||||||||||||||||||
| Operating activities |
$ | 15,834 | $ | 38,027 | $ | 31,226 | $ | 36,412 | $ | 33,971 | ||||||||||
| Investing activities |
$ | (95,059 | ) | $ | (37,190 | ) | $ | (144,344 | ) | $ | (90,157 | ) | $ | (19,472 | ) | |||||
| Financing activities |
$ | 73,334 | $ | 2,928 | $ | 110,413 | $ | 24,864 | $ | 23,361 | ||||||||||
| Selected operating data: |
||||||||||||||||||||
| Purchases of receivable portfolios, at cost(4) |
$ | 208,953 | $ | 144,287 | $ | 195,554 | $ | 103,374 | $ | 89,834 | ||||||||||
| Gross collections for the period |
$ | 355,193 | $ | 337,097 | $ | 292,163 | $ | 234,676 | $ | 190,519 | ||||||||||
| Average active employees for the period(5) |
907 | 858 | 739 | 728 | 679 | |||||||||||||||
| Gross collections per average active employee for the period |
$ | 392 | $ | 393 | $ | 395 | $ | 322 | $ | 281 | ||||||||||
| Consolidated statements of financial condition data: |
||||||||||||||||||||
| Cash and marketable securities |
$ | 4,900 | $ | 10,791 | $ | 7,026 | $ | 49,731 | $ | 38,612 | ||||||||||
| Restricted cash |
3,776 | 4,660 | 4,212 | 3,432 | 842 | |||||||||||||||
| Investment in receivable portfolios, net |
392,209 | 300,348 | 256,333 | 137,963 | 89,136 | |||||||||||||||
| Investment in retained interest |
— | — | — | — | 1,231 | |||||||||||||||
| Total assets |
483,495 | 395,338 | 368,445 | 201,142 | 138,285 | |||||||||||||||
| Accrued profit sharing arrangement |
— | 6,869 | 16,528 | 20,881 | 12,749 | |||||||||||||||
| Total debt |
272,420 | 200,132 | 198,121 | 66,828 | 41,638 | |||||||||||||||
| Total liabilities |
311,975 | 244,202 | 250,093 | 105,127 | 66,914 | |||||||||||||||
| Total stockholders’ equity |
$ | 171,520 | $ | 151,136 | $ | 118,352 | $ | 96,015 | $ | 71,371 | ||||||||||
| (1) |
Includes net impairments of $11.2 million for the year ended December 31, 2007, $1.4 million for the year ended December 31, 2006, and $3.1 million for the year ended December 31, 2005. Also includes gains from whole portfolio sales totaling $0.3 million for the year ended December 31, 2003. |
| (2) |
Includes $12.5 million, $15.7 million and $5.5 million in revenues from Ascension Capital Group for the years ending December 31, 2007, 2006 and 2005, respectively. |
| (3) |
Reflects a non-recurring net pre-tax gain totaling $7.2 million, recognized in the first quarter of 2003 upon settlement of a lawsuit against the seller of certain accounts. This resulted in an after tax net gain of $4.4 million or $0.21 per share on a fully diluted basis. |
| (4) |
Purchase price includes an $11.7 million, $10.6 million and $4.3 million allocation of the forward flow asset for 2007, 2006 and 2005, respectively. See Note 2 to the consolidated financial statements for a further discussion of our forward flow asset. |
| (5) |
Excludes employees of Ascension Capital Group, which average approximately 133, 184, and 198, for the years ended December 31, 2007, 2006, and 2005, respectively. |
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Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
We are a systems-driven purchaser and manager of charged-off consumer receivable portfolios and a provider of bankruptcy services to the finance industry. We acquire receivable portfolios at deep discounts from their face values using our proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon the ongoing analysis of these accounts, we employ a dynamic mix of collection strategies to maximize our return on investment.
Contingent Interest Pay-off
On May 7, 2007, we entered into an agreement with the lender under our Secured Financing Facility to eliminate all future contingent interest payments, for a one-time payment of $16.9 million. This agreement released the lender’s security interests in the remaining receivables originally financed under the Secured Financing Facility. This payment, less $5.2 million accrued on our balance sheet ($11.7 million, or $6.9 million after the effect of income taxes), is included in total other expense in our statements of operations for the year ended December 31, 2007. The charge reduced earnings per share by approximately $0.30 for the year ended December 31, 2007. Subsequent to the second quarter of 2007, we were no longer obligated to make any contingent interest payments under the Secured Financing Facility and as a result, no longer record such interest in our statements of operations.
Cost Savings Initiatives
In September 2007, we announced certain cost savings initiatives aimed at reducing our overall operating expenses. These initiatives included reducing our workforce by 115 people and exiting from our healthcare purchasing and collection activities. The reduction in workforce comprised 70 people at our call center in Phoenix, Arizona, 30 people at our bankruptcy servicing center in Arlington, Texas and 15 people at our corporate headquarters in San Diego, California.
The cost associated with exiting our healthcare purchasing and collection activities was approximately $1.7 million, including a charge of $1.4 million related to the impairment of our healthcare receivable portfolios and $0.3 million of salaries and benefits, primarily severance payments, for our healthcare purchasing and collection employees.
Additionally, we recorded a one-time charge of approximately $1.1 million in the third quarter of 2007 related to our reduction in workforce. This one-time charge is composed primarily of severance payments for our former employees.
Acquisition of outstanding membership interest in India operation
We have experienced tremendous growth in our India operation since its inception in the fourth quarter of 2005. Our India operation has become an integral part of our organizational strategy. On October 30, 2007, we entered into a membership interest purchase agreement with our then joint venture partner, to acquire its 49% ownership interest in our India operation. As a result, on October 30, 2007, we acquired full ownership of our India site. The total purchase price was $2.3 million in cash. Prior to the acquisition, our India site was determined to be a variable interest entity, subject to the provisions of Interpretation No. 46, (revised December 2003), “Consolidation of Variable Interest Entities,” and was already included in our consolidated financial statements. The entire purchase price of $2.3 million was allocated to goodwill. See Note 2 to the consolidated financial statements for additional information related to the acquisition.
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Amendments of Revolving Credit Facility
During 2005, we entered into a three-year revolving credit facility (“Revolving Credit Facility”), to be used for the purposes of purchasing receivable portfolios and for general working capital needs. This Revolving Credit Facility has been amended several times to meet our needs. We entered into four amendments to our Revolving Credit Facility during the year ended December 31, 2007. The most significant of these amendments was entered into and effective on December 27, 2007, to increase the borrowing base of our Revolving Credit Facility. The amendment expands the size of the facility to $230 million, with an “accordion” feature that provides for an additional $70 million in availability under certain circumstances. As a result, the allocated revolving loan commitments of each of the lenders under the facility has been increased as stated in the amendment. See Note 8 to the consolidated financial statements for a further discussion of our debt and amendments to our Revolving Credit Facility.
Purchases and Collections
Purchases by Paper Type
The following table summarizes the types of charged-off consumer receivables portfolios we have purchased for the periods presented (in thousands):
| Years Ended December 31, | |||||||||
| 2007 | 2006 | 2005 | |||||||
| Credit card |
$ | 188,207 | $ | 66,657 | $ | 176,379 | |||
| Other |
20,746 | 77,630 | 19,175 | ||||||
| Total purchases |
$ | 208,953 | $ | 144,287 | $ | 195,554 | |||
Collections by Channel
During 2007, 2006 and 2005, we utilized numerous business channels for the collection of charged-off credit cards and other receivables. The following table summarizes the gross collections by collection channel (in thousands):
| Years Ended December 31, | |||||||||
| 2007 | 2006 | 2005 | |||||||
| Collection sites(1) |
$ | 126,093 | $ | 129,009 | $ | 127,980 | |||
| Legal collections |
169,005 | 118,712 | 88,144 | ||||||
| Collection agencies(1) |
33,325 | 49,696 | 44,384 | ||||||
| Sales |
24,001 | 34,035 | 26,739 | ||||||
| Other |
2,769 | 5,645 | 4,916 | ||||||
| Gross collections |
$ | 355,193 | $ | 337,097 | $ | 292,163 | |||
| (1) |
Collection agencies for the year ended December 31, 2005, includes collections made by the employees of Jefferson Capital through the end of the three-month transition services agreement, which expired in September 2005. Collections made by these employees subsequent to the expiration of the transition services agreement are included in collection sites. Collections by Jefferson Capital employees included in collection agencies were $3.4 million during the term of the transition services agreement. |
Gross collections increased $18.1 million, or 5.4%, to $355.2 million during the year ended December 31, 2007, from $337.1 million during the year ended December 31, 2006.
Gross collections increased $44.9 million, or 15.4%, to $337.1 million during the year ended December 31, 2006, from $292.2 million during the year ended December 31, 2005.
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Results of Operations
Results of operations in dollars and as a percentage of total revenue were as follows (in thousands, except percentages):
| 2007 | 2006 | 2005 | |||||||||||||||||||
| Revenues |
|||||||||||||||||||||
| Revenue from receivable portfolios, net |
$ | 241,402 | 95.0 | % | $ | 239,340 | 93.8 | % | $ | 215,931 | 97.3 | % | |||||||||
| Servicing fees and other related revenue |
12,609 | 5.0 | % | 15,800 | 6.2 | % | 5,904 | 2.7 | % | ||||||||||||
| Total revenues |
254,011 | 100.0 | % | 255,140 | 100.0 | % | 221,835 | 100.0 | % | ||||||||||||
| Operating expenses |
|||||||||||||||||||||
| Salaries and employee benefits |
64,153 | 25.2 | % | 63,962 | 25.0 | % | 52,410 | 23.6 | % | ||||||||||||
| Stock-based compensation expense |
4,287 | 1.7 | % | 5,669 | 2.2 | % | — | — | |||||||||||||
| Cost of legal collections |
78,636 | 31.0 | % | 52,079 | 20.4 | % | 35,090 | 15.8 | % | ||||||||||||
| Other operating expenses |
21,533 | 8.5 | % | 22,585 | 8.9 | % | 16,973 | 7.7 | % | ||||||||||||
| Collection agency commissions |
12,411 | 4.9 | % | 18,030 | 7.1 | % | 17,287 | 7.8 | % | ||||||||||||
| General and administrative expenses |
17,478 | 6.9 | % | 17,310 | 6.8 | % | 13,375 | 6.0 | % | ||||||||||||
| Depreciation and amortization |
3,351 | 1.3 | % | 3,894 | 1.5 | % | 2,686 | 1.2 | % | ||||||||||||
| Total operating expenses |
201,849 | 79.5 | % | 183,529 | 71.9 | % | 137,821 | 62.1 | % | ||||||||||||
| Income before other (expense) income and income taxes |
52,162 | 20.5 | % | 71,611 | 28.1 | % | 84,014 | 37.9 | % | ||||||||||||
| Other (expense) income |
|||||||||||||||||||||
| Interest expense |
(13,904 | ) | (5.5 | )% | (12,512 | ) | (4.9 | )% | (9,530 | ) | (4.3 | )% | |||||||||
| Contingent interest expense |
(4,123 | ) | (1.6 | )% | (18,520 | ) | (7.3 | )% | (23,187 | ) | (10.5 | )% | |||||||||
| Pay-off of future contingent interest |
(11,733 | ) | (4.6 | )% | — | — | — | — | |||||||||||||
| Other income |
1,071 | 0.4 | % | 609 | 0.2 | % | 929 | 0.4 | % | ||||||||||||
| Total other expense |
(28,689 | ) | (11.3 | )% | (30,423 | ) | (12.0 | )% | (31,788 | ) | (14.4 | )% | |||||||||
| Income before income taxes |
23,473 | 9.2 | % | 41,188 | 16.1 | % | 52,226 | 23.5 | % | ||||||||||||
| Provision for income taxes |
(8,431 | ) | (3.3 | )% | (17,180 | ) | (6.7 | )% | (21,135 | ) | (9.5 | )% | |||||||||
| Net income |
$ | 15,042 | 5.9 | % | $ | 24,008 | 9.4 | % | $ | 31,091 | 14.0 | % | |||||||||
Year Ended December 31, 2007 Compared to Year Ended December 31, 2006
Revenue
Our revenue consists primarily of portfolio revenue and bankruptcy servicing revenue. Portfolio revenue consists of accretion revenue and zero basis revenue. Accretion revenue represents revenue derived from pools (quarterly groupings of purchased receivable portfolios) with a cost basis that has not been fully amortized. Revenue from pools with a remaining unamortized cost basis is accrued based on each pool’s effective interest rate applied to each pool’s remaining unamortized cost basis. The cost basis of each pool is increased by revenue earned and decreased by gross collections and impairments. The effective interest rate is the internal rate of return derived from the timing and amounts of actual cash received and anticipated future cash flow projections for each pool. All collections realized after the net book value of a portfolio has been fully recovered (“Zero Basis Portfolios”) are recorded as revenue (“Zero Basis Revenue”). We account for our investment in receivable portfolios utilizing the interest method in accordance with the provisions of the AICPA’s Statement of Position 03-03, “Accounting for Certain Debt Securities Acquired in a Transfer” (“SOP 03-03”). Servicing fee revenue is revenue primarily associated with bankruptcy servicing fees earned from our subsidiary, Ascension Capital Group, Inc. (“Ascension”), a provider of bankruptcy services to the finance industry.
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The following tables summarize collections, revenue, end of period receivable balance and other related supplemental data by year of purchase (in thousands, except percentages):
| For the Year Ended December 31, 2007 | As of December 31, 2007 |
|||||||||||||||||||||
| Collections(1) | Net Revenue |
Revenue Recognition Rate |
% of Total Revenue |
Net Impairment |
Unamortized Balance |
Monthly IRR |
||||||||||||||||
| ZBA(2) |
$ | 15,164 | $ | 15,164 | 100.0 | % | 6.3 | % | $ | — | $ | — | — | |||||||||
| 2002 |
10,216 | 8,476 | 83.0 | % | 3.5 | % | (699 | ) | 1,823 | 26.3 | % | |||||||||||
| 2003 |
26,605 | 22,130 | 83.2 | % | 9.2 | % | (2,485 | ) | 4,417 | 30.7 | % | |||||||||||
| 2004 |
34,626 | 22,231 | 64.2 | % | 9.2 | % | (3,861 | ) | 20,721 | 8.0 | % | |||||||||||
| 2005 |
107,800 | 67,733 | 62.8 | % | 28.1 | % | (2,466 | ) | 87,350 | 5.6 | % | |||||||||||
| 2006 |
92,265 | 62,010 | 67.2 | % | 25.6 | % | (1,563 | ) | 95,739 | 4.9 | % | |||||||||||
| 2007 |
68,048 | 43,658 | 64.2 | % | 18.1 | % | (156 | ) | 182,159 | 4.3 | % | |||||||||||
| Total |
$ | 354,724 | $ | 241,402 | 68.1 | % | 100.0 | % | $ | (11,230 | ) | $ | 392,209 | 5.4 | % | |||||||
| For the Year Ended December 31, 2006 | As of December 31, 2006 |
|||||||||||||||||||||
| Collections(1) | Net Revenue |
Revenue Recognition Rate |
% of Total Revenue |
Net (Impairment) Reversal |
Unamortized Balance |
Monthly IRR |
||||||||||||||||
| ZBA(2) |
$ | 28,588 | $ | 28,588 | 100.0 | % | 11.9 | % | $ | — | $ | — | — | |||||||||
| 2001 |
2,766 | 1,263 | 45.7 | % | 0.5 | % | 135 | — | 19.4 | % | ||||||||||||
| 2002 |
24,185 | 17,578 | 72.7 | % | 7.3 | % | (799 | ) | 3,566 | 22.3 | % | |||||||||||
| 2003 |
55,093 | 44,310 | 80.4 | % | 18.5 | % | 434 | 8,902 | 24.7 | % | ||||||||||||
| 2004 |
54,832 | 37,330 | 68.1 | % | 15.6 | % | (648 | ) | 33,131 | 8.0 | % | |||||||||||
| 2005 |
128,556 | 84,033 | 65.4 | % | 35.2 | % | (471 | ) | 127,477 | 4.8 | % | |||||||||||
| 2006 |
42,354 | 26,238 | 61.9 | % | 11.0 | % | (30 | ) | 127,272 | 3.8 | % | |||||||||||
| Total |
$ | 336,374 | $ | 239,340 | 71.2 | % | 100.0 | % | $ | (1,379 | ) | $ | 300,348 | 5.5 | % | |||||||
| (1) |
Does not include amounts collected on behalf of others. |
| (2) |
Gross collections and revenue related to the retained interest are included in these tables. |
Total revenue was $254.0 million for the year ended December 31, 2007, a decrease of $1.1 million, or 0.4%, compared to total revenue of $255.1 million for the year ended December 31, 2006. Revenue, excluding Ascension’s bankruptcy servicing fees for 2007 and 2006 of $12.5 million and $15.7 million, respectively, increased $2.1 million, or 0.9%, to $241.5 million. The increase in portfolio revenue was primarily the result of additional accretion revenue associated with higher purchasing volumes in 2007 compared to 2006 and increased accretion revenue related to new operating initiatives. The increase in portfolio revenue was partially offset by a greater impairment on receivable portfolios, lower revenue recognition rates and a reduction in Zero Basis Revenue. During the year ended December 31, 2007, we recorded a net impairment provision of $11.2 million, including a $1.4 million impairment on our healthcare receivables in connection with exiting our healthcare purchasing and collecting activities, compared to a net impairment provision of $1.4 million in the prior year. The increase in the impairment provision in 2007, as compared to 2006, was primarily due to three factors. First, in the fourth quarter, we experienced a shortfall in collections against our forecast, a large percentage of which came from our older pool groups, which have very high monthly IRRs. Second, during the last two quarters of 2007, we experienced a trend in which a larger percentage of collections from our legal channel came from multi-payment settlements versus single-payment settlements. Given the high IRRs in our older pool groups, when payments are extended over a longer period of time and the cash flows are delayed, this generally results in an impairment provision, even if we receive the collections in the future. Despite this recent trend in the shift in payment types from single-payment settlements to multi-payment settlements in our legal channel, we have not experienced any material shifts in our overall payer rates or settlement rates. Finally, since it is reasonable to
26
assume that current economic conditions will have some negative impact on consumers’ willingness or ability to repay their accounts, we felt it was prudent to reduce some of our near-term forecasted collections, which resulted in an increase to the impairment provision. The lower revenue recognition rates were due to a greater portion of our collections coming from our 2004 to 2007 portfolio purchases that have lower revenue recognition rates than our 2003 and prior purchases, due to a more competitive pricing environment since 2004.
During the year ended December 31, 2007, $14.3 million (exclusive of $0.9 million of Zero Basis Revenue on the retained interest) was recognized as Zero Basis Revenue, a $13.0 million decrease from the $27.3 million (exclusive of $1.3 million of Zero Basis Revenue on the retained interest) recognized during the year ended December 31, 2006. The reduction in Zero Basis Revenue was primarily the result of the sale of certain receivables portfolios in 2006 from Zero Basis Portfolios and an expected reduction in collections from Zero Basis Portfolios. In 2006, we sold accounts amounting to approximately $1.9 billion in face value for $13.9 million. This sale resulted in additional Zero Basis Revenue of $3.4 million for the year ended December 31, 2006. Additionally, we expect the revenue from our Zero Basis Portfolios to decline in future quarters as collections from these portfolios diminish.
Revenue associated with bankruptcy servicing fees earned from Ascension, a provider of bankruptcy services to the finance industry, was $12.5 million for the year ended December 31, 2007, a decrease of $3.2 million, or 20.4%, compared to revenue of $15.7 million for the year ended December 31, 2006. The decrease in Ascension revenue was due to the high volume of bankruptcy placements in October 2005 just prior to the effective date of the Bankruptcy Reform Act (the “Act”). Consistent with our revenue recognition policy, the revenue associated with the significant number of Chapter 7 bankruptcy placements in October 2005 was recognized during the year ended December 31, 2006. We have experienced a significant decline in bankruptcy placements since the effective date of the Act. Although bankruptcy placements have not returned to the levels experienced prior to the Act, they have increased gradually from the low levels experienced in late 2005 and 2006.
During the year ended December 31, 2007, we invested $209.0 million to acquire portfolios with face values aggregating $6.9 billion, for an average purchase price of 3.0% of face value. This is a $64.7 million increase, or 44.8%, in the amount invested compared with the $144.3 million invested during the year ended December 31, 2006, to acquire portfolios with a face value aggregating $3.7 billion, for an average purchase price of 3.9% of face value.
Operating Expenses
Total operating expenses were $201.8 million for the year ended December 31, 2007, an increase of $18.3 million, or 10.0%, compared to total operating expenses of $183.5 million for the year ended December 31, 2006.
Operating expenses are explained in more detail as follows:
Salaries and employee benefits
Total salaries and employee benefits increased by $0.2 million, or 0.3%, to $64.2 million during the year ended December 31, 2007, from $64.0 million during the year ended December 31, 2006. The increase was primarily the result of a $1.6 million increase in severance expenses largely associated with the reduction in our workforce and the decision to exit our healthcare purchasing and collection activities, offset by decreases of $0.8 million in salary and wages, $0.2 million in bonuses, $0.2 million in payroll taxes and $0.2 million in health insurance costs due to reduced headcount as a result of the reduction in workforce in September 2007.
27
Stock-based compensation expenses
Stock-based compensation decreased by $1.4 million, or 24.4%, to $4.3 million during the year ended December 31, 2007, from $5.7 million during the year ended December 31, 2006. This decrease was primarily the result of a reduction of approximately $0.4 million of expenses related to changes in assumptions used in calculating our stock-based compensation, a reduction in expense of $1.5 million resulting from forfeited shares and a reduction in expense of $0.5 million resulting from stock options fully vested during the year ended December 31, 2007, offset by additional expenses of $1.0 million associated with new equity grants issued during the year ended December 31, 2007 and $0.1 million associated with a modification of certain stock options.
Cost of legal collections
The cost of legal collections increased $26.5 million, or 51.0%, to $78.6 million during the year ended December 31, 2007, as compared to $52.1 million during the year ended December 31, 2006. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in contingent fees was primarily the result of an increase of $50.3 million, or 42.4%, in gross collections through our legal channel. Gross legal collections amounted to $169.0 million during the year ended December 31, 2007, compared to $118.7 million collected during the year ended December 31, 2006. The cost of legal collections increased as a percent of gross collections through this channel to 46.5% during the year ended December 31, 2007, from 43.9% during the year ended December 31, 2006, primarily as a result of increased upfront court costs expensed associated with our pursuit of legal collections. Upfront court costs expensed were $28.0 million for the year ended December 31, 2007, including a reduction in expense of $0.8 million in connection with a change in our expected recovery rate. Upfront court costs expensed were $15.5 million for the year ended December 31, 2006. See “Legal Outsourcing Collections and Related Costs” under Supplemental Performance Data for further discussion of cost of legal collections.
Other operating expenses
Other operating expenses decreased $1.1 million, or 4.7%, to $21.5 million during the year ended December 31, 2007, from $22.6 million during the year ended December 31, 2006. This decrease was primarily the result of a decrease in Ascension’s legal expense, a decrease in the amortization of a previously acquired deferred revenue asset, a decrease in skiptracing expenses, and a decrease in recruiting expenses, offset by an increase in the number of direct mail campaigns and its related expense. Ascension’s legal expense decreased $0.9 million, or 37.4%, to $1.6 million during the year ended December 31, 2007. Amortization of a previously acquired deferred revenue asset decreased $0.9 million, or 48.9%, to $1.0 million during the year ended December 31, 2007. Skiptracing expenses decreased $0.4 million, or 22.0%, to $1.4 million during the year ended December 31, 2007. Recruiting expenses decreased $0.9 million, or 55.5%, to $0.7 million during the year ended December 31, 2007. The cost of direct mail campaigns increased $2.1 million, or 28.0%, to $9.6 million during the year ended December 31, 2007, compared to $7.5 million during year ended December 31, 2006.
Collection agency commissions
During the year ended December 31, 2007, we paid $12.4 million in commissions to third party collection agencies, or 37.2% of the related gross collections of $33.3 million, compared to $18.0 million in commissions, or 36.3% of the related gross collections of $49.7 million, during the year ended December 31, 2006. The decrease in commissions is consistent with the decrease in collections through this channel. The increase in commission rate as a percentage of the related gross collection is primarily the result of the mix of accounts placed with the agencies. Commissions, as a percentage of collections in this channel, vary from period to period depending on, among other things, the time from charge-off of the accounts placed with an agency. Generally, freshly charged-off accounts have a lower commission rate than accounts that have been charged off for a longer period of time.
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General and administrative expenses
General and administrative expenses increased $0.2 million, or 1.0%, to $17.5 million during the year ended December 31, 2007, from $17.3 million during the year ended December 31, 2006. The increase was primarily the result of approximately $0.5 million of increased accounting and consulting service fees related to the filing of our 1999-2005 state tax returns, a $1.4 million net increase in general corporate expenses and $0.7 million of increased building rent, offset by a $1.3 million decrease in costs associated with the strategic alternatives process, and a $1.1 million decrease in litigation settlement costs.
Depreciation and amortization
Depreciation and amortization expense decreased $0.5 million, or 13.9%, to $3.4 million during the year ended December 31, 2007, from $3.9 million during the year ended December 31, 2006. Depreciation expense remained consistent at $2.3 million during the years ended December 31, 2007 and 2006. Amortization expense relating to intangible assets acquired in conjunction with the acquisition of Ascension in the third quarter of 2005 was $1.1 million for the year ended December 31, 2007, compared to $1.6 million for the year ended December 31, 2006.
Interest expense
Interest expense decreased $1.2 million, or 4.1%, to $29.8 million during the year ended December 31, 2007, from $31.0 million during the year ended December 31, 2006.
The following table summarizes our interest expense (in thousands):
| For the Years Ended December 31, | |||||||||||||
| 2007 | 2006 | $ Change | % Change |
||||||||||
| Stated interest on debt obligations |
$ | 12,401 | $ | 10,637 | $ | 1,764 | 16.6 | % | |||||
| Amortization of loan fees and other loan costs |
1,503 | 1,875 | (372 | ) | (19.8 | )% | |||||||
| Subtotal |
13,904 | 12,512 | 1,392 | 11.1 | % | ||||||||
| Contingent interest |
4,123 | 18,520 | (14,397 | ) | (77.7 | )% | |||||||
| Pay-off of future contingent interest |
11,733 | — | 11,733 | — | |||||||||
| Total interest expense |
$ | 29,760 | $ | 31,032 | $ | (1,272 | ) | (4.1 | )% | ||||
As of December 31, 2004, we no longer made borrowings under our Secured Financing Facility. As of December 31, 2006, we repaid in full the principal balance of our Secured Financing Facility. Prior to May 7, 2007, we shared with the lender the residual collections on purchases made under this facility, net of servicing fees paid to us. The residual collections paid to the lender were classified as contingent interest.
On May 7, 2007, we entered into an agreement with the lender under our Secured Financing Facility to eliminate all future contingent interest payments, for a one-time payment of $16.9 million. This agreement released the lender’s security interests in the remaining receivables originally financed under the Secured Financing Facility. This payment, less $5.2 million accrued on our balance sheet ($11.7 million, or $6.9 million after the effect of income taxes), is included in total other expense in our statement of operations for the year ended December 31, 2007. The charge reduced earnings per share by approximately $0.30 for the year ended December 31, 2007. Subsequent to the second quarter of 2007, we are no longer obligated to pay any contingent interest expense under the Secured Financing Facility and, as a result, no longer record such interest in our statements of operations.
During 2005, we entered into a three-year Revolving Credit Facility, to be used for the purposes of purchasing receivable portfolios and for general working capital needs. This Revolving Credit Facility has been amended several times to meet our needs, and is due to expire in May 2010. We have financed portfolio
29
purchases subsequent to December 31, 2004, using our Revolving Credit Facility, which does not require the sharing of residual collections with the lender. See Note 8 to the consolidated financial statements for a further discussion on our Revolving Credit Facility.
Other income and expense
During the year ended December 31, 2007, total other income was $1.1 million, compared to $0.6 million for the year ended December 31, 2006. The increase in other income was primarily attributable to the realization of previously unrecognized gains of $0.8 million associated with the plan assets of our non-qualified employee benefit plan, offset by a $0.3 million decrease associated with the change in the value of plan assets and plan liabilities. During the year ended December 31, 2007, we liquidated all of our mutual funds within the plan assets. As a result, previously unrealized investment gains of $0.8 million were recognized as other income. As of December 31, 2007, investments in plan assets consist only of Company Owned Life Insurance. For this investment, the change in the cash surrender value of the insurance policies is recognized in earnings.
Provision for income taxes
During the year ended December 31, 2007, we recorded an income tax provision of $8.4 million, reflecting an effective rate of 35.9% of pretax income. The effective tax rate for the year ended December 31, 2007, consists primarily of a provision for Federal income taxes of 32.6% (which is net of a benefit for state taxes of 2.4%), a blended provision for state taxes of 6.7%, a provision for the effect of permanent book versus tax differences of 0.1%, and a benefit of 3.5% relating to state taxes. The 3.5% benefit is primarily due to a new effective State tax rate resulting from the receipt of a favorable ruling from a state tax authority granting us the right to use a more favorable filing methodology, a net beneficial adjustment of $0.3 million to the state and Federal tax payables resulting from the completion of our 1999-2006 state tax returns, a beneficial adjustment to our deferred taxes and the recognition of the benefit of certain state net operating losses generated in 2006. For the year ended December 31, 2006, we recorded an income tax provision of $17.2 million, reflecting an effective rate of 41.7% of pretax income. Our effective tax rate for the year ended December 31, 2006, differed from the Federal statutory rate primarily due to the net effect of state taxes, permanent book versus tax differences, and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of our 2003 income tax return. The decrease in our effective tax rate was the result of the changing mix of permanent book versus tax differences relative to taxable income, offset by the increase in tax expense related to the tax audit issue noted above. See Note 10 to the consolidated financial statements for a further discussion of income taxes.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
Revenue
The following table summarizes collections, revenue, end of period receivable balance and other related supplemental data by year of purchases (in thousands, except percentages):
| For the Year Ended December 31, 2006 | As of December 31, 2006 |
|||||||||||||||||||||
| Collections(1) | Net Revenue |
Revenue Recognition Rate |
% of Total Revenue |
Net (Impairment) Reversal |
Unamortized Balance |
Monthly IRR |
||||||||||||||||
| ZBA(2) |
$ | 28,588 | $ | 28,588 | 100.0 | % | 11.9 | % | $ | — | $ | — | — | |||||||||
| 2001 |
2,766 | 1,263 | 45.7 | % | 0.5 | % | 135 | — | 19.4 | % | ||||||||||||
| 2002 |
24,185 | 17,578 | 72.7 | % | 7.3 | % | (799 | ) | 3,566 | 22.3 | % | |||||||||||
| 2003 |
55,093 | 44,310 | 80.4 | % | 18.5 | % | 434 | 8,902 | 24.7 | % | ||||||||||||
| 2004 |
54,832 | 37,330 | 68.1 | % | 15.6 | % | (648 | ) | 33,131 | 8.0 | % | |||||||||||
| 2005 |
128,556 | 84,033 | 65.4 | % | 35.2 | % | (471 | ) | 127,477 | 4.8 | % | |||||||||||
| 2006 |
42,354 | 26,238 | 61.9 | % | 11.0 | % | (30 | ) | 127,272 | 3.8 | % | |||||||||||
| Total |
$ | 336,374 | $ | 239,340 | 71.2 | % | 100.0 | % | $ | (1,379 | ) | $ | 300,348 | 5.5 | % | |||||||
30
| For the Year Ended December 31, 2005 | As of December 31, 2005 |
|||||||||||||||||||||
| Collections(1) | Net Revenue |
Revenue Recognition Rate |
% of Total Revenue |
Net Impairment |
Unamortized Balance |
Monthly IRR |
||||||||||||||||
| ZBA(2) |
$ | 32,412 | $ | 32,412 | 100.0 | % | 15.0 | % | $ | — | $ | — | — | |||||||||
| 2000 |
245 | 115 | 46.9 | % | 0.1 | % | — | — | — | |||||||||||||
| 2001 |
8,664 | 6,557 | 75.7 | % | 3.0 | % | (135 | ) | 1,499 | 21.8 | % | |||||||||||
| 2002 |
33,522 | 27,516 | 82.1 | % | 12.7 | % | (531 | ) | 10,207 | 18.7 | % | |||||||||||
| 2003 |
69,932 | 58,188 | 83.2 | % | 26.9 | % | (270 | ) | 19,669 | 21.2 | % | |||||||||||
| 2004 |
79,845 | 45,083 | 56.5 | % | 20.9 | % | — | 50,998 | 5.8 | % | ||||||||||||
| 2005 |
66,491 | 46,060 | 69.3 | % | 21.4 | % | (2,207 | ) | 173,960 | 4.3 | % | |||||||||||
| Total |
$ | 291,111 | $ | 215,931 | 74.2 | % | 100.0 | % | $ | (3,143 | ) | $ | 256,333 | 6.5 | % | |||||||
| (1) |
Does not include amounts collected on behalf of others. |
| (2) |
Gross collections and revenue related to the retained interest are included in these tables. |
Total revenue was $255.1 million for the year ended December 31, 2006, an increase of $33.3 million, or 15.0%, compared to total revenue of $221.8 million for the year ended December 31, 2005. The increase in revenue is primarily the result of increased revenue from portfolio purchases during 2006, increased accretion revenue associated with extending our collection forecast from 60 months to 72 months, additional Zero Basis Revenue related to the sale of certain accounts in December 2006, as discussed below, and increased accretion revenue related to new operating initiatives. The increase in revenue was offset, in part, by a greater portion of our collections coming from 2004, 2005, and 2006 purchases that have lower revenue recognition rates due to a more competitive pricing environment than purchases made in prior years and due to a reduction in Zero Basis Revenue. During the year ended December 31, 2006, we recorded a net impairment provision of $1.4 million on certain of our receivable portfolios. During the same period in the prior year we recorded an impairment provision of $3.1 million on certain of our receivable portfolios. Revenue also increased due to our full year of ownership of Ascension in 2006. Ascension’s bankruptcy servicing revenue of $15.7 million represents twelve months of revenue for the year ended December 31, 2006, compared to $5.5 million for the year ended December 31, 2005. The 2005 revenue represents only the revenue for the period of time after our acquisition of Ascension in August 2005.
During December 2006, we sold accounts amounting to approximately $1.9 billion in face value for $13.9 million. The accounts sold were purchased in 2001, 2002, 2003 and 2004 under our Secured Financing Facility. This sale resulted in additional Zero Basis Revenue of $3.4 million and additional contingent interest expense of $1.6 million. The net impact of this sale was to increase pretax income for the year ended December 31, 2006 by $1.8 million, net income by $1.1 million and fully diluted earnings per share by $0.05. Since the sale of these accounts accelerated collections from future years into 2006, future years’ collections and the related revenue, operating expenses and contingent interest expense associated with the pool groups from which these accounts were sold, will be reduced. Of the proceeds, $10.3 million was applied to pay off the remaining principal balance of the Secured Financing Facility in December 2006.
During the year ended December 31, 2006, $27.3 million (exclusive of $1.3 million of Zero Basis Revenue on the retained interest) was recognized as Zero Basis Revenue, a $3.4 million decrease from the $30.7 million (exclusive of $1.7 million of Zero Basis Revenue on the retained interest) recognized during the year ended December 31, 2005. The reduction in Zero Basis Revenue was primarily the result of the reduction in collections from Zero Basis Portfolios, offset by Zero Basis Revenue recognized related to the December 2006 sale of the approximately $1.9 billion in face value of receivables discussed above. We expect the revenue from Zero Basis Portfolios to decline in future quarters as collections from these portfolios diminish. For additional information on revenue see the Supplemental Performance Data below.
31
During the year ended December 31, 2006, we invested $144.3 million for portfolios with face values aggregating $3.7 billion, for an average purchase price of 3.9% of face value. This is a $51.3 million decrease, or 26.2%, in the amount invested compared with the $195.6 million invested during the year ended December 31, 2005, to acquire portfolios with a face value aggregating $5.9 billion, for an average purchase price of 3.3% of face value. The decrease in amount invested is primarily a result of the $96.6 million allocated to the $2.8 billion of face value portfolio purchased as part of our acquisition of certain assets of Jefferson Capital in June 2005.
Operating Expenses
Total operating expenses were $183.5 million for the year ended December 31, 2006, an increase of $45.7 million, or 33.2%, compared to total operating expenses of $137.8 million for the year ended December 31, 2005.
Operating expenses are explained in more detail as follows:
Salaries and employee benefits
Total salaries and employee benefits increased by $11.6 million, or 22.0%, to $64.0 million during the year ended December 31, 2006, from $52.4 million during the year ended December 31, 2005. The increase was primarily the result of a $9.2 million, or 24.9% increase in salaries, wages and payroll taxes associated with additional headcount. Of this increase, approximately 150 employees or $3.0 million in salaries, wages and payroll taxes related to the new collection site in St. Cloud, Minnesota acquired from Jefferson Capital in June 2005, and approximately 160 employees or $5.1 million in salaries, wages and payroll taxes, which includes $0.4 million of amortization cost of an employment agreement, related to the Ascension acquisition in August 2005. The remaining amount is due to salary increases, additional corporate headcount to support operating initiatives focused on increasing portfolio liquidation, and general headcount to support the growth of our Company.
Stock-based compensation expenses
Stock-based compensation amounted to $5.7 million for the year ended December 31, 2006. These amounts are the result of implementing Statement of Financial Accounting Standards No. 123R, “Share-Based Payments” (“FAS 123R”), effective January 1, 2006. FAS 123R requires us to expense stock options, restricted stock, and any other share-based payments beginning January 1, 2006, but does not require us to expense these amounts in any prior periods. See Note 9 to the consolidated financial statements for a further discussion of stock-based compensation.
Cost of legal collections
The cost of legal collections increased $17.0 million, or 48.4%, to $52.1 million during the year ended December 31, 2006, as compared to $35.1 million during the year ended December 31, 2005. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in contingent fees was primarily the result of an increase of $30.6 million, or 34.7% in gross collections through our legal channel. Gross legal collections amounted to $118.7 million during the year ended December 31, 2006, from $88.1 million collected during the year ended December 31, 2005. Cost of legal collections increased as a percent of gross collections through this channel to 43.9% during the year ended December 31, 2006, from 39.8% during the year ended December 31, 2005, primarily as a result of increased upfront court costs expensed associated with our pursuit of legal collections of $15.5 million and $6.3 million for the years ended December 31, 2007 and 2006, respectively, and changes in our expected recovery rate on court costs spent. See “Legal Outsourcing Collections and Related Costs” under Supplemental Performance Data for further discussion of cost of legal collections.
32
Other operating expenses
Other operating expenses increased $5.6 million, or 33.1%, to $22.6 million during the year ended December 31, 2006, from $17.0 million during the year ended December 31, 2005. This increase was the result of increases in the number of direct mail campaigns and the inclusion of a full year of operating costs associated with Ascension, which we acquired in August 2005. The cost of direct mail campaigns increased $1.1 million, or 16.2%, to $7.5 million during the year ended December 31, 2006, compared to $6.4 million during the year ended December 31, 2005. Ascension contributed $3.8 million to the overall increase, including $1.2 million of amortization expense relating to the purchased servicing asset.
Collection agency commissions
During the year ended December 31, 2006, we paid $18.0 million in commissions to third party collection agencies, or 36.3% of the related gross collections of $49.7 million, compared to $17.3 million in commissions, or 38.9% of the related gross collections of $44.4 million during the year ended December 31, 2005. The increase in commissions was consistent with the increase in collections through this channel. The decrease in the commission rate as a percentage of the related gross collections is primarily due to the mix of accounts placed with the agencies. Commissions as a percentage of collections in this channel vary from period to period depending on, among other things, the time from charge-off of the accounts placed with an agency (freshly charged-off accounts have a lower commission rate).
General and administrative expenses
General and administrative expenses increased $3.9 million, or 29.4%, to $17.3 million during the year ended December 31, 2006, from $13.4 million during the year ended December 31, 2005. The increase was primarily the result of approximately $2.6 million of increased expenses due to the inclusion of a full year of costs related to the acquisitions of the St. Cloud site and Ascension in 2005, costs associated with our evaluation of strategic alternatives of $1.5 million, and general corporate matters. These increases were offset by lower legal costs of $0.2 million relating to litigation defense.
Depreciation and amortization
Depreciation and amortization expense increased $1.2 million, or 45.0%, to $3.9 million during the year ended December 31, 2006, from $2.7 million during the year ended December 31, 2005. Depreciation expense remained relatively consistent at $2.3 million and $1.9 million during the year ended December 31, 2006 and 2005, respectively. Amortization expense relating to intangible assets acquired in conjunction with the acquisition of Ascension in the third quarter of 2005 was $1.6 million for the year ended December 31, 2006, compared to $0.8 million for the year ended December 31, 2005.
Interest expense
Interest expense decreased $1.7 million, or 5.2% to $31.0 million during the year ended December 31, 2006, from $32.7 million during the year ended December 31, 2005.
The following table summarizes our interest expense (in thousands):
| For the Years Ended December 31, | |||||||||||||
| 2006 | 2005 | $ Change | % Change | ||||||||||
| Stated interest on debt obligations |
$ | 10,637 | $ | 8,326 | $ | 2,311 | 27.8 | % | |||||
| Amortization of loan fees and other loan costs |
1,875 | 1,204 | 671 | 55.7 | % | ||||||||
| Contingent interest |
18,520 | 23,187 | (4,667 | ) | (20.1 | )% | |||||||
| Total interest expense |
$ | 31,032 | $ | 32,717 | $ | (1,685 | ) | (5.2 | )% | ||||
33
The decrease in interest expense is due to a decrease in contingent interest recorded under the terms of our Secured Financing Facility. Under the terms of our Secured Financing Facility, once we repay the lender for the notes associated with each purchased portfolio and collect sufficient amounts to recoup our initial cash investment in each purchased portfolio, we then share the residual collections, “Contingent Interest,” from the receivable portfolios, net of our servicing fees, with the lender. We make estimates with respect to the timing and amount of collections of future cash flows from these receivable portfolios. Based on these estimates, we record a portion of the estimated future profit sharing obligation as Contingent Interest expense.
As of December 31, 2006, the principal balance of the Secured Financing Facility had been paid in full.
We have financed portfolio purchases subsequent to December 31, 2004, using our Revolving Credit Facility, which does not require the sharing of residual collections with the lender. See Note 8 to the consolidated financial statements for a further discussion on our Revolving Credit Facility.
Other income and expense
During the year ended December 31, 2006, total other income was $0.6 million, compared to $0.9 million for the year ended December 31, 2005. For the year ended December 31, 2006, the decrease in other income and expense was primarily the result of lower interest income due to lower balances of invested cash.
Provision for income taxes
During the year ended December 31, 2006, we recorded an income tax provision of $17.2 million, reflecting an effective rate of 41.7% of pretax income. Our effective tax rate for the year ended December 31, 2006, differed from the Federal statutory rate primarily due to the net effect of state taxes, permanent book versus tax differences, and the effect of an anticipated adjustment related to an Internal Revenue Service tax audit of our 2003 income tax return. For the year ended December 31, 2005, we recorded an income tax provision of $21.1 million, reflecting an effective rate of 40.5% of pretax income. Our effective tax rate for the year ended December 31, 2005, differed from the Federal statutory rate primarily due to the net effect of state taxes. The increase in our effective tax rate was the result of the changing mix of permanent book versus tax differences relative to taxable income and the increase in tax expense related to the tax audit issue noted above. See Note 10 to the consolidated financial statements for a further discussion of income taxes.
Supplemental Performance Data
Cumulative Collections to Purchase Price Multiple
The following table summarizes our purchases and related resulting gross collections per year of purchase (in thousands, except multiples):
| Year of Purchase |
Purchase Price(1) |
Cumulative Collections through December 31, 2007 | |||||||||||||||||||||||||||||||
| <2001 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | Total(2) | CCM(3) | ||||||||||||||||||||||||
| <1999 |
$ | 41,117 | (4) | $ | 88,629 | $ | 22,545 | $ | 15,007 | $ | 7,546 | $ | 4,202 | $ | 2,042 | $ | 1,513 | $ | 989 | $ | 142,473 | 3.5 | |||||||||||
| 1999 |
48,712 | 29,163 | 19,174 | 16,259 | 11,508 | 8,654 | 5,157 | 3,513 | 1,954 | 95,382 | 2.0 | ||||||||||||||||||||||
| 2000 |
6,153 | 5,489 | 7,172 | 4,542 | 4,377 | 2,293 | 1,323 | 1,007 | 566 | 26,769 | 4.4 | ||||||||||||||||||||||
| 2001 |
38,186 | — | 21,197 | 54,184 | 33,072 | 28,551 | 20,622 | 14,521 | 5,644 | 177,791 | 4.7 | ||||||||||||||||||||||
| 2002 |
61,501 | — | — | 48,322 | 70,227 | 62,282 | 45,699 | 33,694 | 14,902 | 275,126 | 4.5 | ||||||||||||||||||||||
| 2003 |
88,533 | — | — | — | 59,038 | 86,958 | 69,932 | 55,131 | 26,653 | 297,712 | 3.4 | ||||||||||||||||||||||
| 2004 |
101,349 | — | — | — | — | 39,400 | 79,845 | 54,832 | 34,625 | 208,702 | 2.1 | ||||||||||||||||||||||
| 2005 |
192,881 | — | — | — | — | — | 66,491 | 129,809 | 109,078 | 305,378 | 1.6 | ||||||||||||||||||||||
| 2006 |
142,110 | — | — | — | — | — | — | 42,354 | 92,265 | 134,619 | 0.9 | ||||||||||||||||||||||
| 2007 |
206,549 | — | — | — | — | — | — | — | 68,048 | 68,048 | 0.3 | ||||||||||||||||||||||
| Total |
$ | 927,091 | $ | 123,281 | $ | 70,088 | $ | 138,314 | $ | 185,768 | $ | 232,340 | $ | 291,111 | $ | 336,374 | $ | 354,724 | $ | 1,732,000 | 1.9 | ||||||||||||
34
| (1) |
Adjusted for put-backs, account recalls, purchase price rescissions, and the impact of an acquisition in 2000. Put-backs represent accounts that are returned to the seller in accordance with the respective purchase agreement (“Put-Backs”). Recalls represents accounts that are recalled by the seller in accordance with the respective purchase agreement (“Recalls”). |
| (2) |
Cumulative collections from inception through December 31, 2007. |
| (3) |
Cumulative Collections Multiple (“CCM”) through December 31, 2007—collections as a multiple of purchase price. |
| (4) |
From inception through December 31, 1998. |
Total Estimated Collections to Purchase Price Multiple
The following table summarizes our purchases, resulting historical gross collections, and estimated remaining gross collections, by year of purchase (in thousands, except multiples):
| Purchase Price(1) |
Historical Gross Collections(2) |
Estimated Remaining Gross Collections(3) |
Total Estimated Gross Collections |
Total Estimated Gross Collections to Purchase Price | |||||||||||
| <1999 |
$ | 41,117 | (4) | $ | 142,473 | $ | 704 | $ | 143,177 | 3.5 | |||||
| 1999 |
48,712 | 95,382 | 1,800 | 97,182 | 2.0 | ||||||||||
| 2000 |
6,153 | 26,769 | 502 | 27,271 | 4.4 | ||||||||||
| 2001 |
38,186 | 177,791 | 3,915 | 181,706 | 4.8 | ||||||||||
| 2002 |
61,501 | 275,126 | 8,866 | 283,992 | 4.6 | ||||||||||
| 2003 |
88,533 | 297,712 | 20,657 | 318,369 | 3.6 | ||||||||||
| 2004 |
101,349 | 208,702 | 48,191 | 256,893 | 2.5 | ||||||||||
| 2005 |
192,881 | 305,378 | 184,079 | 489,457 | 2.5 | ||||||||||
| 2006 |
142,110 | 134,619 | 216,695 | 351,314 | 2.5 | ||||||||||
| 2007(5) |
206,549 | 68,048 | 406,454 | 474,502 | 2.3 | ||||||||||
| Total |
$ | 927,091 | $ | 1,732,000 | $ | 891,863 | $ | 2,623,863 | 2.8 | ||||||
| (1) |
Adjusted for Put-Backs, Recalls, purchase price rescissions, and the impact of an acquisition in 2000. |
| (2) |
Cumulative collections from inception through December 31, 2007. |
| (3) |
Includes $1.6 million in expected collections for the healthcare portfolios on cost recovery. |
| (4) |
From inception through December 31, 1998. |
| (5) |
As of April 1, 2007, initial collection forecasts for portfolio purchases were extended from 54 or 60 months to 72 months consistent with all other collection forecasts. |
Estimated Remaining Gross Collections by Year of Purchase
The following table summarizes our estimated remaining gross collections by year of purchase (in thousands):
| Estimated Remaining Gross Collections by Year of Purchase | |||||||||||||||||||||
| 2008 | 2009 | 2010 | 2011 | 2012 | 2013 | Total | |||||||||||||||
| <1999(1) |
$ | 479 | $ | 225 | $ | — | $ | — | $ | — | $ | — | $ | 704 | |||||||
| 1999(1) |
1,209 | 591 | — | — | — | — | 1,800 | ||||||||||||||
| 2000(1) |
326 | 175 | 1 | — | — | — | 502 | ||||||||||||||
| 2001(1) |
2,291 | 1,122 | 411 | 91 | — | — | 3,915 | ||||||||||||||
| 2002(1) |
7,277 | 1,129 | 386 | 74 | — | — | 8,866 | ||||||||||||||
| 2003 |
14,705 | 5,952 | — | — | — | — | 20,657 | ||||||||||||||
| 2004 |
23,885 | 15,994 | 8,312 | — | — | — | 48,191 | ||||||||||||||
| 2005 |
82,583 | 51,134 | 35,680 | 14,682 | — | — | 184,079 | ||||||||||||||
| 2006 |
76,111 | 52,327 | 40,316 | 32,023 | 15,918 | — | 216,695 | ||||||||||||||
| 2007 |
125,527 | 111,162 | 73,388 | 50,178 | 34,470 | 11,729 | 406,454 | ||||||||||||||
| Total |
$ | 334,393 | $ | 239,811 | $ | 158,494 | $ | 97, 048 | $ | 50,388 | $ | 11,729 | $ | 891,863 | |||||||
35
| (1) |
Estimated remaining collections for Zero Basis Portfolios can extend beyond the normal 72-month accrual basis collection forecast. |
Unamortized Balances of Portfolios
The following table summarizes the remaining unamortized balances of our purchased receivable portfolios by year of purchase as of December 31, 2007 (in thousands, except percentages):
| Unamortized Balance as of December 31, 2007(1) |
Purchase Price(2) |
Unamortized Balance as a Percentage of Purchase Price |
Unamortized Balance as a Percentage of Total |
|||||||||
| 2002 |
$ | 1,823 | $ | 61,501 | 3.0 | % | 0.5 | % | ||||
| 2003 |
4,417 | 88,533 | 5.0 | % | 1.1 | % | ||||||
| 2004 |
20,721 | 101,349 | 20.4 | % | 5.3 | % | ||||||
| 2005 |
87,350 | 192,880 | 45.3 | % | 22.3 | % | ||||||
| 2006 |
95,739 | 142,110 | 67.4 | % | 24.4 | % | ||||||
| 2007 |
182,159 | 206,550 | 88.2 | % | 46.4 | % | ||||||
| Totals |
$ | 392,209 | $ | 792,923 | 49.5 | % | 100.0 | % | ||||
| (1) |
Includes $1.6 million for healthcare portfolios being accounted for on the cost recovery method. |
| (2) |
Purchase price refers to the cash paid to a seller to acquire a portfolio less Put- Backs, and less the purchase price for accounts that were sold at the time of purchase to another debt purchaser. |
Collections by Channel
During 2007, 2006 and 2005, we utilized numerous business channels for the collection of charged-off credit cards and other receivables. The following table summarizes the gross collections by collection channel (in thousands):
| Years Ended December 31, | |||||||||
| 2007 | 2006 | 2005 | |||||||
| Collection sites(1) |
$ | 126,093 | $ | 129,009 | $ | 127,980 | |||
| Legal collections |
169,005 | 118,712 | 88,144 | ||||||
| Collection agencies(1) |
33,325 | 49,696 | 44,384 | ||||||
| Sales |
24,001 | 34,035 | 26,739 | ||||||
| Other |
2,769 | 5,645 | 4,916 | ||||||
| Gross collections |
$ | 355,193 | $ | 337,097 | $ | 292,163 | |||
| (1) |
Collection agencies for the year ended December 31, 2005, includes collections made by the employees of Jefferson Capital through the end of the three-month transition services agreement, which expired in September 2005. Collections made by these employees subsequent to the expiration of the transition services agreement are included in collection sites. Collections by Jefferson Capital employees included in collection agencies were $3.4 million during the term of the transition services agreement. |
36
External Collection Channels and Related Direct Costs
The following table summarizes our external collection channel performance and related direct costs (in thousands, except percentages):
| Legal Collections | ||||||||||||||||||
| Year Ended December 31, | ||||||||||||||||||
| 2007 | 2006 | 2005 | ||||||||||||||||
| Collections |
$ | 169,005 | 100.0 | % | $ | 118,712 | 100.0 | % | $ | 88,144 | 100.0 | % | ||||||
| Commissions |
49,344 | 29.2 | % | 36,390 | 30.6 | % | 28,716 | 32.6 | % | |||||||||
| Court cost expense(1) |
28,045 | 16.6 | % | 15,503 | 13.1 | % | 6,301 | 7.1 | % | |||||||||
| Other(2) |
1,247 | 0.7 | % | 186 | 0.2 | % | 73 | 0.1 | % | |||||||||
| Total Costs |
$ | 78,636 | 46.5 | % | $ | 52,079 | 43.9 | % | $ | 35,090 | 39.8 | % | ||||||
|
(1) In connection with our agreement with contracted attorneys, we advance certain out-of-pocket court costs. We capitalize these costs in our consolidated financial statements and provide a reserve and corresponding court cost expense for the costs that we believe will ultimately be uncollectible. This amount includes changes in our anticipated recovery rate of court costs expensed. (2) Other costs consist primarily of costs related to counter claims. |
| |||||||||||||||||
| Collection Agencies | ||||||||||||||||||
| Year Ended December 31, | ||||||||||||||||||
| 2007 | 2006 | 2005 | ||||||||||||||||
| Collections |
$ | 33,325 | 100.0 | % | $ | 49,696 | 100.0 | % | $ | 44,384 | 100.0 | % | ||||||
| Commissions |
12,411 | 37.2 | % | 18,030 | 36.3 | % | 17,287 | 38.9 | % | |||||||||
Legal Outsourcing Collections and Related Costs
The following tables summarize our legal outsourcing collection channel performance and related direct costs for the previous five placement years (in thousands, except percentages):
| Gross Collections by Year of Collection(1) | ||||||||||||||||||
| Placement Year |
2003 | 2004 | 2005 | 2006 | 2007 | Total Collections | ||||||||||||
| 2003 |
$ | 10,750 | $ | 27,192 | $ | 17,212 | $ | 9,566 | $ | 5,561 | $ | 70,281 | ||||||
| 2004 |
— | $ | 23,455 | $ | 37,674 | $ | 21,676 | $ | 12,029 | $ | 94,834 | |||||||
| 2005 |
— | — | $ | 21,694 | $ | 40,762 | $ | 22,152 | $ | 84,608 | ||||||||
| 2006 |
— | — | — | $ | 39,395 | $ | 82,740 | $ | 122,135 | |||||||||
| 2007 |
— | — | — | — | $ | 41,958 | $ | 41,958 | ||||||||||
|
(1) Includes collections for accounts placed in our legal channel beginning January 1, 2003. We continue to collect on accounts placed in this channel prior to that date. | ||||||||||||||||||
| Court Cost Expense by Year of Collection(1) | ||||||||||||||||||
| Placement Year |
2003 | 2004 | 2005 | 2006 | 2007 | Total Court Costs | ||||||||||||
| 2003 |
$ | 908 | $ | 2,046 | $ | 571 | $ | 300 | $ | 147 | $ | 3,972 | ||||||
| 2004 |
— | $ | 2,509 | $ | 2,937 | $ | 1,087 | $ | 406 | $ | 6,939 | |||||||
| 2005 |
— | — | $ | 3,271 | $ | 4,426 | $ | 859 | $ | 8,556 | ||||||||
| 2006 |
— | — | — | $ | 10,158 | $ | 10,291 | $ | 20,449 | |||||||||
| 2007 |
— | — | — | — | $ | 15,357 | $ | 15,357 | ||||||||||
| (1) |
Includes court cost expense for accounts placed in our legal channel beginning January 1, 2003. We continue to incur court cost expense on accounts placed in this channel prior to that date. |
37
| Commissions by Year of Collection(1) | ||||||||||||||||||||||||
| Placement Year |
2003 | 2004 | 2005 | 2006 | 2007 | Total Commissions |
||||||||||||||||||
| 2003 |
$ | 3,574 | $ | 8,606 | $ | 5,496 | $ | 2,898 | $ | 1,574 | $ | 22,148 | ||||||||||||
| 2004 |
— | $ | 7,273 | $ | 12,060 | $ | 6,653 | $ | 3,498 | $ | 29,484 | |||||||||||||
| 2005 |
— | — | $ | 6,725 | $ | 12,108 | $ | 6,364 | $ | 25,197 | ||||||||||||||
| 2006 |
— | — | — | $ | 11,451 | $ | 23,659 | $ | 35,110 | |||||||||||||||
| 2007 |
— | — | — | — | $ | 11,845 | $ | 11,845 | ||||||||||||||||
|
(1) Includes commissions for accounts placed in our legal channel beginning January 1, 2003. We continue to incur commissions on collections for accounts placed in this channel prior to that date. |
| |||||||||||||||||||||||
| Court Cost Expense and Commissions as a Percentage of Gross Collections by Year of Collection |
||||||||||||||||||||||||
| Placement Year |
2003 | 2004 | 2005 | 2006 | 2007 | Cumulative Average |
||||||||||||||||||
| 2003 |
46.3 | % | 39.2 | % | 32.4 | % | 30.8 | % | 27.2 | % | 36.5 | % | ||||||||||||
| 2004 |
— | 46.6 | % | 39.8 | % | 32.8 | % | 28.3 | % | 38.4 | % | |||||||||||||
| 2005 |
— | — | 55.8 | % | 42.2 | % | 28.5 | % | 42.1 | % | ||||||||||||||
| 2006 |
— | — | — | 72.1 | % | 43.2 | % | 52.5 | % | |||||||||||||||
| 2007 |
— | — | — | — | 89.7 | % | 89.7 | % | ||||||||||||||||
| Lawsuits Filed by Year(1) | ||||||||||||||||||||||||
| Placement Year(2) |
2003 | 2004 | 2005 | 2006 | 2007 | Total Sued | ||||||||||||||||||
| 2003 |
23 | 29 | 5 | 2 | — | 59 | ||||||||||||||||||
| 2004 |
— | 59 | 39 | 11 | 2 | 111 | ||||||||||||||||||
| 2005 |
— | — | 76 | 46 | 3 | 125 | ||||||||||||||||||
| 2006 |
— | — | — | 205 | 105 | 310 | ||||||||||||||||||
| 2007 |
— | — | — | — | 269 | 269 | ||||||||||||||||||
| Total Sued |
23 | 88 | 120 | 264 | 379 | 874 | ||||||||||||||||||
| (1) |
Represents the year the account was placed into litigation. |
| (2) |
Represents the year the account was placed into our legal channel. |
Changes in the Investment in Receivable Portfolios
Revenue related to our investment in receivable portfolios comprises two groups: first, revenue from those portfolios that have a remaining book value and are accounted for on the accrual basis (“Accrual Basis Portfolios”), and second, revenue from those portfolios that have fully recovered their book value Zero Basis Portfolios and, therefore, every dollar of gross collections is recorded entirely as Zero Basis Revenue. If the amount and timing of future cash collections on a pool of receivables are not reasonably estimable, we account for such portfolios on the cost recovery method (“Cost Recovery Portfolios”). No revenue is recognized on Cost Recovery Portfolios until the cost basis has been fully recovered, at which time they become Zero Basis Portfolios.
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The following tables summarize the changes in the balance of the investment in receivable portfolios and the proportion of revenue recognized as a percentage of collections (in thousands, except percentages):
| For the Year Ended December 31, 2007 | ||||||||||||||||
| Accrual Basis Portfolios |
Cost Recovery Portfolios |
Zero Basis Portfolios |
Total | |||||||||||||
| Balance, beginning of period |
$ | 300,348 | $ | — | $ | — | $ | 300,348 | ||||||||
| Purchases of receivable portfolios |
208,953 | — | — | 208,953 | ||||||||||||
| Transfer of healthcare receivables |
(3,241 | ) | 3,241 | — | — | |||||||||||
| Gross collections(1) |
(339,357 | ) | (203 | ) | (14,312 | ) | (353,872 | ) | ||||||||
| Put-backs and recalls |
(3,767 | ) | (2 | ) | — | (3,769 | ) | |||||||||
| Revenue recognized(1) |
237,467 | — | 14,312 | 251,779 | ||||||||||||
| Impairment, net |
(9,839 | ) | — | — | (9,839 | ) | ||||||||||
| Write-down of healthcare receivables |
— | (1,391 | ) | — | (1,391 | ) | ||||||||||
| Balance, end of period |
$ | 390,564 | $ | 1,645 | $ | — | $ | 392,209 | ||||||||
| Revenue as a percentage of collections |
67.1 | % | 0.0 | % | 100.0 | % | 68.0 | % | ||||||||
| For the Year Ended December 31, 2006 | ||||||||||||||||
| Accrual Basis Portfolios |
Cost Recovery Portfolios |
Zero Basis Portfolios |
Total | |||||||||||||
| Balance, beginning of period |
$ | 255,299 | $ | 1,034 | $ | — | $ | 256,333 | ||||||||
| Purchases of receivable portfolios |
140,664 | 3,623 | — | 144,287 | ||||||||||||
| Transfers of portfolios |
2,485 | (2,485 | ) | — | — | |||||||||||
| Gross collections(1) |
(305,609 | ) | (2,172 | ) | (27,298 | ) | (335,079 | ) | ||||||||
| Put-backs and recalls |
(3,243 | ) | — | (3 | ) | (3,246 | ) | |||||||||
| Revenue recognized(1) |
212,131 | — | 27,301 | 239,432 | ||||||||||||
| Impairments, net |
(1,379 | ) | — | — | (1,379 | ) | ||||||||||
| Balance, end of period |
$ | 300,348 | $ | — | $ | — | $ | 300,348 | ||||||||
| Revenue as a percentage of collections |
69.0 | % | 0.0 | % | 100.0 | % | 71.0 | % | ||||||||
| For the Year Ended December 31, 2005 | ||||||||||||||||
| Accrual Basis Portfolios |
Cost Recovery Portfolios |
Zero Basis Portfolios |
Total | |||||||||||||
| Balance, beginning of period |
$ | 137,553 | $ | 410 | $ | — | $ | 137,963 | ||||||||
| Purchases of receivable portfolios |
193,154 | 2,400 | — | 195,554 | ||||||||||||
| Transfers of portfolios |
404 | (404 | ) | — | — | |||||||||||
| Gross collections(1) |
(257,335 | ) | (1,372 | ) | (30,659 | ) | (289,366 | ) | ||||||||
| Put-backs and recalls |
(1,996 | ) | — | (2 | ) | (1,998 | ) | |||||||||
| Revenue recognized(1) |
186,662 | — | 30,661 | 217,323 | ||||||||||||
| Impairments, net |
(3,143 | ) | — | — | (3,143 | ) | ||||||||||
| Balance, end of period |
$ | 255,299 | $ | 1,034 | $ | — | $ | 256,333 | ||||||||
| Revenue as a percentage of collections |
71.3 | % | 0.0 | % | 100.0 | % | 74.0 | % | ||||||||
| (1) |
For accrual basis portfolios, the weighted average annualized effective interest rate is the accrual rate utilized in recognizing revenue on our Accrual Basis Portfolios. This rate represents the monthly internal rate of return, which has been annualized utilizing the simple interest method. The monthly internal rate of return is determined based on the timing and amounts of actual cash received to date and the anticipated future cash flow projections for each pool. |
39
As of December 31, 2007, we had $392.2 million in investment in receivable portfolios. This balance will be amortized based upon current projections of cash collections in excess of revenue applied to the principal balance. The estimated amortization of the investment in receivable portfolio balance is as follows (in thousands):
| For the Years Ended December 31, |
Amortization | ||
| 2008 |
$ | 112,890 | |
| 2009 |
100,097 | ||
| 2010 |
76,885 | ||
| 2011 |
56,297 | ||
| 2012 |
36,082 | ||
| 2013 |
9,958 | ||
| Total |
$ | 392,209 | |
Analysis of Changes in Revenue
The following table analyzes the components of the increase in revenue from our receivable portfolios between the years ended December 31, 2007, 2006 and 2005 (in thousands, except percentages):
| For The Years Ended December 31, | ||||||||||||||||
| Variance Component |
2007 | 2006 | Change | Revenue Variance |
||||||||||||
| Average portfolio balance |
$ | 328,205 | $ | 259,766 | $ | 68,439 | $ | 55,526 | ||||||||
| Weighted average effective interest rate(1) |
68.9 | % | 81.1 | % | (12.2 | )% | (40,040 | ) | ||||||||
| Zero basis portfolios |
14,312 | 27,301 | (12,989 | ) | ||||||||||||
| Retained interest revenue |
852 | 1,287 | (435 | ) | ||||||||||||
| Total variance |
$ | 2,062 | ||||||||||||||
| For The Years Ended December 31, | ||||||||||||||||
| Variance Component |
2006 | 2005 | Change | Revenue Variance |
||||||||||||
| Average portfolio balance |
$ | 259,766 | $ | 198,652 | $ | 61,114 | $ | 56,456 | ||||||||
| Weighted average effective interest rate(1) |
81.1 | % | 92.4 | % | (11.3 | )% | (29,223 | ) | ||||||||
| Zero basis portfolios |
27,301 | 30,661 | (3,360 | ) | ||||||||||||
| Retained interest revenue |
1,287 | 1,751 | (464 | ) | ||||||||||||
| Total variance |
$ | 23,409 | ||||||||||||||
| (1) |
For Accrual Basis Portfolios, the weighted average annualized effective interest rate is the accrual rate utilized in recognizing revenue on our accrual basis portfolios. This rate represents the monthly internal rate of return, which has been annualized utilizing the simple interest method. The monthly internal rate of return is determined based on the timing and amounts of actual cash received to date and the anticipated future cash flow projections for each pool. |
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Purchases by Quarter
The following table summarizes the purchases we have made by quarter, and the respective purchase prices (in thousands):
| Quarter |
# of Accounts |
Face Value | Purchase Price |
Forward Flow Allocation(2) | ||||
| Q1 2005 |
513 | 530,047 | 19,523 | — | ||||
| Q2 2005(1) |
2,773 | 3,675,277 | 121,939 | — | ||||
| Q3 2005 |
434 | 381,508 | 14,151 | 2,330 | ||||
| Q4 2005 |
1,568 | 1,326,216 | 39,941 | 1,935 | ||||
| Q1 2006 |
673 | 558,574 | 27,091 | 2,403 | ||||
| Q2 2006 |
837 | 594,190 | 21,262 | 2,118 | ||||
| Q3 2006 |
1,469 | 1,081,892 | 32,334 | 2,939 | ||||
| Q4 2006 |
814 | 1,439,826 | 63,600 | 3,184 | ||||
| Q1 2007 |
1,434 | 2,510,347 | 45,386 | 3,539 | ||||
| Q2 2007 |
1,042 | 1,341,148 | 41,137 | 2,949 | ||||
| Q3 2007 |
659 | 1,281,468 | 47,869 | 2,680 | ||||
| Q4 2007 |
1,204 | 1,768,111 | 74,561 | 2,536 |
| (1) |
Purchase price for Q2 2005 includes a $0.9 million cost adjustment associated with the finalization of the Jefferson Capital purchase price allocation. |
| (2) |
Allocation of the forward flow asset to the cost basis of receivable portfolio purchases. See Note 2 to the consolidated financial statements for a further discussion on our forward flow asset. |
Purchases by Paper Type
The following table summarizes the types of charged-off consumer receivable portfolios we have purchased for the periods presented (in thousands):
| Years Ended December 31, | |||||||||
| 2007 | 2006 | 2005 | |||||||
| Credit card |
$ | 188,207 | $ | 66,657 | $ | 176,379 | |||
| Other |
20,746 | 77,630 | 19,175 | ||||||
| Total purchases |
$ | 208,953 | $ | 144,287 | $ | 195,554 | |||
Liquidity and Capital Resources
Overview
Historically, we have met our cash requirements by utilizing our cash flows from operations, bank borrowings, and equity offerings. Our primary cash requirements have included the purchase of receivable portfolios, operational expenses, the payment of interest and principal on bank borrowings, and tax payments.
The following table summarizes our cash flows by category for the periods presented (in thousands):
| For the Years Ended December 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
| Net cash provided by operating activities |
$ | 15,834 | $ | 38,027 | $ | 31,226 | ||||||
| Net cash used in investing activities |
$ | (95,059 | ) | $ | (37,190 | ) | $ | (144,344 | ) | |||
| Net cash provided by financing activities |
$ | 73,334 | $ | 2,928 | $ | 110,413 | ||||||
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On December 31, 2004, our Secured Financing Facility expired. All of our portfolio purchases are now funded with cash or financed under our $230.0 million Revolving Credit Facility. Unlike our Secured Financing Facility, our Revolving Credit Facility does not require us to share with the lender the residual collections on the portfolios financed. See Note 8 to the consolidated financial statements for a further discussion on our Revolving Credit Facility, Secured Financing Facility and Contingent Interest.
On May 7, 2007, we entered into an agreement with the lender under our Secured Financing Facility to eliminate all future Contingent Interest payments, for a one-time payment of $16.9 million. As a result, beginning in May 2007, we are no longer obligated to make future Contingent Interest payments under this facility.
Operating Cash Flows
Net cash provided by operating activities was $15.8 million, $38.0 million and $31.2 million for the years ended December 31, 2007, 2006 and 2005, respectively. We have been able to generate consistent operating cash flow by maintaining our gross collections performance. Gross collections for the year ended December 31, 2007 grew $18.1 million, or 5.4% to $355.2 million, from $337.1 million for the year ended December 31, 2006. Gross collections for the year ended December 31, 2006, grew $44.9 million, or 15.4%, to $337.1 million, from $292.2 million for the year ended December 31, 2005.
Total cash basis operating expenses were $193.8 million for the year ended December 31, 2007, compared to $161.3 million for the year ended December 31, 2006, and $128.4 million for the year ended December 31, 2005. The increase was primarily volume-related, driven by our collections growth and new operational initiatives, as well as increases in rent expense, and the cost of corporate compliance, offset by lower litigation defense costs.
Interest payments were $35.7 million, $40.0 million and $34.7 million for the years ended December 31, 2007, 2006 and 2005, respectively. The decrease in interest expense was due to the elimination of Contingent Interest payments subsequent to May 2007, offset by the one-time Contingent Interest payment discussed above.
Investing Cash Flows
Net cash used in investing activities was $95.1 million, $37.2 million and $144.3 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The cash flows used in investing activities for the year ended December 31, 2007, are primarily related to receivable portfolio purchases of $197.2 million ($208.9 million of gross purchases less our forward flow allocation of $11.7 million), offset by gross collection proceeds applied to the principal of our receivable portfolios in the amount of $102.1 million. The cash flows used in investing activities for the year ended December 31, 2006, are primarily related to receivable portfolio purchases of $133.7 million, offset by gross collection proceeds applied to the principal of our receivable portfolios in the amount of $95.6 million. The cash flows used in investing activities for the year ended December 31, 2005, are primarily related to our acquisition of certain assets of Jefferson Capital for $142.9 million, which included $96.6 million of receivable portfolios and our acquisition of Ascension, of which $16.0 million of the total consideration consisted of cash. In addition, the Company deposited $2.0 million into an escrow account in connection with a three-year employment agreement with a key executive of Ascension. These cash outflows were offset by gross collection proceeds applied to the principal of our receivable portfolios in the amount of $72.0 million, and $40.0 million in proceeds from the sale of marketable securities.
Capital expenditures for fixed assets acquired with internal cash flow were $1.4 million, $2.4 million and $2.9 million for years ended December 31, 2007, 2006 and 2005, respectively.
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Financing Cash Flows
Net cash provided by financing activities was $73.3 million, $2.9 million and $110.4 million for the years ended December 31, 2007, 2006 and 2005, respectively.
The cash provided by financing activities during the year ended December 31, 2007, reflects $48.5 million in repayments of notes payable, amounts outstanding under our line of credit and other borrowings, offset by $121.0 million in borrowings under our line of credit agreement. Cash provided by financing activities during the year ended December 31, 2006, reflects $51.3 million in repayments of notes payable, amounts outstanding under our line of credit and other borrowings, offset by $53.5 million in borrowings under our line of credit agreement. Cash provided by financing activities for the year ended December 31, 2005, reflects $191.4 million in borrowings under line of credit agreements, proceeds from the issuance of convertible notes of $100.0 million and the sale of $11.6 million of warrants, offset by $160.9 million in repayment of debt principal, the purchase of $27.4 million of call options and the payment of $5.8 million of debt issuance costs.
Future Contractual Cash Obligations
The following table summarizes our future contractual cash obligations as of December 31, 2007 (in thousands):
| Payments Due by Period | |||||||||||||||
| Total | Less Than 1 Year |
1 –3 Years | 3 –5 Years | More Than 5 Years | |||||||||||
| Capital lease obligations |
$ | 251 | $ | 251 | $ | — | $ | — | $ | — | |||||
| Operating leases |
12,638 | 2,991 | 5,035 | 2,063 | 2,549 | ||||||||||
| Employment agreements |
193 | 193 | — | — | — | ||||||||||
| Revolving Credit Facility |
172,169 | — | 172,169 | — | — | ||||||||||
| Contractual interest on derivative instruments |
7,081 | 2,500 | 4,165 | 416 | — | ||||||||||
| 3.375% Convertible Senior Notes |
100,000 | — | 100,000 | — | — | ||||||||||
| Contractual interest on 3.375% Convertible Senior Notes |
9,281 | 3,375 | 5,906 | — | — | ||||||||||
| Portfolio forward flow agreement |
79,118 | 31,647 | 47,471 | — | — | ||||||||||
| Total contractual cash obligations |
$ | 380,731 | $ | 40,957 | $ | 334,746 | $ | 2,479 | $ | 2,549 | |||||
Our Revolving Credit Facility has a remaining term of 2.3 years and to the extent that a balance is outstanding on our Revolving Credit Facility, it would be due in May 2010. Interest on the Revolving Credit Facility is variable and is not included in this table. The outstanding balance on our Revolving Credit Facility as of December 31, 2007, was $172.7 million. The portfolio forward flow agreement represents estimated payments under our five-year portfolio purchase forward flow agreement entered into on September 7, 2005. For additional information on our debt, see Note 8 to the consolidated financial statements. Also, for additional information on purchase commitments see Note 12 to the consolidated financial statements.
We are in compliance with all covenants under our financing arrangements and, excluding the effects of the one-time payment of $16.9 million to eliminate all future Contingent Interest payments in the second quarter of 2007 (this payment, less amounts accrued on our balance sheet, resulted in a charge to our statement of operations of $6.9 million after the effect of income taxes), we have achieved 24 consecutive quarters of positive net income. We believe that we have sufficient liquidity to fund our operations for at least the next twelve months, given our expectation of continued positive cash flows from operations, our cash and cash equivalents of $4.9 million as of December 31, 2007, and $57.3 million in borrowing capacity and $56.0 million in borrowing base availability under our Revolving Credit Facility as of December 31, 2007.
Off Balance Sheet Arrangements
We do not have any off balance sheet arrangements as defined by regulation S-K 303(a)(4).
43
Inflation
We believe that inflation has not had a material impact on our results of operations for the three years ended December 31, 2007, 2006, and 2005, since inflation rates have generally remained at relatively low levels and our operations are not otherwise uniquely affected by inflation concerns.
Critical Accounting Policies
Investment in Receivable Portfolios. Commencing January 1, 2005, we began accounting for our investment in receivable portfolios in accordance with the provisions of SOP 03-03. SOP 03-03 addresses accounting for differences between initial estimated cash flows expected to be collected from purchased receivables, or “pools,” and subsequent changes to those estimated cash flows. SOP 03-03 limits the revenue that may be accreted, (also known as accretable yield), to the excess of our estimate of undiscounted cash flows expected to be collected over our investment, or cost basis, in the pool.
As permitted by SOP 03-03, static pools are established on a quarterly basis with accounts purchased during the quarter that have common risk characteristics. Discrete receivable portfolio purchases during a quarter are aggregated into pools based on these common risk characteristics. Once a static pool is established, the portfolios are permanently assigned to the pool. The discount (i.e., the difference between the cost of each static pool and the related aggregate contractual receivable balance) is not recorded because we expect to collect a relatively small percentage of each static pool’s contractual receivable balance. As a result, receivable portfolios are recorded at cost at the time of acquisition. All portfolios with common risk characteristics purchased prior to the adoption of SOP 03-03 were aggregated by quarter of purchase.
In compliance with SOP 03-03, we account for our investments in consumer receivable portfolios, using either the interest method or the cost recovery method. The interest method applies an effective interest rate, or internal rate of return (“IRR”) to the cost basis of the pool, which is to remain level, or unchanged throughout the life of the pool unless there is an increase in subsequent expected cash flows. Subsequent increases in cash flows expected to be collected generally are recognized prospectively through an upward adjustment of the pool’s effective interest rate over its remaining life. Subsequent decreases in expected cash flows do not change the effective interest rate, but are recognized as an impairment of the cost basis of the pool, and are reflected in the consolidated statements of operations as a reduction in revenue with a corresponding valuation allowance offsetting the investment in receivable portfolios in the consolidated statements of financial condition.
We account for each static pool as a unit for the economic life of the pool (similar to one loan) for recognition of revenue from receivable portfolios, for collections applied to the cost basis of receivable portfolios and for provision for loss or impairment. Revenue from receivable portfolios is accrued based on each pool’s effective interest rate applied to each pool’s adjusted cost basis. The cost basis of each pool is increased by revenue earned and decreased by gross collections and impairments.
If the amount and timing of future cash collections on a pool of receivables are not reasonably estimable, we account for such portfolios as Cost Recovery Portfolios. The accounts in these portfolios have different risk characteristics than those included in other portfolios acquired during the same quarter, or the necessary information was not available to estimate future cash flows and, accordingly, they were not aggregated with other portfolios.
Contingent Interest. Prior to May 7, 2007, under the terms of the our Secured Financing Facility, once we repaid the lender for the notes for each purchased portfolio and collected sufficient amounts to recoup our initial cash investment in each purchased portfolio, then we shared the residual collections (“Contingent Interest”) from the receivable portfolios, net of servicing fees, with the lender. We made estimates with respect to the timing and amount of collections of future cash flows from these receivable portfolios. Based on these estimates, we recorded a portion of the estimated future profit sharing obligation as Contingent Interest expense.
44
On May 7, 2007, we entered into an agreement with the lender under our Secured Financing Facility to eliminate all future Contingent Interest payments, for a one-time payment of $16.9 million. Subsequent to that date, we are no longer obligated to make any contingent interest payments under the Secured Financing Facility and as a result, no longer record such interest in our statements of operations.
See Note 8 to the consolidated financial statements for a further discussion on Contingent Interest.
Deferred Revenue. On August 30, 2005, we acquired substantially all the assets and assumed certain liabilities of Ascension. Ascension provides bankruptcy administration services primarily to holders of motor vehicle secured loans, on which the debtor has filed for Chapter 7 or 13 bankruptcy. These services are provided subject to the terms of long-term contracts. Such contracts generally have initial terms of one or two years and automatically renew for yearly periods. Fees for the bankruptcy administration services are charged on a ‘per referred’ account basis and generally consist of an upfront fee at the time of account referral. This initial fee is typically coupled with either an ongoing monthly service fee per referred account or service specific fees based on a predetermined fee schedule. The servicing deliverable for Chapter 7 accounts is focused on the completion of the entire bankruptcy process resulting in the most favorable possible conclusion for the customer. As a result, revenue is deferred and not recognized until the bankruptcy case is closed (dismissal/discharge). Due to practical limitations and constraints, a historical average life of seven months is used instead of actual closure dates. Therefore, the total financial consideration (less efforts applied to litigation for client contracts without a separate litigation fee schedule) is recognized seven months after a referred account is activated. Chapter 13 bankruptcy proceedings, also known as reorganization, are generally designed to restructure an individual’s debts and allow them to propose a repayment plan detailing how they are going to pay back their debts over the plan period. The responsibility of Ascension is to ensure that the client’s claim is recognized by the court to the maximum benefit of Ascension’s client, and to monitor and/or collect the debtor payments throughout the confirmed bankruptcy plan term. The average duration period for Chapter 13 bankruptcy placements is thirty-five months. Given the nature and duration of a Chapter 13 proceeding, the monthly servicing deliverable provided relative to a Chapter 13 referred account is considered “delivered” each month and revenue is recognized ratably, including any upfront fees received by the Company over time as the services are provided. The litigation deliverable is an as incurred event, with revenue recognized based on the historical percentage of accounts litigated over the average duration of an account. Any billings in excess of the ratable revenue will be deferred. The average duration period for Chapter 7 and 13 bankruptcy placements is reviewed periodically for changes.
Convertible Notes Hedge. In 2005, we issued $100.0 million of 3.375% convertible senior notes due September 19, 2010 (the “Convertible Notes”). Concurrent with the sale of the Convertible Notes, we purchased call options to purchase shares of our common stock and sold warrants to sell shares of our our common stock to the parties to which the Convertible Notes were issued. In accordance with EITF No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company’s Own Stock,” and Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity,” we recorded the net call options and warrants as a reduction in additional paid in capital as of December 31, 2005, and will not recognize subsequent changes in fair value of the call options and warrants in our consolidated financial statements.
Forward Flow Asset. In connection with our acquisition of a business in June 2005, we entered into a forward flow agreement to purchase a minimum of $3.0 billion in face value of credit card charge-offs over the next five years at a fixed price. We allocated $42.5 million of the acquisition purchase price to this agreement, which is reflected on the consolidated statements of financial condition as forward flow asset. We allocate a portion of the forward flow asset to the cost basis of receivable portfolio purchases under the forward flow agreement based on the proportion the purchase represents to the total purchase commitment, as adjusted for the time-value of money. We allocated $11.7 million of the forward flow asset to the cost basis of receivable portfolios purchased during the year ended December 31, 2007. As part of this forward flow agreement, the seller is obligated to sell a predetermined minimum amount of charged-off credit card accounts to us. The forward flow agreement contains penalty provisions if the seller fails to meet such minimum requirements. Any monies received pursuant to such penalty provisions would be applied to the carrying balance of the forward flow asset. We routinely evaluate the forward flow asset carrying balance for impairment.
45
Deferred Court Costs. We contract with a nationwide network of attorneys that specialize in collection matters. We generally refer charged-off accounts to our contracted attorneys when we believe the related debtor has sufficient assets to repay the indebtedness and has, to date, been unwilling to pay. In connection with our agreements with our contracted attorneys, we advance certain out-of-pocket court costs (“Deferred Court Costs”). We capitalize these costs in the consolidated financial statements and provide a reserve for those costs that we believe will ultimately be uncollectible. We determine the reserve based on our analysis of court costs that have been advanced, or recovered, or that we anticipate recovering. See Changes in Accounting Estimate below for further discussion of Deferred Court Costs.
Derivative Instruments and Hedging Activities. We have hedged the cash flows of a portion of our long-term debt by entering into two separate interest rate swap agreements, with an intention to more effectively manage our exposure to interest rate changes by establishing a set level of fixed interest rates. We adopted Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedge Activities, as amended” (“FAS 133”) in the second quarter of 2007. FAS 133 requires that qualifying derivative instruments be recorded on the balance sheet as either an asset or liability measured at its fair value. The effective portion of the change in fair value of the derivative is recorded in other comprehensive income. The ineffective portion of the change in fair value of the derivative, if any, is recognized in interest expense in the period of change. See Note 8 to the consolidated financial statements for further discussion of our derivative instruments.
Stock-Based Compensation. On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”). Under FAS 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period. We use the Black-Scholes option-pricing model to determine the fair-value of stock-based awards, which is consistent with that used for pro forma disclosures under Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). We had elected the modified prospective transition method as permitted by FAS 123R and, accordingly, prior periods have not been restated to reflect the impact of FAS 123R. The modified prospective transition method requires us to record stock-based compensation expense for all new and unvested stock options and restricted stock units that are ultimately expected to vest, as the requisite service is rendered, beginning January 1, 2006. Stock-based compensation expense for awards granted prior to January 1, 2006, is based on the grant date fair-value as determined under the pro forma provisions of FAS 123. In accordance with FAS 123R, beginning in the first quarter of 2006, we have presented excess tax benefits from the exercise of stock-based compensation awards as a financing activity in the consolidated statements of cash flows. See Note 9 to the consolidated financial statements for further discussion of our stock-based compensation.
Income Taxes. We use the liability method of accounting for income taxes in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” When we prepare the consolidated financial statements, we estimate our income taxes based on the various jurisdictions where we conduct business. This requires us to estimate our 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 differences between the financial statement and income tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. We must then assess the likelihood that our 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 we establish a valuation allowance or increase this allowance in an accounting period, we record a corresponding tax expense on our statement of operations. See Note 10 to the consolidated financial statements for further discussion of income taxes.
Accounting for Uncertainty in Income Taxes. In July, 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which establishes recognition and measurement thresholds that must be met before a tax benefit can be recognized in the financial statements. Additionally, FIN 48 provides guidance on the derecognition, classification, accounting in interim periods and disclosure requirements for uncertain tax positions. Effective January 1, 2007, we adopted
46
the accounting provisions of FIN 48. We were not required to record any cumulative effect adjustment to retained earnings as a result of adopting FIN 48. See Note 10 to the consolidated financial statements for further discussion of the impact of FIN 48 on our consolidated financial statements.
Changes in Accounting Estimate
We capitalize Deferred Court Costs in our consolidated financial statements and provide a reserve for those costs that we believe will be ultimately uncollectible. We determine the reserve based on our analysis of court costs that have been advanced, recovered, or we anticipate recovering. When we first developed our analysis of court cost methodology, we had limited historical collection data with which to accurately model projected court cost recoveries beyond 24 months. With additional court cost recovery data accumulated over the last several years, we now have enough history to extend our recovery period to 36 months and have done so prospectively beginning October 1, 2007. In connection with this change and with the availability of additional recovery data, we have also enhanced our methodology in determining the recovery rates used in calculating our reserve for amounts estimated to be uncollectible. This change in our court costs reserve methodology is treated as a change in estimate in accordance with Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections.” This change in estimate resulted in a one time reduction in pre tax expense and an increase in our Deferred Court Cost asset of $0.8 million, an increase in our net income of $0.5 million, and an increase in our earnings per share of $0.02 for the year ended December 31, 2007.
New Accounting Pronouncements
In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (“FAS 157”), which is effective for financial statements issued for fiscal years beginning after November 15, 2007. FAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. Subsequently, the FASB also issued FAS 157-1, “Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements that Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13.” We are currently analyzing the effects of the new standard and its potential impact, if any, on our financial statements.
In February 2007, the FASB issued Statement No. 159, “Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”), which is effective for financial statements issued for fiscal years beginning after November 15, 2007. FAS 159 permits entities to account for most financial instruments at fair value rather than under other applicable generally accepted accounting principles such as historical cost. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. The Company is currently analyzing the effects of the new standard and its potential impact, if any, on its consolidated financial statements.
In December 2007, the FASB issued Statement No. 141 (revised 2007), “Business Combinations.” The new standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. We will adopt this new standard for fiscal years beginning January 1, 2009.
In December, 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51.” This statement establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. This statement is effective prospectively, except for certain retrospective disclosure requirements, for fiscal years beginning after December 15, 2008. We are currently analyzing the effects of the new standard and its potential impact, if any, on our consolidated financial statements.
47
Special Note on Forward-Looking Statements
This Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which we believe are subject to certain safe harbors. Many statements, other than statements of historical facts, included or incorporated into this Annual Report on Form 10-K are forward-looking statements. The words “believe,” “expect,” “anticipate,” “estimate,” “project,” “intend,” “plan,” “will,” “may,” and similar expressions often characterize forward-looking statements. These statements may include, but are not limited to, projections of collections, revenues, income or loss, estimates of capital expenditures, plans for future operations, products or services, and financing needs or plans, as well as assumptions relating to these matters. In particular, these statements may be found, among other places, under the “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business,” and “Risk Factors” sections.
Although we believe that the expectations reflected in these forward-looking statements are reasonable, we caution that these expectations or predictions may not prove to be correct or we may not achieve the financial results, savings or other benefits anticipated in the forward-looking statements. These forward-looking statements are necessarily estimates reflecting the best judgement of our senior management and involve a number of risks and uncertainties, some of which may be beyond our control or cannot be predicted or quantified, that could cause actual results to differ materially from those suggested by the forward-looking statements. Many factors, including but not limited to those set forth in this Annual Report on Form 10-K under “Part I, Item 1A. Risk Factors,” could cause our actual results, performance, achievements, or industry results to be very different from the results, performance or achievements expressed or implied by these forward-looking statements. Our business, financial condition or results of operations could also be materially and adversely affected by other factors besides those listed here. However, these are the risks we currently believe are material.
Forward-looking statements speak only as of the date the statements were made. We do not undertake any obligation to update or revise any forward-looking statements to reflect new information or future events, or for any other reason even if experience or future events make it clear that any expected results expressed or implied by these forward-looking statements will not be realized.
In addition, it is our policy generally not to make any specific projections as to future earnings, and we do not endorse projections regarding future performance that may be made by third parties.
Item 7A—Quantitative and Qualitative Disclosure About Market Risk
Our exposure to market risk relates to interest rate risk associated with our variable rate borrowings. As of December 31, 2007, we had total borrowings of $172.2 million outstanding under our Revolving Credit Facility, of which $122.2 million was subject to variable interest rates. See Note 8 to the consolidated financial statements for a further discussion of debt.
Changes in short-term interest rates also affect our earnings as a result of our borrowings under variable rate borrowing agreements. If the market interest rates for our variable rate agreements increase at an average of 10.0%, interest expense would increase, and income before income taxes would decrease by approximately $0.9 million, on an annualized basis, based on the amount of related outstanding borrowings subject to variable interest rates as of December 31, 2007, of $122.2 million. Conversely, if market interest rates decreased an average of 10.0%, our interest expense would decrease, thereby increasing income before income taxes by approximately $0.9 million, on an annualized basis, based on borrowings subject to variable interest rates as of December 31, 2007.
48
Item 8—Financial Statements and Supplementary Data
Encore Capital Group, Inc.
Consolidated Financial Statements
Years ended December 31, 2007, 2006 and 2005
Contents
| 50 | ||
| Audited Consolidated Financial Statements: |
||
| 51 | ||
| 52 | ||
| Consolidated Statements of Stockholders’ Equity and Comprehensive Income |
53 | |
| 54 | ||
| 56 |
49
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Encore Capital Group, Inc.
San Diego, California
We have audited the accompanying consolidated statements of financial condition of Encore Capital Group, Inc. and its subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial condition of Encore Capital Group, Inc. and its subsidiaries as of December 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the years in the three year period ended December 31, 2007, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 1 to the consolidated financial statements, effective 2007, the Company adopted Statement of Financial Accountings Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedge Activities, as amended” and Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB No. 109.” Effective 2006, the Company adopted SFAS No. 123R, “Share-Based Payment.”
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) Encore Capital Group, Inc.’s internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 19, 2008 expressed an unqualified opinion thereon.
/s/ BDO Seidman, LLP
San Diego, California
February 19, 2008
50
Consolidated Statements of Financial Condition
(In Thousands, Except Par Value Amounts)
| December 31, 2007 |
December 31, 2006 | ||||||
| Assets |
|||||||
| Cash and cash equivalents |
$ | 4,900 | $ | 10,791 | |||
| Restricted cash |
3,776 | 4,660 | |||||
| Accounts receivable, net |
4,136 | 2,599 | |||||
| Investment in receivable portfolios, net |
392,209 | 300,348 | |||||
| Deferred court costs |
20,533 | 10,934 | |||||
| Property and equipment, net |
4,390 | 5,249 | |||||
| Prepaid income tax |
10,346 | 3,727 | |||||
| Forward flow asset |
15,863 | 27,566 | |||||
| Other assets |
8,800 | 12,101 | |||||
| Goodwill |
15,985 | 13,735 | |||||
| Identifiable intangible assets, net |
2,557 | 3,628 | |||||
| Total assets |
$ | 483,495 | $ | 395,338 | |||
| Liabilities and stockholders’ equity |
|||||||
| Liabilities: |
|||||||
| Accounts payable and accrued liabilities |
$ | 20,346 | $ | 23,744 | |||
| Accrued profit sharing arrangement |
— | 6,869 | |||||
| Deferred tax liabilities, net |
13,669 | 10,667 | |||||
| Deferred revenue and purchased servicing obligation |
3,898 | 2,790 | |||||
| Debt |
272,420 | 200,132 | |||||
| Other liabilities |
1,642 | — | |||||
| Total liabilities |
311,975 | 244,202 | |||||
| Commitments and contingencies |
|||||||
| Stockholders’ equity: |
|||||||
| Convertible preferred stock, $.01 par value, 5,000 shares authorized, no shares issued and outstanding |
— | — | |||||
| Common stock, $.01 par value, 50,000 shares authorized, 22,992 shares and 22,781 shares issued and outstanding as of December 31, 2007, and 2006, respectively |
230 | 228 | |||||
| Additional paid-in capital |
73,310 | 66,532 | |||||
| Accumulated earnings |
98,975 | 83,933 | |||||
| Accumulated other comprehensive (loss) income |
(995 | ) | 443 | ||||
| Total stockholders’ equity |
171,520 | 151,136 | |||||
| Total liabilities and stockholders’ equity |
$ | 483,495 | $ | 395,338 | |||
See accompanying notes to consolidated financial statements.
51
Consolidated Statements of Operations
(In Thousands, Except Per Share Amounts)
| Years ended December 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
| Revenues |
||||||||||||
| Revenue from receivable portfolios, net |
$ | 241,402 | $ | 239,340 | $ | 215,931 | ||||||
| Servicing fees and other related revenue |
12,609 | 15,800 | 5,904 | |||||||||
| Total revenues |
254,011 | 255,140 | 221,835 | |||||||||
| Operating expenses |
||||||||||||
| Salaries and employee benefits (excluding stock-based compensation expense) |
64,153 | 63,962 | 52,410 | |||||||||
| Stock-based compensation expense |
4,287 | 5,669 | — | |||||||||
| Cost of legal collections |
78,636 | 52,079 | 35,090 | |||||||||
| Other operating expenses |
21,533 | 22,585 | 16,973 | |||||||||
| Collection agency commissions |
12,411 | 18,030 | 17,287 | |||||||||
| General and administrative expenses |
17,478 | 17,310 | 13,375 | |||||||||
| Depreciation and amortization |
3,351 | 3,894 | 2,686 | |||||||||
| Total operating expenses |
201,849 | 183,529 | 137,821 | |||||||||
| Income before other (expense) income and income taxes |
52,162 | 71,611 | 84,014 | |||||||||
| Other (expense) income |
||||||||||||
| Interest expense |
(13,904 | ) | (12,512 | ) | (9,530 | ) | ||||||
| Contingent interest expense |
(4,123 | ) | (18,520 | ) | (23,187 | ) | ||||||
| Pay-off of future contingent interest |
(11,733 | ) | — | — | ||||||||
| Other income |
1,071 | 609 | 929 | |||||||||
| Total other expense |
(28,689 | ) | (30,423 | ) | (31,788 | ) | ||||||
| Income before income taxes |
23,473 | 41,188 | 52,226 | |||||||||
| Provision for income taxes |
(8,431 | ) | (17,180 | ) | (21,135 | ) | ||||||
| Net income |
$ | 15,042 | $ | 24,008 | $ | 31,091 | ||||||
| Basic—earnings per share computation: |
||||||||||||
| Net income available to common stockholders |
$ | 15,042 | $ | 24,008 | $ | 31,091 | ||||||
| Weighted average shares outstanding |
22,865 | 22,754 | 22,299 | |||||||||
| Earnings per share—Basic |
$ | 0.66 | $ | 1.06 | $ | 1.39 | ||||||
| Diluted—earnings per share computation: |
||||||||||||
| Net income available to common stockholders |
$ | 15,042 | $ | 24,008 | $ | 31,091 | ||||||
| Interest expense on convertible notes, net of tax |
— | — | 207 | |||||||||
| Income available to common stockholders assuming conversion of convertible notes |
$ | 15,042 | $ | 24,008 | $ | 31,298 | ||||||
| Weighted average shares outstanding |
22,876 | 22,754 | 22,299 | |||||||||
| Incremental shares from assumed conversion of warrants and stock awards |
510 | 636 | 1,240 | |||||||||
| Incremental shares from assumed conversion of convertible notes |
— | — | 459 | |||||||||
| Diluted weighted average shares outstanding |
23,386 | 23,390 | 23,998 | |||||||||
| Earnings per share—Diluted |
$ | 0.64 | $ | 1.03 | $ | 1.30 | ||||||
See accompanying notes to consolidated financial statements.
52
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
(In Thousands)
| Common Stock | Additional Paid-In Capital |
Accumulated Earnings |
Accumulated Other Comprehensive Income |
Total Equity |
Comprehensive Income |
|||||||||||||||||||
| Shares | Par | |||||||||||||||||||||||
| Balance at December 31, 2004 |
22,166 | $ | 222 | $ | 66,788 | $ | 28,834 | $ | 171 | $ | 96,015 | $ | 23,241 | |||||||||||
| Net income |
— | — | — | 31,091 | — | 31,091 | $ | 31,091 | ||||||||||||||||
| Other comprehensive income: |
||||||||||||||||||||||||
| unrealized gain on non-qualified deferred compensation plan assets, net of tax |
— | — | — | — | 40 | 40 | 40 | |||||||||||||||||
| Issuance of common stock for acquisition of business |
230 | 2 | 3,997 | — | — | 3,999 | — | |||||||||||||||||
| Exercise of stock options |
255 | 3 | 1,210 | — | — | 1,213 | — | |||||||||||||||||
| Sale of warrants associated with convertible notes |
— | — | 11,573 | — | — | 11,573 | — | |||||||||||||||||
| Purchase of call options associated with convertible notes |
— | — | (27,418 | ) | — | — | (27,418 | ) | — | |||||||||||||||
| Tax benefit from convertible note interest expense |
— | — | 490 | — | — | 490 | — | |||||||||||||||||
| Tax benefit related to stock option exercises |
— | — | 1,258 | — | — | 1,258 | — | |||||||||||||||||
| Amortization of stock options issued below market |
— | — | 91 | — | — | 91 | — | |||||||||||||||||
| Balance at December 31, 2005 |
22,651 | 227 | 57,989 | 59,925 | 211 | 118,352 | $ | 31,131 | ||||||||||||||||
| Net income |
— | — | — | 24,008 | — | 24,008 | $ | 24,008 | ||||||||||||||||
| Other comprehensive income: |
||||||||||||||||||||||||
| unrealized gain on non-qualified deferred compensation plan assets, net of tax |
— | — | — | — | 232 | 232 | 232 | |||||||||||||||||
| Exercise of stock options |
130 | 1 | 148 | — | — | 149 | — | |||||||||||||||||
| Stock-based compensation related to stock options |
— | — | 5,669 | — | — | 5,669 | — | |||||||||||||||||
| Tax benefit from convertible note interest expense |
— | — | 1,851 | — | — | 1,851 | — | |||||||||||||||||
| Tax benefit related to stock option exercises |
— | — | 875 | — | — | 875 | — | |||||||||||||||||
| Balance at December 31, 2006 |
22,781 | 228 | 66,532 | 83,933 | 443 | 151,136 | 24,240 | |||||||||||||||||
| Net income |
— | — | — | 15,042 | — | 15,042 | 15,042 | |||||||||||||||||
| Other comprehensive income: |
||||||||||||||||||||||||
| realized gain on non-qualified deferred compensation plan assets, net of tax |
— | — | — | — | (443 | ) | (443 | ) | (443 | ) | ||||||||||||||
| unrealized loss on cash flow hedge, net of tax |
— | — | — | — | (995 | ) | (995 | ) | (995 | ) | ||||||||||||||
| Exercise of stock options |
205 | 2 | 346 | — | — | 348 | — | |||||||||||||||||
| Issuance of share based awards |
6 | — | — | — | — | — | — | |||||||||||||||||
| Stock-based compensation related to stock awards |
— | — | 4,287 | — | — | 4,287 | — | |||||||||||||||||
| Tax benefit from convertible note interest expense |
— | — | 2,051 | — | — | 2,051 | — | |||||||||||||||||
| Tax benefit related to stock option exercises |
— | — | 94 | — | — | 94 | — | |||||||||||||||||
| Balance at December 31, 2007 |
22,992 | $ | 230 | $ | 73,310 | $ | 98,975 | $ | (995 | ) | $ | 171,520 | $ | 13,604 | ||||||||||
See accompanying notes to consolidated financial statements.
53
Consolidated Statements of Cash Flows
(In Thousands)
| Years ended December 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
| Operating activities |
||||||||||||
| Gross collections |
$ | 355,193 | $ | 337,097 | $ | 292,163 | ||||||
| Less: |
||||||||||||
| Amounts collected on behalf of third parties |
(469 | ) | (723 | ) | (1,052 | ) | ||||||
| Amounts applied to principal on receivable portfolios |
(102,093 | ) | (95,647 | ) | (72,044 | ) | ||||||
| Servicing fees |
112 | 91 | 451 | |||||||||
| Operating expenses |
(193,729 | ) | (161,294 | ) | (128,355 | ) | ||||||
| Interest payments |
(12,983 | ) | (11,838 | ) | (7,139 | ) | ||||||
| Contingent interest payments |
(22,724 | ) | (28,178 | ) | (27,541 | ) | ||||||
| Other income |
1,071 | 609 | 929 | |||||||||
| Decrease (increase) in restricted cash |
884 | (448 | ) | (780 | ) | |||||||
| Income taxes |
(8,730 | ) | (874 | ) | (25,406 | ) | ||||||
| Excess tax benefits from stock-based payment arrangements |
(698 | ) | (768 | ) | — | |||||||
| Net cash provided by operating activities |
15,834 | 38,027 | 31,226 | |||||||||
| Investing activities |
||||||||||||
| Cash paid for Jefferson Capital |
— | — | (142,862 | ) | ||||||||
| Cash paid for Ascension Capital Group |
— | — | (15,970 | ) | ||||||||
| Escrow deposit on employee retention contract |
— | — | (2,000 | ) | ||||||||
| Cash paid for India membership interest |
(2,250 | ) | — | — | ||||||||
| Purchases of receivable portfolios, net of forward flow allocation |
(197,249 | ) | (133,653 | ) | (94,689 | ) | ||||||
| Collections applied to principal of receivable portfolios |
102,093 | 95,647 | 72,044 | |||||||||
| Proceeds from the sale of marketable securities |
— | — | 40,000 | |||||||||
| Proceeds from put-backs and recalls of receivable portfolios |
3,769 | 3,246 | 1,996 | |||||||||
| Purchases of property and equipment |
(1,422 | ) | (2,430 | ) | (2,863 | ) | ||||||
| Net cash used in investing activities |
(95,059 | ) | (37,190 | ) | (144,344 | ) | ||||||
| Financing activities |
||||||||||||
| Proceeds from notes payable and other borrowings |
121,000 | 53,500 | 191,367 | |||||||||
| Proceeds from convertible note borrowings |
— | — | 100,000 | |||||||||
| Proceeds from sale of warrants associated with convertible notes |
— | — | 11,573 | |||||||||
| Purchase of call options associated with convertible notes |
— | — | (27,418 | ) | ||||||||
| Repayment of notes payable and other borrowings |
(48,500 | ) | (51,250 | ) | (160,947 | ) | ||||||
| Capitalization of loan fees |
— | — | (5,816 | ) | ||||||||
| Proceeds from exercise of common stock options and warrants |
348 | 149 | 1,213 | |||||||||
| Excess tax benefits from stock-based payment arrangements |
698 | 768 | — | |||||||||
| Net (repayment) borrowing of capital lease obligations |
(212 | ) | (239 | ) | 441 | |||||||
| Net cash provided by financing activities |
73,334 | 2,928 | 110,413 | |||||||||
| Net (decrease) increase in cash |
(5,891 | ) | 3,765 | (2,705 | ) | |||||||
| Cash and cash equivalents, beginning of year |
10,791 | 7,026 | 9,731 | |||||||||
| Cash and cash equivalents, end of year |
$ | 4,900 | $ | 10,791 | $ | 7,026 | ||||||
See accompanying notes to consolidated financial statements.
54
Encore Capital Group, Inc.
Consolidated Statements of Cash Flows (continued)
Reconciliation of Net Income to Net Cash Provided by Operating Activities
(In Thousands)
| Years ended December 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
| Net income |
$ | 15,042 | $ | 24,008 | $ | 31,091 | ||||||
| Adjustments to reconcile net income to net cash provided by operating activities: |
||||||||||||
| Depreciation and amortization |
3,351 | 3,894 | 2,686 | |||||||||
| Amortization of loan costs |
1,219 | 1,340 | 817 | |||||||||
| Stock based compensation |
4,287 | 5,669 | 91 | |||||||||
| Tax benefit from convertible note interest expense |
2,051 | 1,851 | 490 | |||||||||
| Tax benefit from stock option exercises |
94 | 875 | 1,258 | |||||||||
| Deferred income tax expense (benefit) |
3,002 | 3,426 | (2,062 | ) | ||||||||
| Excess tax benefits from stock-based payment arrangements |
(698 | ) | (768 | ) | — | |||||||
| Net impairment on receivable portfolios |
11,230 | 1,379 | 3,143 | |||||||||
| Changes in operating assets and liabilities |
||||||||||||
| Decrease (increase) in restricted cash |
884 | (448 | ) | (780 | ) | |||||||
| Decrease (increase) in other assets |
545 | 5,177 | (914 | ) | ||||||||
| Increase in deferred court costs |
(9,599 | ) | (7,123 | ) | (2,042 | ) | ||||||
| (Increase) decrease in prepaid income tax |
(6,619 | ) | 9,843 | (4,265 | ) | |||||||
| Decrease in accrued profit sharing arrangement |
(6,869 | ) | ||||||||||