Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

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)

 

(IRS Employer

Identification No.)

8875 Aero Drive, Suite 200

San Diego, California

  92123
(Address of principal executive offices)   (Zip code)

(877) 445 - 4581

(Registrant’s telephone number, including area code)

(Not Applicable)

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

 

 

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨    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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding at October 21, 2009

Common Stock, $0.01 par value   23,180,747 shares

 

 

 


Table of Contents

ENCORE CAPITAL GROUP, INC.

INDEX TO FORM 10-Q

 

     Page

PART I – FINANCIAL INFORMATION

   1

Item 1 – Condensed Consolidated Financial Statements (Unaudited)

   1

Condensed Consolidated Statements of Financial Condition

   1

Condensed Consolidated Statements of Income

   2

Condensed Consolidated Statements of Stockholders’ Equity

   3

Condensed Consolidated Statements of Cash Flows

   4

Notes to Condensed Consolidated Financial Statements (Unaudited)

   5

Item  2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations

   22

Supplemental Performance Data

   34

Liquidity and Capital Resources

   43

Item 3 – Quantitative and Qualitative Disclosures About Market Risk

   45

Item 4 – Controls and Procedures

   45

PART II – OTHER INFORMATION

   46

Item 1 – Legal Proceedings

   46

Item 1A – Risk Factors

   48

Item 6 – Exhibits

   50

SIGNATURES

   51


Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements (Unaudited)

ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Financial Condition

(In Thousands, Except Par Value Amounts)

(Unaudited)

 

     September 30,
2009
    December 31,
2008
 
           Adjusted  

Assets

    

Cash and cash equivalents

   $ 6,940      $ 10,341   

Accounts receivable, net

     3,211        1,757   

Investment in receivable portfolios, net

     534,656        461,346   

Deferred court costs

     27,710        28,335   

Property and equipment, net

     8,698        6,290   

Prepaid income tax

     —          7,935   

Forward flow asset

     —          10,302   

Other assets

     4,414        5,049   

Goodwill

     15,985        15,985   

Identifiable intangible assets, net

     1,268        1,739   
                

Total assets

   $ 602,882      $ 549,079   
                

Liabilities and stockholders’ equity

    

Liabilities:

    

Accounts payable and accrued liabilities

   $ 19,775      $ 18,204   

Income taxes payable

     3,256        —     

Deferred tax liabilities, net

     15,545        15,108   

Deferred revenue and purchased servicing obligation

     5,675        5,203   

Debt

     324,394        303,655   

Other liabilities

     2,306        3,483   
                

Total liabilities

     370,951        345,653   
                

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, 23,159 shares and 23,053 shares issued and outstanding as of September 30, 2009, and December 31, 2008, respectively

     232        231   

Additional paid-in capital

     101,677        98,521   

Accumulated earnings

     131,437        106,795   

Accumulated other comprehensive loss

     (1,415     (2,121
                

Total stockholders’ equity

     231,931        203,426   
                

Total liabilities and stockholders’ equity

   $ 602,882      $ 549,079   
                

See accompanying notes to unaudited condensed consolidated financial statements

 

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Table of Contents

ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Income

(In Thousands, Except Per Share Amounts)

(Unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
           Adjusted           Adjusted  

Revenue

        

Revenue from receivable portfolios, net

   $ 76,448      $ 62,557      $ 222,688      $ 192,900   

Servicing fees and other related revenue

     3,938        3,816        12,179        11,047   
                                

Total revenue

     80,386        66,373        234,867        203,947   
                                

Operating expenses

        

Salaries and employee benefits (excluding stock-based compensation expense)

     14,411        14,963        43,130        45,503   

Stock-based compensation expense

     1,261        860        3,335        3,182   

Cost of legal collections

     26,092        25,390        84,665        69,525   

Other operating expenses

     6,034        6,018        18,612        17,656   

Collection agency commissions

     5,795        2,996        13,483        10,808   

General and administrative expenses

     7,280        4,864        20,074        13,905   

Depreciation and amortization

     652        674        1,895        2,162   
                                

Total operating expenses

     61,525        55,765        185,194        162,741   
                                

Income before other (expense) income and income taxes

     18,861        10,608        49,673        41,206   
                                

Other (expense) income

        

Interest expense

     (3,970     (5,140     (12,201     (15,171

Gain on repurchase of convertible notes, net

     —          —          3,268        707   

Other income (expense)

     61        (32     (11     341   
                                

Total other expense

     (3,909     (5,172     (8,944     (14,123
                                

Income before income taxes

     14,952        5,436        40,729        27,083   

Provision for income taxes

     (5,948     (2,408     (16,087     (11,142
                                

Net income

   $ 9,004      $ 3,028      $ 24,642      $ 15,941   
                                

Weighted average shares outstanding:

        

Basic

     23,225        23,029        23,177        23,009   

Diluted

     24,199        23,675        23,936        23,531   

Earnings per share:

        

Basic

   $ 0.39      $ 0.13      $ 1.06      $ 0.69   

Diluted

   $ 0.37      $ 0.13      $ 1.03      $ 0.68   

See accompanying notes to unaudited condensed consolidated financial statements

 

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ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Stockholders’ Equity

(Unaudited, In Thousands)

 

     Common Stock    Additional
Paid-In
Capital
    Accumulated
Earnings
   Accumulated
Other
Comprehensive
(Loss) Income
    Total
Equity
    Comprehensive
Income
   Shares    Par            

Balance at December 31, 2008, Adjusted

   23,053    $ 231    $ 98,521      $ 106,795    $ (2,121   $ 203,426     

Net income

   —        —        —          24,642      —          24,642        24,642

Other comprehensive income:

                 

Unrealized gain on cash flow hedge, net of tax

   —        —        —          —        706        706        706

Exercise of stock options and issuance of share-based awards

   106      1      (137     —        —          (136     —  

Stock-based compensation

   —        —        3,335        —        —          3,335        —  

Tax provision related to stock option exercises

   —        —        (42     —        —          (42     —  
                                                 

Balance at September 30, 2009

   23,159    $ 232    $ 101,677      $ 131,437    $ (1,415   $ 231,931      $ 25,348
                                                 

See accompanying notes to unaudited condensed consolidated financial statements

 

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ENCORE CAPITAL GROUP, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited, In Thousands)

 

     Nine Months Ended
September 30,
 
     2009     2008  
           Adjusted  

Operating activities:

    

Net Income

   $ 24,642      $ 15,941   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation and amortization

     1,895        2,162   

Amortization of loan costs and debt discount

     3,100        4,751   

Stock-based compensation expense

     3,335        3,182   

Gain on repurchase of convertible notes, net

     (3,268     (707

Deferred income tax expense

     437        825   

Tax provision from stock-based payment arrangements

     42        4   

Provision for impairment on receivable portfolios, net

     14,323        15,993   

Changes in operating assets and liabilities

    

Other assets

     (1,623     1,091   

Deferred court costs

     625        (6,674

Prepaid income tax and income tax payable

     11,149        9,920   

Deferred revenue and purchased service obligation

     472        999   

Accounts payable, accrued liabilities and other liabilities

     840        (2,203
                

Net cash provided by operating activities

     55,969        45,284   
                

Investing activities:

    

Purchases of receivable portfolios, net of forward flow allocation

     (205,378     (160,940

Collections applied to investment in receivable portfolios, net

     126,019        95,144   

Proceeds from put-backs of receivable portfolios

     2,028        2,610   

Purchases of property and equipment

     (3,626     (2,139
                

Net cash used in investing activities

     (80,957     (65,325
                

Financing activities:

    

Proceeds from revolving credit facility

     85,500        57,000   

Repayment of revolving credit facility

     (41,500     (32,169

Repurchase of convertible notes

     (22,262     (3,500

Proceeds from exercise of stock options

     123        84   

Tax provision from stock-based payment arrangements

     (42     (4

Repayment of capital lease obligations

     (232     (208
                

Net cash provided by financing activities

     21,587        21,203   
                

Net (decrease) increase in cash

     (3,401     1,162   

Cash and cash equivalents, beginning of period

     10,341        8,676   
                

Cash and cash equivalents, end of period

   $ 6,940      $ 9,838   
                

Supplemental disclosures of cash flow information:

    

Cash paid for interest

   $ 9,568      $ 10,928   

Income tax payment

   $ 4,859      $ 1,158   

Supplemental schedule of non-cash investing and financing activities:

    

Fixed assets acquired through capital lease

   $ 224      $ 201   

Allocation of forward flow asset to acquired receivable portfolios

   $ 10,302      $ 5,561   

See accompanying notes to unaudited condensed consolidated financial statements

 

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ENCORE CAPITAL GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1: Ownership, Description of Business and Summary of Significant Accounting Policies

Encore Capital Group, Inc. (“Encore”), through its subsidiaries (collectively, the “Company”), is a systems-driven purchaser and manager of charged-off consumer receivable portfolios and, through its wholly owned subsidiary Ascension Capital Group, Inc. (“Ascension”), a provider of bankruptcy services to the finance industry. The Company acquires its receivable portfolios at deep discounts from their face values using its proprietary valuation process that is based on the consumer attributes of the underlying accounts. Based upon the Company’s ongoing analysis of these accounts, it employs a dynamic mix of collection strategies to maximize its return on investment. The receivable portfolios the Company purchases consist primarily of unsecured, charged-off domestic consumer credit card, auto deficiency and telecom receivables purchased from national financial institutions, major retail credit corporations, telecom companies and resellers of such portfolios. Acquisitions of receivable portfolios are financed by operations and by borrowings from third parties. See Note 7 for further discussion of the Company’s debt.

Financial Statement Preparation

The accompanying interim condensed consolidated financial statements have been prepared by Encore, without audit, in accordance with the instructions to Form 10-Q, and Rule 10-01 of Regulation S-X promulgated by the Securities and Exchange Commission and, therefore, do not include all information and footnotes necessary for a fair presentation of its consolidated financial position, results of operations and cash flows in accordance with accounting principles generally accepted in the United States.

In the opinion of management, the unaudited financial information for the interim periods presented reflects all adjustments, consisting of only normal and recurring adjustments, necessary for a fair presentation of the Company’s consolidated results of operations, financial position and cash flows. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2008. Operating results for interim periods are not necessarily indicative of operating results for an entire fiscal year. Further, in connection with the condensed consolidated financial statements and in accordance with the recently issued Financial Accounting Standard Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 855, “Subsequent Events” (prior authoritative literature: Statement of Financial Accounting Standard No. 165 “Subsequent Events”), the Company evaluated subsequent events after the balance sheet date of September 30, 2009 through October 28, 2009, the date of the filing of these condensed consolidated financial statements.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts and the disclosure of contingent amounts in the Company’s financial statements and the accompanying notes. Actual results could materially differ from those estimates.

Principles of Consolidation

The Company’s condensed consolidated financial statements include the assets, liabilities and operating results of its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Change in Accounting Principle

Effective January 1, 2009, the Company retrospectively applied the provisions of FASB ASC Subtopic 470-20 (“Subtopic 470-20”) “Debt with Conversion and Other Options” (prior authoritative literature: FASB Staff Position APB 14-1 “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)”) to account for its outstanding convertible senior notes. As a result, prior years’ consolidated financial statements have been retrospectively adjusted. See Note 12 for additional information on the application of this accounting principle.

Reclassification

The prior year’s consolidated statement of cash flows has been changed to the indirect method, to conform to the current year’s presentation. Additionally, certain reclassifications have been made to the consolidated financial statements to conform to the current year’s presentation.

 

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Earnings per Share

Basic earnings per share (“EPS”) is calculated by dividing net earnings available to common stockholders by the weighted average number of shares of common stock outstanding. Common stock outstanding includes shares of common stock and restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted EPS includes the determinants of basic EPS and, in addition, reflects the dilutive effect of the common stock deliverable pursuant to stock options and to restricted stock units for which future service is required as a condition to the delivery of the underlying common stock. Employee stock options to purchase approximately 995,000 and 1,484,000 shares of common stock were outstanding during the three and nine months ended September 30, 2009, respectively, and employee stock options to purchase approximately 1,159,000 and 1,246,000 shares of common stock were outstanding during the three and nine months ended September 30, 2008, respectively, but not included in the computation of diluted earnings per share because the effect on diluted earnings per share would be anti-dilutive.

New Accounting Pronouncements

On July 1, 2009, the FASB officially launched the FASB Accounting Standards Codification, which has become the single official source of authoritative, nongovernmental U.S. Generally Accepted Accounting Principles (“GAAP”), in addition to guidance issued by the Securities and Exchange Commission. The codification supersedes all prior FASB, AICPA, EITF, and related literature. The codification, which is effective for interim and annual periods ending after September 15, 2009, is organized into approximately 90 accounting topics. The FASB no longer issues new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, amendments to the codification are made by issuing “Accounting Standards Updates.” The Company has incorporated the current codification in its form 10-Q.

In December 2008, the FASB released FSP FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets” (Subtopic 715-20 “Defined Benefit Plans” under the FASB’s codification). This FSP amends Statement of Financial Accounting Standard No. 132R to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. This FSP is effective for financial statements issued for fiscal years ending after December 15, 2009. The Company expects to adopt this new standard and its required disclosures in its consolidated financial statements for the fiscal year ending December 31, 2009.

In June 2009, the FASB issued FAS No. 166, “Accounting for Transfers of Financial Assets—an amendment of FASB Statement No. 140.” This pronouncement has not yet been incorporated into the FASB’s codification. This standard will require more information about transferred financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. This standard is effective at the start of a company’s first fiscal year beginning after November 15, 2009, or January 1, 2010, for companies reporting earnings on a calendar-year basis. The Company is currently analyzing the impact of this statement, if any, to its consolidated financial statements.

In August 2009, the FASB issued Accounting Standards Update No. 2009-05, “Fair Value Measurements and Disclosures (Topic 820)—Measuring Liabilities at Fair Value,” which provides guidance on how to measure liabilities at fair value in circumstance in which a quoted price in an active market for the identical liability is not available. This update is effective for the first reporting period, including interim periods, beginning after issuance. The Company has no liabilities that are governed by this update but will apply its provisions in the future as applicable.

In October 2009, the FASB issued Accounting Standards Update No. 2009-13, “Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements—a consensus of the FASB Emerging Issues Task Force,” which establishes a selling price hierarchy for determining the selling price of a deliverable, and eliminates the residual method of allocation. This update requires the arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. This update is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. The Company is currently analyzing the impact of this update, if any, to its consolidated financial statements.

Note 2: Fair Value Measurement

On January 1, 2008, the Company adopted the provisions of ASC Topic 820 (“Topic 820”) “Fair Value Measurements and Disclosures” (prior authoritative literature: Statement of Financial Accounting Standard No. 157, “Fair Value Measurements”) for financial assets and liabilities. On January 1, 2009, the Company adopted the provisions of Topic 820 for non-financial assets and non-financial liabilities that are recognized and disclosed at fair value on a nonrecurring basis. Topic 820 defines fair value, provides guidance for measuring fair value and requires certain disclosures. It does not require any new fair value measurements, but rather applies to all other accounting pronouncements that require or permit fair value measurements.

 

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Topic 820 utilizes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The following is a brief description of those three levels:

 

   

Level 1: Observable inputs such as quoted prices (unadjusted) in active markets for identical assets or liabilities.

 

   

Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.

 

   

Level 3: Unobservable inputs that reflect the reporting entity’s own assumptions.

The Company’s financial instruments consist of the following:

Financial instruments recognized at fair value in the statement of financial position

The Company’s financial instruments measured at fair value on a recurring basis are summarized below (in thousands):

 

Financial instruments measured at fair value

   Fair Value
Hierarchy
   As of September 30, 2009     As of December 31, 2008  
      Carrying
Value
    Fair Value     Carrying
Value
    Fair Value  

Cash and cash equivalents

   Level 1    $ 6,940      $ 6,940      $ 10,341      $ 10,341   

Cash flow hedging instruments

   Level 2      (2,306     (2,306     (3,483     (3,483

The fair value of cash and cash equivalents approximates their respective carrying value. Cash flow hedging instruments, which are considered over-the-counter derivatives, are also carried at their fair values. The Company’s fair value estimate for such derivative instruments incorporates quoted market prices at the balance sheet date from the counter party using significant observable inputs and is considered a level 2 fair value measurement. As of September 30, 2009, the Company did not have any financial instruments carried at fair value that required level 3 measurement.

Financial instruments not required to be carried at fair value

Topic 820 requires disclosures about fair value of financial instruments for interim reporting periods of publicly traded companies as well as in annual financial statements. The Company is required to estimate the fair value of financial instruments when it is practical to do so.

Borrowings under the Company’s Revolving Credit Facility are carried at historical cost, adjusted for additional borrowings less principal repayments, which approximates fair value. The Company’s Convertible Notes are carried at historical cost, adjusted for repurchases and debt discount. The fair value estimate incorporates quoted market prices at the balance sheet date, which was determined to be approximately $41.0 million and $51.4 million as of September 30, 2009 and December 31, 2008, respectively. For investment in receivable portfolios, there is no active market or observable inputs for the fair value estimation. The Company considers it not practical to attempt to estimate the fair value of such financial instruments due to the excessive costs that would be incurred in doing so.

The Company does not have any non-financial assets or liabilities that are measured at fair value.

Note 3: Stock-Based Compensation

On March 9, 2009, the Board of Directors approved an amendment and restatement of the 2005 Stock Incentive Plan (“2005 Plan”) which was originally adopted on March 30, 2005, for Board members, employees, officers, and executives of, and consultants and advisors to, the Company. The amendment and restatement of the 2005 Plan increased by 2,000,000 shares the maximum number of shares of the Company’s common stock that may be issued or subject to awards under the plan, established a new 10-year term for the plan and made certain other amendments. The 2005 Plan amendment was approved by the Company’s stockholders on June 9, 2009. The 2005 Plan provides for the granting of incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, restricted stock units, and performance-based awards to eligible individuals. The amended 2005 Plan allows the granting of an aggregate of 3,500,000 shares of the Company’s common stock for awards, plus the number of ungranted shares of stock that were available for future awards under the prior 1999 Equity Participation Plan (“1999 Plan”). In addition, shares subject to options granted under either the 1999 Plan or the 2005 Plan that terminate or expire without being exercised will become available for grant under the 2005 Plan. The benefits provided under these plans are share-based compensation subject to the provisions of ASC Topic 718 (“Topic 718”) “Compensation – Stock Compensation” (prior authoratative literiture: Statement of Financial Accounting Standard No. 123R, “Share-Based Payment”).

 

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In accordance with Topic 718, compensation expense is recognized only for those shares expected to vest, based on the Company’s historical experience and future expectations. For the nine months ended September 30, 2009, approximately $3.3 million was recognized as stock-based compensation expense.

The Company’s stock-based compensation arrangements are described below:

Stock Options

The 2005 Plan permits the granting of stock options to certain employees and directors of the Company. Option awards are generally granted with an exercise price equal to the market price of the Company’s stock at the date of issuance. Options generally vest based on three to five years of continuous service and have ten-year contractual terms.

The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock-based awards. All options are amortized ratably over the requisite service periods of the awards, which are generally the vesting periods.

The fair value of options granted is estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:

 

     Nine Months Ended
September 30, 2009
    Nine Months Ended
September 30, 2008
 

Weighted average fair value of options granted

   $ 4.91      $ 5.37   

Risk free interest rate

     2.1     3.0

Dividend yield

     0.0     0.0

Volatility factor of the expected market price of the Company’s common stock

     57.0     46.0

Weighted-average expected life of options

     5 Years        5 Years   

Unrecognized estimated compensation cost related to stock options as of September 30, 2009, was $4.4 million, which is expected to be recognized over a weighted-average period of approximately 2.6 years.

A summary of the Company’s stock option activity and related information is as follows for the nine months ended September 30, 2009:

 

     Number of
Shares
    Option Price
Per Share
   Weighted
Average
Exercise
Price
   Aggregate
Intrinsic
Value
(in thousands)

Outstanding at December 31, 2008

   2,139,503      $ 0.35 - $20.09    $ 9.14   

Granted

   797,500      2.89 - 13.17      9.33   

Cancelled/forfeited

   (78,383   10.92 - 16.19      12.17   

Exercised

   (19,511   1.00 - 10.92      6.33   
                    

Outstanding at September 30, 2009

   2,839,109      $ 0.35 - $20.09    $ 9.10    $ 13,829
                    

Exercisable at September 30, 2009

   1,819,594      $ 0.35 - $20.09    $ 8.70    $ 10,126
                    

The total intrinsic value of options exercised during the nine months ended September 30, 2009 and 2008 was $0.1 million and $0.3 million, respectively. As of September 30, 2009, the weighted-average remaining contractual life of options outstanding and options exercisable was 6.23 years and 4.48 years, respectively.

Restricted Stock Units

Under the Company’s 2005 Plan, certain employees and directors are eligible to receive restricted stock units. In accordance with Topic 718, the fair value of restricted stock units is equal to the closing price of the Company’s common stock on the date of issuance. The total number of restricted stock unit awards expected to vest is adjusted by estimated forfeiture rates. As of September 30, 2009, 88,825 of the non-vested shares are expected to vest over their remaining terms of approximately one to three years based on certain performance goals (“Performance-Based Awards”). The fair value of the Performance-Based Awards is expensed over the expected vesting period based on our forfeiture assumptions. If performance goals are not expected to be met, the compensation expense previously recognized would be reversed. No reversals of compensation expense related to the Performance-Based Awards have been made as of September 30, 2009. The remaining 615,999 non-vested shares are not performance-based, and will vest over their remaining terms of approximately one to four years of service.

 

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For the nine months ended September 30, 2009, restricted stock unit activity and related information are as follows:

 

Restricted Stock Units

   Non-Vested
Shares
    Weighted Average
Grant Date
Fair Value

Non-vested at December 31, 2008

   628,752      $ 11.18

Awarded

   275,655      $ 5.82

Vested

   (149,337   $ 11.12

Cancelled/forfeited

   (50,246   $ 10.85
            

Non-vested at September 30, 2009

   704,824      $ 9.12
            

Unrecognized estimated compensation cost related to restricted stock units as of September 30, 2009, was $3.0 million, which is expected to be recognized over a weighted-average period of approximately 2.5 years. The fair value of restricted stock units vested for the nine months ended September 30, 2009 and 2008 was $1.1 million and $0.2 million, respectively.

Note 4: Investment in Receivable Portfolios, Net

In accordance with the provisions of FASB ASC Subtopic 310-30 (“Subtopic 310-30) “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (prior authoritative literature: AICPA’s Statement of Position 03-3, “Accounting for Certain Debt Securities Acquired in a Transfer”), discrete receivable portfolio purchases during a quarter are aggregated into pools based on 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 the Company expects 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 Subtopic 310-30 in the first quarter of 2005 were aggregated by quarter of purchase.

In compliance with Subtopic 310-30, the Company accounts for its investments in consumer receivable portfolios using either the interest method or the cost recovery method. The interest method applies an effective interest rate, or IRR, to the cost basis of the pool, which remains unchanged throughout the life of the pool, unless there is an increase in subsequent, expected cash flows. Subsequent increases in expected cash flows are generally recognized prospectively through an upward adjustment of the pool’s IRR over its remaining life. Subsequent decreases in expected cash flows do not change the IRR, but are recognized as an impairment of the cost basis of the pool, and are reflected in the consolidated statements of income as a reduction in revenue, with a corresponding valuation allowance, offsetting the investment in receivable portfolios in the consolidated statements of financial condition.

The Company accounts 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 IRR 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, the Company accounts for such portfolios on the cost recovery method 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. Under the cost recovery method of accounting, no income is recognized until the purchase price of a Cost Recovery Portfolio has been fully recovered. As of September 30, 2009, there were five portfolios accounted for using the cost recovery method, consisting of $0.5 million in net book value of investment in receivable portfolios, representing all of the healthcare portfolios that the Company had acquired. In September 2007, the Company decided to exit its healthcare purchasing and collection activities. At that time, the Company anticipated either selling these healthcare portfolios or placing the underlying accounts with external agencies for collections. The Company no longer anticipates a sale of these receivable portfolios and has placed them with external collection agencies. Since the Company is no longer actively collecting on these accounts internally, it has classified them as Cost Recovery Portfolios. The $0.5 million net book value reflects the value the Company expects to realize through the collection activities of the external agencies.

Accretable yield represents the amount of revenue the Company expects to generate over the remaining life of its existing investment in receivable portfolios based on estimated future cash flows. Total accretable yield is the difference between future estimated collections and the current carrying value of a portfolio. All estimated cash flows on portfolios where the cost basis has been fully recovered are classified as zero basis cash flows.

 

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The following tables summarize the Company’s accretable yield and an estimate of future zero basis cash flows at the beginning and end of the current period (in thousands):

 

     Nine Months Ended September 30, 2009  
     Accretable
Yield
    Estimate of
Zero Basis
Cash Flows
    Total  

Beginning balance at December 31, 2008

   $ 592,825      $ 8,337      $ 601,162   

Revenue recognized, net

     (69,775     (2,500     (72,275

Additions on existing portfolios

     5,715        1,032        6,747   

Additions for current purchases

     81,917        —          81,917   
                        

Balance at March 31, 2009

   $ 610,682      $ 6,869      $ 617,551   

Revenue recognized, net

     (71,576     (2,389     (73,965

(Reductions) additions on existing portfolios

     (15,399     2,614        (12,785

Additions for current purchases

     106,771        —          106,771   
                        

Balance at June 30, 2009

   $ 630,478      $ 7,094      $ 637,572   

Revenue recognized, net

     (74,335     (2,113     (76,448

(Reductions) additions on existing portfolios

     (12,805     511        (12,294

Additions for current purchases

     104,569        —          104,569   
                        

Balance at September 30, 2009

   $ 647,907      $ 5,492      $ 653,399   
                        
     Nine Months Ended September 30, 2008  
     Accretable
Yield
    Estimate of
Zero Basis
Cash Flows
    Total  

Beginning balance at December 31, 2007

   $ 486,652      $ 13,002      $ 499,654   

Revenue recognized, net

     (61,510     (2,558     (64,068

Reductions on existing portfolios

     (50,898     (1,015     (51,913

Additions for 12 months curve extension

     67,287        —          67,287   

Additions for current purchases

     112,780        —          112,780   
                        

Balance at March 31, 2008

   $ 554,311      $ 9,429      $ 563,740   

Revenue recognized, net

     (63,652     (2,623     (66,275

(Reductions) additions on existing portfolios

     (3,206     1,598        (1,608

Additions for current purchases

     79,159        —          79,159   
                        

Balance at June 30, 2008

   $ 566,612      $ 8,404      $ 575,016   

Revenue recognized, net

     (60,298     (2,259     (62,557

(Reductions) additions on existing portfolios

     (11,736     2,752        (8,984

Additions for current purchases

     106,525        —          106,525   
                        

Balance at September 30, 2008

   $ 601,103      $ 8,897      $ 610,000   
                        

During the three months ended September 30, 2009, the Company purchased receivable portfolios with a face value of $2.2 billion for $77.7 million, or a purchase cost of 3.6% of face value. The estimated future collections at acquisition for these portfolios amounted to $181.3 million. During the nine months ended September 30, 2009, the Company purchased receivable portfolios with a face value of $5.5 billion for $215.7 million, or a purchase cost of 4.0% of face value. The estimated future collections at acquisition for these portfolios amounted to $522.9 million.

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”). During the three months ended September 30, 2009 and 2008, approximately $2.1 million and $2.3 million were recognized as Zero Basis Revenue, respectively. During the nine months ended September 30, 2009 and 2008, approximately $7.0 million and $7.4 million were recognized as Zero Basis Revenue, respectively.

During the quarter ended March 31, 2008, the Company revised the forecasting methodology it used to value a portfolio by extending the collection forecast from 72 months to 84 months. This change was made as a result of the Company’s increased confidence in its ability to forecast future cash collections to 84 months. Extending the collection forecast from 72 months to 84 months resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios, as of March 31, 2008, by $67.3 million, or 7.5%. The impact of the change in estimate resulted in an increase in net income of $1.9 million, and an increase in fully diluted earnings per share of $0.08, for the quarter ended March 31, 2008.

 

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The following tables summarize the changes in the balance of the investment in receivable portfolios during the following periods (in thousands, except percentages):

 

     For the Three Months Ended September 30, 2009  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 506,155      $ 553      $ —       $ 506,708   

Purchases of receivable portfolios

     77,734        —         —         77,734   

Gross collections(1)

     (123,498     (25     (2,113     (125,636

Put-backs and recalls(2)

     (598     —         —         (598

Revenue recognized

     78,680        —         2,100        80,780   

(Impairment) impairment reversals, net

     (4,345     —         13        (4,332
                                

Balance, end of period

   $ 534,128      $ 528      $ —       $ 534,656   
                                

Revenue as a percentage of collections(3)

     63.7     0.0     99.4     64.3
                                
     For the Three Months Ended September 30, 2008  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 413,256      $ 1,303      $ —        $ 414,559   

Purchases of receivable portfolios

     66,107        —          —          66,107   

Gross collections(1)

     (95,349     (89     (2,259     (97,697

Put-backs and recalls(2)

     (562     (1     —          (563

Revenue recognized(4)

     67,566        —          2,259        69,825   

Impairment, net(4)

     (7,268     —          —          (7,268
                                

Balance, end of period

   $ 443,750      $ 1,213      $ —        $ 444,963   
                                

Revenue as a percentage of collections(3)

     70.9     0.0     100.0     71.5
                                
     For the Nine Months Ended September 30, 2009  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 460,598      $ 748      $ —       $ 461,346   

Purchases of receivable portfolios

     215,680        —         —         215,680   

Gross collections(1)

     (355,812     (220     (6,998     (363,030

Put-backs and recalls(2)

     (2,024     —         (4     (2,028

Revenue recognized

     230,054        —         6,957        237,011   

(Impairment) impairment reversals, net

     (14,368     —         45        (14,323
                                

Balance, end of period

   $ 534,128      $ 528      $ —       $ 534,656   
                                

Revenue as a percentage of collections(3)

     64.7     0.0     99.4     65.3
                                
     For the Nine Months Ended September 30, 2008  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 390,564      $ 1,645      $ —        $ 392,209   

Purchases of receivable portfolios

     166,501        —          —          166,501   

Gross collections(1)

     (296,178     (419     (7,440     (304,037

Put-backs and recalls(2)

     (2,597     (13     —          (2,610

Revenue recognized(4)

     201,453        —          7,440        208,893   

Impairment, net(4)

     (15,993     —          —          (15,993
                                

Balance, end of period

   $ 443,750      $ 1,213      $ —        $ 444,963   
                                

Revenue as a percentage of collections(3)

     68.0     0.0     100.0     68.7
                                

 

(1)

Does not include amounts collected on behalf of others.

 

(2)

Put-backs represent accounts that are returned to the seller in accordance with the respective purchase agreement (“Put-Backs”). Recalls represent accounts that are recalled by the seller in accordance with the respective purchase agreement (“Recalls”).

 

(3)

Revenue as a percentage of collections excludes the effects of net impairment or net impairment reversals.

 

(4)

Reflects additional revenue of $0.1 million and a lower net impairment of $3.1 million, as a result of extending the collection curves from 72 to 84 months.

 

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The following table summarizes the change in the valuation allowance for investment in receivable portfolios during the nine months ended September 30, 2009 (in thousands):

 

     Valuation
Allowance
 

Balance at December 31, 2008

   $ 57,152   

Provision for impairment losses

     5,580   

Reversal of prior allowance

     (153
        

Balance at March 31, 2009

   $ 62,579   

Provision for impairment losses

     4,722   

Reversal of prior allowance

     (158
        

Balance at June 30, 2009

   $ 67,143   

Provision for impairment losses

     4,855   

Reversal of prior allowance

     (523
        

Balance at September 30, 2009

   $ 71,475   
        

The Company utilizes various business channels for the collection of its receivable portfolios. The following table summarizes collections by collection channel (in thousands):

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008

Collection sites

   $ 45,122    $ 36,858    $ 140,144    $ 119,076

Legal collections

     55,584      49,765      173,451      144,241

Collection agencies

     19,705      7,881      42,878      28,851

Sales

     5,299      3,166      6,843      11,013

Other

     —        107      —        1,081
                           

Gross collections for the period

   $ 125,710    $ 97,777    $ 363,316    $ 304,262
                           

Note 5: Deferred Court Costs

The Company contracts with a nationwide network of attorneys that specialize in collection matters. The Company generally refers charged-off accounts to its contracted attorneys when it believes the related debtor has sufficient assets to repay the indebtedness and has, to date, been unwilling to pay. In connection with the Company’s agreement with the contracted

 

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attorneys, it advances certain out-of-pocket court costs (“Deferred Court Costs”). The Company capitalizes Deferred Court Costs in its consolidated financial statements and provides a reserve for those costs that it believes will ultimately be uncollectible. The Company determines the reserve based on its analysis of court costs that have been advanced and those that have been recovered. Deferred Court Costs not recovered within three years of placement are fully written off. Collections received from these debtors are first applied against related court costs with the balance applied to the debtors’ account.

Deferred Court Costs for the three year deferral period consist of the following as of the dates presented (in thousands):

 

     September 30,
2009
    December 31,
2008
 

Court costs advanced

   $ 169,864      $ 145,579   

Court costs recovered

     (43,982     (36,929

Court costs reserve

     (98,172     (80,315
                
   $ 27,710      $ 28,335   
                

Note 6: Other Assets

Other assets consist of the following (in thousands):

 

     September 30,
2009
   December 31,
2008
          Adjusted

Debt issuance costs

   $ 842    $ 1,953

Deferred compensation assets

     730      1,206

Prepaid expenses

     1,668      973

Security deposit – India building lease

     985      —  

Other

     189      917
             
   $ 4,414    $ 5,049
             

Note 7: Debt

The Company is obligated under borrowings as follows (in thousands):

 

     September 30,
2009
    December 31,
2008
 
           Adjusted  

Convertible Senior Notes

   $ 42,920      $ 71,422   

Less: Debt discount

     (2,703     (7,664

Revolving Credit Facility

     282,000        238,000   

Capital Lease Obligations

     2,177        1,897   
                
   $ 324,394      $ 303,655   
                

Convertible Senior Notes

In 2005, the Company issued $100.0 million of 3.375% Convertible Notes due September 19, 2010. Interest on the Convertible Notes is payable semi-annually, in arrears, on March 19 and September 19 of each year. The Convertible Notes rank equally with the Company’s existing and future senior indebtedness and are senior to the Company’s potential future subordinated indebtedness. Prior to the implementation of the net-share settlement feature discussed below, the Convertible Notes were convertible, prior to maturity, subject to certain conditions described below, into shares of the Company’s common stock at an initial conversion rate of 44.7678 per $1,000 principal amount of notes, which represented an initial conversion price of approximately $22.34 per share, subject to adjustment.

In October 2005, the Company obtained stockholder approval of a net-share settlement feature that allows the Company to settle conversion of the Convertible Notes through a combination of cash and stock. Based on the provisions of Subtopic 470-20, the net-settlement feature is accounted for as convertible debt and is not subject to the provisions of FASB ASC Subtopic 815-15 “Embedded Derivatives” (prior authoritative literature: Statement of Financial Accounting Standards No. 133 (“FAS

 

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133”), “Accounting for Derivative Instruments and Hedging Activities”). As a result of the net-settlement feature, the Company will be able to substantially reduce the number of shares issuable in the event of conversion of the Convertible Notes by repaying principal in cash instead of issuing shares of common stock for that amount. Additionally, the Company will not be required to include the underlying shares of common stock in the calculation of the Company’s diluted weighted average shares outstanding for earnings per share until the Company’s common stock price exceeds $22.34.

Effective January 1, 2009, the Company retrospectively adopted the provisions of Subtopic 470-20 to account for its Convertible Notes. Subtopic 470-20 requires that issuers of convertible debt instruments that, upon conversion, may be settled fully or partially in cash, must separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. Additionally, debt issuance costs are required to be allocated in proportion to the allocation of the liability and equity components and accounted for as debt issuance costs and equity issuance costs, respectively. This subtopic requires retrospective application and, accordingly, the prior periods’ financial statements included herein have been adjusted. See Note 12 for additional information and the effect of the change in accounting principle on the Company’s condensed consolidated financial statements.

During the nine months ended September 30, 2009, the Company repurchased $28.5 million principal amount of its outstanding Convertible Notes for a total price of $22.3 million plus accrued interest. These repurchases left $42.9 million principal amount of the Company’s Convertible Notes outstanding as of September 30, 2009, and resulted in a net gain of $3.3 million for the nine months ended September 30, 2009. The Company has written-off approximately $0.2 million in debt issuance costs and $2.7 million in debt discount in connection with the repurchase of its Convertible Notes during the nine months ended September 30, 2009. No repurchases were made during the three months ended September 30, 2009.

During the nine months ended September 30, 2008, the Company repurchased $5.0 million principal amount of its outstanding Convertible Notes for a total price of $3.5 million plus accrued interest. The repurchase resulted in a net gain of $0.7 million. The Company wrote-off approximately $0.1 million in debt issuance costs and $0.7 million in debt discount in connection with the repurchase of its Convertible Notes during the nine months ended September 30, 2008. No repurchases were made during the three months ended September 30, 2008.

In accordance with the provisions of Subtopic 470-20, the Company determined that the fair value of the Convertible Notes at issuance in 2005 was approximately $73.2 million, and designated the residual value of approximately $26.8 million as the equity component. Additionally, the Company allocated approximately $2.5 million of the $3.4 million original Convertible Notes issuance cost as debt issuance cost and the remaining $0.9 million as equity issuance cost.

The balances of the liability and equity components as of each period presented are as follows (in thousands):

 

     September 30,
2009
    December 31,
2008
 
           Adjusted  

Liability component – principal amount

   $ 42,920      $ 71,422   

Unamortized debt discount

     (2,703     (7,664
                

Liability component – net carrying amount

     40,217        63,758   

Equity component

     25,878        25,878   

The remaining debt discount is being amortized into interest expense over the remaining life of the Convertible Notes using the effective interest rate. The Convertible Notes are due on September 19, 2010. The effective interest rate on the liability component was 10.38% for the nine months ended September 30, 2009 and 2008.

Interest expense related to the Convertible Notes was as follows (in thousands):

 

     Three Months Ended September 30,    Nine Months Ended September 30,
     2009    2008    2009    2008
          Adjusted         Adjusted

Interest expense – stated coupon rate

   $ 362    $ 802    $ 1,270    $ 2,455

Interest expense – amortization of debt discount

     651      1,302      2,211      3,891
                           

Total interest expense – convertible notes

   $ 1,013    $ 2,104    $ 3,481    $ 6,346
                           

As of September 30, 2009, the Company is making the required interest payments on the Convertible Notes and no other changes in the balance or structure of the Convertible Notes has occurred.

 

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The Convertible Notes also contain a restricted convertibility feature that does not affect the conversion price of the Convertible Notes but, instead, places restrictions on a holder’s ability to convert their Convertible Notes into shares of the Company’s common stock. A holder may convert the Convertible Notes prior to March 19, 2010, only if one or more of the following conditions are satisfied:

 

   

the average of the trading prices of the Convertible Notes for any five consecutive trading day period is less than 103% of the average of the conversion values of the Convertible Notes during that period;

 

   

the Company makes certain significant distributions to holders of the Company’s common stock;

 

   

the Company enters into specified corporate transactions; or

 

   

the Company’s common stock ceases to be approved for listing on the NASDAQ Global Market and is not listed for trading on a U.S. national securities exchange or any similar U.S. system of automated securities price dissemination.

Holders may also surrender their Convertible Notes for conversion anytime on or after March 19, 2010, until the close of business on the trading day immediately preceding September 19, 2010, regardless of whether any of the foregoing conditions have been satisfied. Upon the satisfaction of any of the foregoing conditions, on the last day of a reporting period, or during the twelve months prior to September 19, 2010, the Company would write off to expense all remaining unamortized debt issuance costs in that period.

If the Convertible Notes are converted in connection with certain fundamental changes that occur prior to March 19, 2010, the Company may be obligated to pay an additional make-whole premium with respect to the Convertible Notes.

Convertible Notes Hedge Strategy. Concurrent with the sale of the Convertible Notes, the Company purchased call options to purchase from the counterparties an aggregate of 4,476,780 shares of the Company’s common stock at a price of $22.34 per share. The cost of the call options totaled $27.4 million. The Company also sold warrants to the same counterparties to purchase from the Company an aggregate of 3,984,334 shares of the Company’s common stock at a price of $29.04 per share and received net proceeds from the sale of these warrants of $11.6 million. Taken together, the call option and warrant agreements have the effect of increasing the effective conversion price of the Convertible Notes to $29.04 per share. The call options and warrants must be settled in net shares, except in connection with certain termination events, in which case they would be settled in cash based on the fair market value of the instruments. On the date of settlement, if the market price per share of the Company’s common stock is above $29.04 per share, the Company will be required to deliver shares of its common stock representing the value of the call options and warrants in excess of $29.04 per share.

The warrants have a strike price of $29.04 and are generally exercisable at any time. The Company issued and sold the warrants in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended, because the offer and sale did not involve a public offering. There were no underwriting commissions or discounts in connection with the sale of the warrants. In accordance with FASB ASC Topic 480 “Distinguishing Liabilities from Equity” (prior authoritative literature: Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”), the Company 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 its consolidated financial statements.

Revolving Credit Facility

During 2005, the Company 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 the needs of the Company and is due to expire in May 2010.

Effective February 27, 2007, the Company amended the Revolving Credit Facility to allow for the Company to repurchase up to $50.0 million of its common stock and Convertible Notes, with no more than $25.0 million to repurchase Convertible Notes. Effective May 9, 2008, the Company amended the Revolving Credit Facility to remove the $25.0 million cap on Convertible Note repurchases and allow for the Company to repurchase up to $50.0 million in any combination of its common stock and Convertible Notes, subject to compliance with certain covenants and available borrowing capacity.

Effective May 7, 2007, the Company amended the Revolving Credit Facility in connection with an agreement reached with the lender under the Company’s prior Secured Financing Facility. This amendment allows the Company to exclude the expense associated with a one-time payment of $16.9 million in connection with its termination of all future obligations under its Secured Financing Facility as further discussed below.

 

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Effective October 19, 2007, the Company amended the Revolving Credit Facility to change the definition of “change of control” to exclude from that definition, acquisitions of stock by Red Mountain Capital Partners LLC (“Red Mountain”), JCF FPK I LP (“JCF FPK”) and their respective affiliates.

Effective July 3, 2008, the Company amended the Revolving Credit Facility to expand the capacity from $230.0 million to $335.0 million. This amendment added three additional lenders to the syndicate of lenders in the Revolving Credit Facility and increased the applicable margin under certain circumstances between 25 and 75 basis points.

Other provisions of the amended Revolving Credit Facility include:

 

   

Interest at a floating rate equal to, at the Company’s option, either: (a) reserve adjusted LIBOR plus a spread that ranges from 225 to 275 basis points, depending on the Company’s leverage; or (b) the higher of the federal funds rate then in effect plus a spread of 50 basis points or the prime rate plus a spread that ranges from 25 to 75 basis points.

 

   

$5.0 million sub-limits for swingline loans and letters of credit.

 

   

A borrowing base that provides for an 85.0% initial advance rate for the purchase of qualified receivable portfolios. The borrowing base reduces for each qualifying portfolio by 3% per month beginning after the third complete month subsequent to the initial purchase. The aggregate borrowing base is equal to the lesser of (a) the sum of all of the borrowing bases of all qualified receivable portfolios under this facility, as defined above, or (b) 95% of the net book value of all receivable portfolios acquired on or after January 1, 2005.

 

   

Restrictions and covenants, which limit, among other things, the payment of dividends and the incurrence of additional indebtedness and liens.

 

   

Events of default which, upon occurrence, may permit the lenders to terminate the Revolving Credit Facility and declare all amounts outstanding to be immediately due and payable.

 

   

Collateralization by all assets of the Company.

At September 30, 2009, the outstanding balance on the Revolving Credit Facility was $282.0 million, which bore a weighted average interest rate of 3.74% and 3.86% for the three and nine months ended September 30, 2009, respectively. The aggregate borrowing base as of September 30, 2009, was $324.2 million, of which $42.2 million was available for future borrowings.

Derivative Instruments

The Company entered into two separate interest rate swap agreements intended to manage interest rates more effectively by establishing a set level of fixed rates associated with a portion of the borrowings under its Revolving Credit Facility. Under the swap agreements, the Company receives floating interest rate payments and makes interest payments based on fixed interest rates. The first agreement is for a notional amount of $25.0 million, a term of three years and a fixed interest rate of 4.99%. The second agreement is for a notional amount of $25.0 million, a term of four years and a fixed interest rate of 5.01%. No credit spread was hedged. The Company intends to continue electing the one-month reserve-adjusted LIBOR as the benchmark interest rate on the debt being hedged through its term. The Company does not intend to repay the Revolving Credit Facility below the notional amounts of the interest rate swaps before the maturity of these swaps. In accordance with the provisions of FASB ASC Subtopic 815-30 “Cash Flow Hedges” (prior authoritative literature: FAS 133), the Company designates its interest rate swap instruments as cash flow hedges.

FASB ASC Topic 815 (“Topic 815”) “Derivatives and Hedging” (prior authoritative literature: FAS 133) requires companies to recognize derivative instruments as either an asset or liability measured at fair value in the statement of financial position. The effective portion of the change in fair value of the derivative instrument is recorded in other comprehensive income. The ineffective portion of the change in fair value of the derivative instrument, if any, is recognized in interest expense in the period of change. From the inception of the hedging program, the Company has determined that the hedging instruments are highly effective.

 

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The following table summarizes the fair value of derivative instruments as recorded in the Company’s consolidated statements of financial position (in thousands):

 

    

Liability Derivatives

    

As of September 30, 2009

  

As of December 31, 2008

    

Balance Sheet
Location

   Fair Value   

Balance Sheet
Location

   Fair Value

Derivatives designated as hedging instruments under Topic 815

           

Interest rate swaps

   Other liabilities    $ 2,306    Other liabilities    $ 3,483

The following tables summarize the effect of the interest rate swaps for the three and nine months ended September 30, 2009 and 2008 on the Company’s statements of income (in thousands):

 

Derivatives in Cash Flow
Hedging Relationships

   Amount of Gain or (Loss)
Recognized in OCI on
Derivative (Effective
Portion)
    Location of Gain
or (Loss)
Reclassified from
Accumulated OCI
into Income
(Effective Portion)
   Amount of Gain or (Loss)
Reclassified from
Accumulated OCI into
Income (Effective Portion)
   Location of Gain or
(Loss) Recognized in

Income on Derivative
(Ineffective Portion
and Amount

Excluded from
Effectiveness Testing)
   Amount of Gain or (Loss)
Recognized in Income
on Derivative
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)
   Three Months Ended
September 30,
       Three Months Ended
September 30,
      Three Months Ended
September 30,
   2009    2008        2009    2008       2009    2008

Interest rate swaps

   $ 342    $ 18      Interest expense    $ —      $ —      Other income (expense)    $ —      $ —  
                      

Derivatives in Cash Flow
Hedging Relationships

   Amount of Gain or (Loss)
Recognized in OCI on
Derivative (Effective
Portion)
    Location of Gain
or (Loss)
Reclassified from
Accumulated OCI
into Income
(Effective Portion)
   Amount of Gain or (Loss)
Reclassified from
Accumulated OCI into
Income (Effective Portion)
   Location of Gain or
(Loss) Recognized in
Income on Derivative
(Ineffective Portion

and Amount
Excluded from
Effectiveness Testing)
   Amount of Gain or (Loss)
Recognized in Income
on Derivative
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)
   Three Months Ended
September 30,
       Three Months Ended
September 30,
      Three Months Ended
September 30,
   2009    2008        2009    2008       2009    2008

Interest rate swaps

   $ 1,177    $ (8   Interest expense    $ —      $ —      Other income (expense)    $ —      $ —  

Capital Lease Obligations

The Company has capital lease obligations for certain computer equipment. These lease obligations require monthly payments that range from approximately $1,000 to $20,000 through June 2013 and have implicit interest rates that range from approximately 5.9% to 7.7%.

The Company finances certain leasehold improvement projects with its lessors in its Phoenix and St. Cloud facilities. As of September 30, 2009, the Company’s combined obligation was approximately $1.1 million. These financing agreements require monthly principal and interest payments, accrue interest at 8% to 9% per annum and will mature in June and September 2013.

Note 8: Income Taxes

The Company recorded an income tax provision of $5.9 million, reflecting an effective rate of 39.8% of pretax income during the three months ended September 30, 2009. The effective tax rate for the three months ended September 30, 2009, consists primarily of a provision for federal income taxes of 32.3% (which is net of a benefit for state taxes of 2.7%), a provision for state taxes of 7.8%, the benefit of permanent book versus tax differences and a state refund of 0.3%. Effective January 1, 2009, the Company retrospectively adjusted its prior years’ income tax provisions for the change in accounting principle related to its accounting for Convertible Notes. See Note 12 for additional information on the change in accounting principle. The adjusted income tax provision for the three months ended September 30, 2008, was $2.4 million, reflecting an effective rate of 44.3% of pretax income. The effective tax rate for the three months ended September 30, 2008, consists primarily of a provision for federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%), a provision for state taxes of 8.8%, and a provision for the effect of permanent book verses tax differences of 3.6%.

The Company recorded an income tax provision of $16.1 million, reflecting an effective rate of 39.5% of pretax income during the nine months ended September 30, 2009. The effective tax rate for the nine months ended September 30, 2009, consists primarily of a provision for federal income taxes of 32.3% (which is net of a benefit for state taxes of 2.7%), a

 

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provision for state taxes of 7.8%, the benefit of permanent book versus tax differences and a state refund of 0.6%. Effective January 1, 2009, the Company retrospectively adjusted its prior years’ income tax provisions for the change in accounting principle related to its accounting for Convertible Notes. See Note 12 for additional information on the change in accounting principle. The adjusted income tax provision for the nine months ended September 30, 2008, was $11.1 million, reflecting an effective rate of 41.1% of pretax income. The effective tax rate for the nine months ended September 30, 2008, consists primarily of a provision for federal income taxes of 31.9% (which is net of a benefit for state taxes of 3.1%), a provision for state taxes of 8.8% and a provision for the effect of permanent book versus tax differences of 0.4%.

Effective January 1, 2007, the Company adopted the provisions related to uncertainty in income taxes within ASC Topic 740 (“Topic 740”) “Income Taxes” (prior authoritative literature: FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes”). As of September 30, 2009, the Company had a gross unrecognized tax benefit of $1.2 million that, if recognized, would result in a net tax benefit of approximately $0.9 million and would have a positive effect on the Company’s effective tax rate. During the three and nine months ended September 30, 2009, there were no material changes to the unrecognized tax benefit.

For the three and nine months ended September 30, 2009, the Company has not provided for the United States income taxes or foreign withholding taxes on the quarterly undistributed earnings from continuing operations of its subsidiary operating outside of the United States. Undistributed earnings of the subsidiary for the three and nine months ended September 30, 2009, were approximately $0.2 million and $0.6 million, respectively. Such undistributed earnings are considered permanently reinvested.

The Company’s subsidiary operating outside of the United States is currently operating under a tax holiday in India. The tax holiday is due to expire on March 31, 2011. The impact of the tax holiday on the Company’s condensed consolidated financial statements is not material.

Note 9: Purchase Concentrations

The following table summarizes the concentration of our purchases by seller sorted by total aggregate costs (in thousands, except percentages):

 

     Concentration of Initial Purchase
Cost by Seller for the Nine

Months Ended September 30, 2009
 
     Cost     %  

Seller 1

   $ 53,995      25.0

Seller 2

     43,014      19.9

Seller 3

     42,386      19.7

Seller 4

     27,000      12.5

Seller 5

     22,670      10.5

Other

     26,615      12.4
              
   $ 215,680      100.0

Adjustments(1)

     (666  
          

Purchases, net

   $ 215,014     
          

 

(1)

Adjusted for Put-backs and Recalls.

Note 10: Commitments and Contingencies

Litigation

On October 18, 2004, Timothy W. Moser, one of the Company’s former officers, filed an action in the United States District Court for the Southern District of California against the Company, and certain individuals, including several of the Company’s officers and directors. On February 14, 2005, the Company was 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 the Company’s Registration Statement on Form S-1, originally filed in September 2003, and alleged to be included in the Company’s 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,

 

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2006, the court denied the Company’s special motion to strike pursuant to California’s anti-SLAPP statute, denied in part and granted in part the Company’s 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 June 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, the Company filed a notice of appeal of the court’s order denying the anti-SLAPP motion and on June 16, 2006, the Company filed a motion to stay the case pending the outcome of the appeal, which was granted. Oral argument on the appeal was heard on July 17, 2008, and on July 28, 2008, the appellate court affirmed the trial court’s denial of the Company’s anti-SLAPP motion. The appellate court denied the Company’s request for a rehearing and the case has been returned to the district court where it is proceeding from the point at which it was stayed. Discovery is in the final stages and the parties have filed various motions. Management believes the claims are without merit and intends to defend the action vigorously.

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 the Company, 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 the Company’s 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 action to the Company, and the Company 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.

The Company, along with others in its industry, are subject to legal actions based on the Fair Debt Collection Practices Act, or FDCPA, and comparable state statutes, which could have a material adverse effect on the Company due to the remedies available under these statutes, including punitive damages. The claimed violations of law include allegations that the Company lacks specified licenses to conduct its business, attempts to collect debts on which the statute of limitations has run, and has made inaccurate assertions of fact in support of its collection actions. A number of these cases are styled as class actions and a class has been certified in several of these cases. Many of these cases present novel issues on which there is no legal precedent. As a result, the Company is unable to predict the range of possible outcomes. However, court rulings in these or other legal actions could affect the Company’s debt collection procedures in the future.

There are a number of other lawsuits, claims and counterclaims pending or threatened against the Company. In general, these lawsuits, claims or counterclaims have arisen in the ordinary course of business and involve claims for damages arising from a variety of alleged misconduct or improper reporting of credit information by the Company or its employees or agents.

In addition, from time to time, the Company is subject to various regulatory investigations relating to its collection activities. For example, on September 21, 2009, the Maryland Department of Labor, Licensing and Regulation, or MDLLR, issued a cease and desist order, barring all collection activities by the Company and certain of its affiliates, alleging that the Company had failed to obtain necessary business licenses and had improperly filed lawsuits to collect credit card accounts, among other claims raised in certain of the legal actions pending against the Company. Pursuant to an Interim Settlement Agreement the Company executed with MDLLR on September 23, 2009, certain of the Company’s affiliates will refrain from collection activities in Maryland until obtaining licenses. Additionally, the Company agreed to assemble certain information and provide it to MDLLR in furtherance of their investigation. While the Company has assembled and supplied the information requested by MDLLR and has applied for the specified licenses, the pending collection lawsuits filed by the Company in Maryland remain subject to a stay pending the outcome of the investigation or other administrative action. Nevertheless, under the Interim Settlement Agreement, the Company’s licensed affiliate was permitted to resume other collection agency business activities within the state of Maryland. The Company cannot predict when or if it will be granted the specified licenses or be able to fully resume collection activities in Maryland, or whether it will be subject to fines or other penalties as a result of this on-going investigation.

In connection with the Company’s acquisition of certain assets of Jefferson Capital in June 2005, the Company entered into a forward flow agreement to purchase a minimum of $3.0 billion in face value of credit card charge-offs over a five-year period at a fixed price. In June 2008, the Federal Trade Commission (the “FTC”) announced that it had sued Jefferson Capital and its parent company, CompuCredit Corporation, alleging that Jefferson Capital and CompuCredit had violated the FTC Act with deceptive marketing practices when issuing credit cards. The FTC announced in December 2008, that it had agreed to a settlement of the litigation with Jefferson Capital and CompuCredit, whereby those companies will credit approximately $114.0 million to certain customer accounts. Jefferson Capital and CompuCredit advised the Company that a substantial number of the accounts affected by the settlement had been sold to the Company.

 

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In July 2008, the Company initiated an arbitration proceeding against Jefferson Capital and CompuCredit based upon the allegations noted in the FTC complaint and other claims. Jefferson Capital and CompuCredit raised their own claims against the Company in the arbitration. In September 2009, the Company settled the dispute with Jefferson Capital and CompuCredit. Under the terms of the settlement, the Company purchased a large portfolio of charged-off credit card account balances on commercially reasonable terms and agreed to resume balance transfers to Jefferson Capital. The forward flow asset of $10.3 million was fully allocated to the purchase price of this portfolio. The Company also agreed to return to Jefferson Capital certain accounts that were subject to Jefferson Capital’s settlement with the FTC. Following its settlement with Jefferson Capital and CompuCredit, the Company will have no further forward flow purchase obligations with Jefferson Capital and CompuCredit.

The Company has established loss provisions only for matters in which losses are probable and can be reasonably estimated. Some of the matters pending against the Company involve potential compensatory, punitive damage claims, fines or sanctions that, if granted, could require the Company to pay damages or make other expenditures in amounts that could have a material adverse effect on the Company’s financial position or results of operations. Although litigation is inherently uncertain, at this time, based on past experience, the information currently available and the possible availability of insurance and/or indemnification in some cases, management does not believe that the resolution of these matters will have a material adverse effect on the Company’s consolidated financial position or results of operations.

Purchase Commitments

In the normal course of business, the Company enters into forward flow purchase agreements and other purchase commitment agreements. As of September 30, 2009, the Company has entered into agreements to purchase receivable portfolios with a face value of approximately $1.2 billion for a purchase price of approximately $53.3 million. Certain of these agreements allow the Company to terminate the commitment with 60 days notice or by paying a one-time cancellation fee. The Company does not anticipate cancelling any of these commitments at this time. The Company has no purchase commitments extending past one year.

Note 11: Securities Repurchase Program

On February 27, 2007, the Company’s board of directors authorized a securities repurchase program under which the Company may buy back up to $50.0 million (at cost) of a combination of its common stock and Convertible Notes. The purchases may be made from time to time in the open market or through privately negotiated transactions and will be dependent upon various business and financial considerations. Repurchases are subject to compliance with applicable legal requirements and other factors. During the nine months ended September 30, 2009, the Company repurchased $28.5 million principal amount of its outstanding Convertible Notes, for a total price of $22.3 million, plus accrued interest. From the inception of the securities repurchase program, the Company has repurchased $57.1 million principal amount of its Convertible Notes, for a total cash payment of $42.4 million. The Company has not repurchased any common stock under this program.

Note 12: Change in Accounting Principle

Effective January 1, 2009, the Company adopted the provisions of ASC Subtopic 470-20 (“Subtopic 470-20”) “Debt with Conversion and Other Options” (prior authoritative literature: FASB Staff Position APB 14-1 “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement”). Subtopic 470-20 applies to convertible debt instruments that may be settled in cash upon conversion, including partial cash settlement, when the conversion option does not need to be bifurcated and accounted for separately as a derivative instrument in accordance with Topic 815.

Subtopic 470-20 requires that issuers of convertible debt instruments that, upon conversion, may be settled fully or partially in cash, must separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. Additionally, debt issuance costs are required to be allocated in proportion to the allocation of the liability and equity components and accounted for as debt issuance costs and equity issuance costs, respectively. Subtopic 470-20 requires retrospective application and, accordingly, the prior periods’ financial statements included herein have been adjusted.

 

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Effect of Change in Accounting Principle to Consolidated Financial Statements

The 2008 condensed consolidated financial statements presented in this quarterly report have been retroactively adjusted to reflect the change in accounting principle related to the Company’s Convertible Notes. The following table provides the impact of Subtopic 470-20 on the 2008 condensed consolidated financial statements (in thousands, except per share amounts):

 

     As Previously
Reported
    As Adjusted by
Subtopic 470-20
    Effect of
Change
 

Condensed Consolidated Statements of Financial Condition

      

(As of December 31, 2008)

      

Assets:

      

Other assets(1)

   $ 5,268      $ 5,049      $ (219

Total assets

     549,298        549,079        (219

Liabilities:

      

Deferred tax liabilities, net

   $ 15,199      $ 15,108      $ (91

Debt

     311,319        303,655        (7,664

Total liabilities

     353,408        345,653        (7,755

Stockholders’ equity:

      

Additional paid-in capital

   $ 79,971      $ 98,521      $ 18,550   

Accumulated earnings

     117,809        106,795        (11,014

Total stockholders’ equity

     195,890        203,426        7,536   

Total liabilities and stockholders’ equity

     549,298        549,079        (219

Condensed Consolidated Statements of Income

      

(Three months ended September 30, 2008)

      

Interest expense

   $ (3,880   $ (5,140   $ (1,260

Income before income taxes

     6,696        5,436        (1,260

Provision for income taxes

     (2,923     (2,408     515   

Net Income

     3,773        3,028        (745

Earnings Per Share:

      

Basic

   $ 0.16      $ 0.13      $ (0.03

Diluted

     0.16        0.13        (0.03

(Nine months ended September 30, 2008)

      

Interest expense

   $ (11,409   $ (15,171   $ (3,762

Gain on repurchase of convertible notes, net

     1,417        707        (710

Income before income taxes

     31,555        27,083        (4,472

Provision for income taxes

     (12,952     (11,142     1,810   

Net Income

     18,603        15,941        (2,662

Earnings Per Share:

      

Basic

   $ 0.81      $ 0.69      $ (0.12

Diluted

     0.79        0.68        (0.11

Condensed Consolidated Statements of Cash Flows

      

(Nine months ended September 30, 2008)

      

Net Income

   $ 18,603      $ 15,941      $ (2,662

Amortization of loan costs and debt discount

     989        4,751        3,762   

Deferred income tax expense

     762        825        63   

Change in prepaid income tax(1)

     11,793        9,920        (1,873

Gain on repurchase of convertible notes, net

     (1,417     (707     710   

Net cash provided by operating activities(1)

     45,284        45,284        —     

 

(1)

Certain reclassifications other than the impact of Subtopic 470-20 have been made to conform to the current year’s presentation.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This information should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 of Part I of this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations for the year ended December 31, 2008 contained in our 2008 Annual Report on Form 10-K. The Form 10-K contains a general description of our industry and a discussion of recent trends affecting the industry. Certain statements herein may constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995 (the “Reform Act”), for which we claim the protection of the safe harbor of the Reform Act. See “Part II, Item 1A—Risk Factors” for more discussion on our forward-looking statements.

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.

Market Overview

The United States and global economies are currently in a recession. In the U.S., the availability of credit is limited, unemployment rates are at 25-year highs, while credit card charge-offs and delinquencies have reached a 20-year high increasing approximately 30% from third quarter 2008 levels. At the same time, home foreclosures have dramatically increased and the housing market is experiencing a significant downturn. These conditions present both opportunities and challenges for Encore.

On the opportunities side, the increase in credit card charge-offs and delinquencies (which contribute to an increase in supply), combined with the challenges some of our competitors are facing in (i) generating sufficient returns on receivables they purchased in 2005 – 2007, when prices were high and (ii) obtaining sufficient capital to fund future purchases (which contributes to a decrease in demand) have resulted in a significant reduction in the market price for portfolios of charged-off receivables. For example, prices for fresh charge-offs (receivables that are sold immediately after charge-off) have declined from 8% - 13% of face value in 2008 to 4% - 8% of face value in 2009. We have seen similar pricing declines across all ages of charge-offs and the decline is more pronounced in the resale market. While this is generally positive for our business, as a result of the significant price decline, some sellers of portfolios have chosen not to sell and, as an alternative to selling their charge-offs, have collected on accounts internally or placed accounts with third-party collection agencies. As such, the full impact the price reduction will have on our purchasing volumes is presently unclear.

On the challenges side, increases in unemployment, high foreclosure rates and the difficulties consumers are experiencing in obtaining credit may, for a period of time, negatively impact collections on receivables that we currently own or that we purchase during these challenging economic times. Despite these market conditions, during 2009, most of the collection metrics we track have remained relatively consistent, as compared to 2008. For example, payer rates and average payment size, adjusted for the change in single payment/payment plan mix, have remained relatively constant. One change we have noted is that more consumers are settling their debts through payment plans rather than in one-time settlements. While settlement rates remain consistent, payments made over longer periods of time impact our business in two ways. First, when payments are extended over longer periods of time rather than received up front, this delay in cash flows could result in a provision for impairment. This is because discounting a long-term payment stream using our pool group IRRs rather than discounting a one-time settlement payment using the same IRR will result in a lower net present value. As a result, even if the cash received through long-term payment plans is the same as the cash received through one-time settlements, accounting for the stream of payments may result in a provision for impairment. Second, when debts are settled through payment plans, there is a possibility that consumers will not make all of the payments required by those plans. We refer to consumers who do not make all of their payments as “broken payers.” When this happens, we are often successful in getting the consumer back on plan, but this is not always the case and, in those instances where we are unable to get the consumer back on plan, we experience a shortfall in collections. Despite the current economic environment, we have not experienced an increase in the broken payer rate in 2009 as compared to the same period in 2008. Please refer to Management’s Discussion and Analysis – Revenue below for a more detailed explanation of the provision for impairment for the three and nine months ended September 30, 2009.

 

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As a result of the uncertainties presented by the current economic environment, we believe we are applying conservative assumptions when valuing portfolios for purchase and when establishing our forecasted collections. Additionally, while we believe that consumers who are currently charging off their debt (when economic conditions are bad) are more likely to recover faster than consumers who charged off their debt historically (when economic times were good), we have not factored any such recovery into our forecasts.

When evaluating the overall long-term returns of our business, we believe that the benefits resulting from the current lower portfolio pricing will outweigh the negative impacts from the collection shortfalls we may experience from a more distressed consumer. However, if the lower pricing environment re-attracts significant capital to our industry and prices are bid up, or if the ability of the consumer to repay their debt deteriorates further, our returns would be negatively impacted.

Purchases and Collections

Purchases by Paper Type

The following table summarizes the types of charged-off consumer receivable portfolios we purchased for the three and nine months ended September 30, 2009 and 2008 (in thousands):

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008

Credit card

   $ 77,734    $ 57,107    $ 215,680    $ 142,552

Other

     —        9,000      —        23,949
                           
   $ 77,734    $ 66,107    $ 215,680    $ 166,501
                           

During the three months ended September 30, 2009, we invested $77.7 million for portfolios with face values aggregating $2.2 billion for an average purchase price of 3.6% of face value. This is an $11.6 million increase, or 17.6%, in the amount invested, compared with the $66.1 million invested during the three months ended September 30, 2008, to acquire portfolios with a face value aggregating $1.8 billion for an average purchase price of 3.6% of face value. During the nine months ended September 30, 2009, we invested $215.7 million for portfolios with face values aggregating $5.5 billion for an average purchase price of 4.0% of face value. This is a $49.2 million increase, or 29.5%, in the amount invested compared with the $166.5 million invested during the nine months ended September 30, 2008, to acquire portfolios with a face value aggregating $4.8 billion for an average purchase price of 3.4% of face value. Average purchase price, as a percentage of face value, varies from period to period depending on, among other things, the quality of the accounts purchased and the length of time from charge off to the time we purchase the portfolios.

Collections by Channel

During the three and nine months ended September 30, 2009 and 2008, we utilized several business channels for the collection of charged-off credit card receivables and other charged-off receivables. The following table summarizes gross collections by collection channel (in thousands):

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008

Collection sites

   $ 45,122    $ 36,858    $ 140,144    $ 119,076

Legal collections

     55,584      49,765      173,451      144,241

Collection agencies

     19,705      7,881      42,878      28,851

Sales

     5,299      3,166      6,843      11,013

Other

     —        107      —        1,081
                           

Gross collections for the period

   $ 125,710    $ 97,777    $ 363,316    $ 304,262
                           

Gross collections increased $27.9 million, or 28.6%, to $125.7 million during the three months ended September 30, 2009, from $97.8 million during the three months ended September 30, 2008.

Gross collections increased $59.0 million, or 19.4%, to $363.3 million during the nine months ended September 30, 2009, from $304.3 million during the nine months ended September 30, 2008.

 

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Results of Operations

Results of operations in dollars and as a percentage of revenue were as follows (in thousands, except percentages):

 

     Three Months Ended September 30,  
     2009     2008  
           Adjusted (1)  

Revenue

        

Revenue from receivable portfolios, net

   $ 76,448      95.1   $ 62,557      94.3

Servicing fees and other related revenue

     3,938      4.9     3,816      5.7
                            

Total revenue

     80,386      100.0     66,373      100.0
                            

Operating expenses

        

Salaries and employee benefits

     14,411      17.9     14,963      22.5

Stock-based compensation expense

     1,261      1.6     860      1.3

Cost of legal collections

     26,092      32.5     25,390      38.3

Other operating expenses

     6,034      7.5     6,018      9.1

Collection agency commissions

     5,795      7.2     2,996      4.5

General and administrative expenses

     7,280      9.1     4,864      7.3

Depreciation and amortization

     652      0.8     674      1.0
                            

Total operating expenses

     61,525      76.6     55,765      84.0
                            

Income before other (expense) income and income taxes

     18,861      23.4     10,608      16.0
                            

Other (expense) income

        

Interest expense

     (3,970   (4.9 )%      (5,140   (7.8 )% 

Gain on repurchase of convertible notes

     —        0.0     —        0.0

Other income (expense)

     61      0.1     (32   0.0
                            

Total other expense

     (3,909   (4.8 )%      (5,172   (7.8 )% 
                            

Income before income taxes

     14,952      18.6     5,436      8.2

Provision for income taxes

     (5,948   (7.4 )%      (2,408   (3.6 )% 
                            

Net income

   $ 9,004      11.2   $ 3,028      4.6
                            
     Nine Months Ended September 30,  
     2009     2008  
           Adjusted (1)  

Revenue

        

Revenue from receivable portfolios, net

   $ 222,688      94.8   $ 192,900      94.6

Servicing fees and other related revenue

     12,179      5.2     11,047      5.4
                            

Total revenue

     234,867      100.0     203,947      100.0
                            

Operating expenses

        

Salaries and employee benefits

     43,130      18.4     45,503      22.3

Stock-based compensation expense

     3,335      1.4     3,182      1.6

Cost of legal collections

     84,665      36.1     69,525      34.1

Other operating expenses

     18,612      7.9     17,656      8.7

Collection agency commissions

     13,483      5.7     10,808      5.3

General and administrative expenses

     20,074      8.6     13,905      6.8

Depreciation and amortization

     1,895      0.8     2,162      1.0
                            

Total operating expenses

     185,194      78.9     162,741      79.8
                            

Income before other (expense) income and income taxes

     49,673      21.1     41,206      20.2
                            

Other (expense) income

        

Interest expense

     (12,201   (5.2 )%      (15,171   (7.4 )% 

Gain on repurchase of convertible notes

     3,268      1.4     707      0.3

 

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Table of Contents
     Nine Months Ended September 30,  
     2009     2008  
           Adjusted (1)  

Other (expense) income

     (11   (0.0 )%      341      0.2
                            

Total other expense

     (8,944   (3.8 )%      (14,123   (6.9 )% 
                            

Income before income taxes

     40,729      17.3     27,083      13.3

Provision for income taxes

     (16,087   (6.8 )%      (11,142   (5.5 )% 
                            

Net income

   $ 24,642      10.5   $ 15,941      7.8
                            

 

(1)

Adjusted for change in accounting principle related to our convertible senior notes. See Note 12 to our unaudited condensed consolidated financial statements for additional information and the effect of the change in accounting principle to our financial statements.

 

Comparison of Results of Operations

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 Financial Accounting Standard Board (“FASB”) Accounting Standards Codification (“ASC”) Subtopic 310-30 (“Subtopic 310-30”) “Loans and Debt Securities Acquired with Deteriorated Credit Quality” (prior authoritative literature: AICPA’s Statement of Position 03-3, “Accounting for Certain Debt Securities Acquired in a Transfer”). 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.

Effective January 1, 2008, we revised our Unified Collection Score (“UCS”) and Behavioral Liquidation Score (“BLS”) methodologies by extending our collection forecast from 72 months to 84 months. UCS is a proprietary forecasting tool that generates portfolio level expectations of liquidation for portfolios that we have owned and serviced for more than six months. BLS forecasts portfolio level expectations based on credit characteristics for portfolios owned and serviced less than six months. We have observed that receivable portfolios purchased in 2001 and prior have consistently experienced cash collections beyond 72 months from the date of purchase. When we first developed our cash forecasting models in 2001, limited historical collection data was available with which to accurately model projected cash flows beyond 60 months. During the quarter ended June 30, 2006, we determined there was enough additional collection data accumulated over the previous several years, in addition to improvements in our forecasting tools, allowing us to extend the collection forecast to 72 months. During the quarter ended March 31, 2008, we determined that there was enough additional collection data to accurately extend the collection forecast in both our UCS and BLS models to 84 months. The increase in the collection forecast from 72 to 84 months was applied, effective January 1, 2008, to each portfolio for which we could accurately forecast through such term and resulted in an increase in the aggregate total estimated remaining collections for the receivable portfolios by $67.3 million, or 7.5%, as of March 31, 2008. We did not extend the forecast on telecom portfolios as we do not anticipate significant collections past 72 months on these portfolios. The extension of the collection forecast is treated as a change in estimate and, in accordance with the provisions of FASB ASC Topic 250 “Accounting Changes and Error Corrections” (prior authoritative literature Statement of Financial Accounting Standard No. 154, “Accounting Changes and Error Corrections”) is being recognized prospectively in our consolidated financial statements. This prospective treatment resulted in a reduction in our net impairment provision of $3.1 million and an increase in revenue of $0.1 million for the quarter ended March 31, 2008. The impact of the change in estimate resulted in an increase in net income of $1.9 million and an increase in fully diluted earnings per share of $0.08 for the quarter ended March 31, 2008.

 

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Table of Contents

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 Three Months Ended
September 30, 2009
    As of
September 30, 2009
 
     Collections(1)    Gross
Revenue(2)
   Revenue
Recognition
Rate(3)
    Net
(Impairment)
Reversal
    Revenue
% of
Total
Revenue
    Unamortized
Balances
   Monthly
IRR(4)
 

ZBA

   $ 2,100    $ 2,100    100.0   $ —        2.6   $ —      —     

2002

     630      31    4.9     511      0.0     —      0.0

2003

     1,770      1,240    70.1     (86   1.5     967    31.2

2004

     2,648      1,571    59.3     (147   1.9     5,688    8.2

2005

     10,729      6,223    58.0     (403   7.7     33,805    5.6

2006

     12,274      7,698    62.7     (59   9.5     46,932    5.1

2007

     25,659      14,727    57.4     (2,247   18.3     79,562    5.6

2008

     38,715      26,861    69.4     (1,901   33.3     170,640    5.0

2009

     31,111      20,329    65.3     —        25.2     197,062    4.3
                                               

Total

   $ 125,636    $ 80,780    64.3   $ (4,332   100.0   $ 534,656    5.0
                                               
     For the Three Months Ended
September 30, 2008
    As of
September 30, 2008
 
     Collections(1)    Gross
Revenue(2)
   Revenue
Recognition
Rate(3)
    Net
(Impairment)
Reversal
    Revenue
% of
Total
Revenue
    Unamortized
Balances
   Monthly
IRR(4)
 

ZBA

   $ 2,259    $ 2,259    100.0   $ —        3.2   $ —      —     

2002

     1,276      872    68.3     220      1.2     895    29.1

2003

     3,327      2,730    82.1     440      3.9     2,808    30.7

2004

     4,310      3,584    83.2     (1,426   5.1     14,420    7.9

2005

     15,048      10,805    71.8     (4,235   15.5     61,044    5.6

2006

     16,268      11,418    70.2     (1,932   16.4     72,214    5.1

2007

     36,020      22,798    63.3     (335   32.7     138,876    5.2

2008

     19,189      15,359    80.0     —        22.0     154,706    4.8
                                               

Total

   $ 97,697    $ 69,825    71.5   $ (7,268   100.0   $ 444,963    5.4
                                               
     For the Nine Months Ended
September 30, 2009
    As of
September 30, 2009
 
     Collections(1)    Gross
Revenue(2)
   Revenue
Recognition
Rate(3)
    Net
(Impairment)
Reversal
    Revenue
% of
Total
Revenue
    Unamortized
Balances
   Monthly
IRR(4)
 

ZBA

   $ 6,957    $ 6,957    100.0   $ —        2.9   $ —      —     

2002

     2,341      903    38.6     764      0.4     —      0.0

2003

     6,366      5,169    81.2     (495   2.2     967    31.2

2004

     8,964      5,626    62.8     (644   2.4     5,688    8.2

2005

     33,892      20,901    61.7     (1,816   8.8     33,805    5.6

2006

     36,406      24,949    68.5     (2,953   10.5     46,932    5.1

2007

     89,090      50,704    56.9     (4,228   21.4     79,562    5.6

2008

     127,048      87,789    69.1     (4,951   37.0     170,640    5.0

2009

     51,966      34,013    65.5     —        14.4     197,062    4.3
                                               

Total

   $ 363,030    $ 237,011    65.3   $ (14,323   100.0   $ 534,656    5.0
                                               

 

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Table of Contents
     For the Nine Months Ended
September 30, 2008
    As of
September 30, 2008
 
     Collections(1)    Gross
Revenue(2)
   Revenue
Recognition
Rate(3)
    Net
(Impairment)
Reversal
    Revenue
% of
Total
Revenue
    Unamortized
Balances
   Monthly
IRR(4)
 

ZBA

   $ 7,440    $ 7,440    100.0   $ —        3.6   $ —      —     

2002

     4,544      3,331    73.3     291      1.6     895    29.1

2003

     11,396      9,681    85.0     127      4.6     2,808    30.7

2004

     15,663      12,376    79.0     (3,003   5.9     14,420    7.9

2005

     54,560      37,164    68.1     (8,880   17.8     61,044    5.6

2006

     57,340      37,966    66.2     (4,086   18.2     72,214    5.1

2007

     113,111      72,392    64.0     (442   34.6     138,876    5.2

2008

     39,983      28,543    71.4     —        13.7     154,706    4.8
                                               

Total

   $ 304,037    $ 208,893    68.7   $ (15,993   100.0   $ 444,963    5.4
                                               

 

(1)

Does not include amounts collected on behalf of others.

 

(2)

Gross revenue excludes the effects of net impairment or net impairment reversals.

 

(3)

Revenue recognition rate excludes the effects of net impairment or net impairment reversals.

 

(4)

Our monthly IRR is calculated based on the weighted average of each pool’s IRR relative to each pool’s percentage of the unamortized balance for each year of purchase. Therefore, it is possible for the monthly IRR to be lower than that reported in the prior quarter due to this weighted average calculation.

Total revenue was $80.4 million for the three months ended September 30, 2009, an increase of $14.0 million, or 21.1%, compared to total revenue of $66.4 million for the three months ended September 30, 2008. Portfolio revenue was $76.4 million for the three months ended September 30, 2009, an increase of $13.8 million, or 22.2%, compared to portfolio revenue of $62.6 million for the three months ended September 30, 2008.

Total revenue was $234.9 million for the nine months ended September 30, 2009, an increase of $31.0 million, or 15.2%, compared to total revenue of $203.9 million for the nine months ended September 30, 2008. Portfolio revenue was $222.7 million for the nine months ended September 30, 2009, an increase of $29.8 million, or 15.4%, compared to portfolio revenue of $192.9 million for the nine months ended September 30, 2008.

The increase in portfolio revenue for the three and nine months ended September 30, 2009, was primarily the result of additional accretion revenue associated with a higher portfolio balance during the three and nine months ending September 30, 2009, compared to the three and nine months ending September 30, 2008, respectively. During the three months ended September 30, 2009, we recorded a net impairment provision of $4.3 million, compared to a net impairment provision of $7.3 million during the same period in the prior year. During the nine months ended September 30, 2009, we recorded a net impairment provision of $14.3 million, compared to a net impairment provision of $16.0 million during the same period in the prior year. The impairments for the three and nine months ended September 30, 2009 and 2008 were primarily due to a shortfall in collections in certain pool groups against our forecast. While our total collections during the three and nine months ended September 30, 2009 have met or exceeded our forecast, there is often variability at the pool group level between our actual collections and our forecasts. This is the result of several factors, including changes in internal operating strategy, shifts in consumer payment patterns and the inherent challenge of forecasting collections at the pool group level.

Revenue associated with bankruptcy servicing fees earned from Ascension was $3.9 million for the three months ended September 30, 2009, an increase of $0.1 million, or 3.2%, compared to revenue of $3.8 million for the three months ended September 30, 2008. Revenue associated with bankruptcy servicing fees earned from Ascension was $12.1 million for the nine months ended September 30, 2009, an increase of $1.1 million, or 10.5%, compared to revenue of $11.0 million for the nine months ended September 30, 2008. The increase in Ascension revenue for the three and nine months ended September 30, 2009, was due to a slightly higher volume of bankruptcy placements.

Operating Expenses

Total operating expenses were $61.5 million for the three months ended September 30, 2009, an increase of $5.7 million, or 10.3%, compared to total operating expenses of $55.8 million for the three months ended September 30, 2008.

Total operating expenses were $185.2 million for the nine months ended September 30, 2009, an increase of $22.5 million, or 13.8%, compared to total operating expenses of $162.7 million for the nine months ended September 30, 2008.

 

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Table of Contents

Operating expenses are explained in more detail as follows:

Salaries and Employee Benefits

Total salaries and employee benefits decreased by $0.6 million, or 3.7%, to $14.4 million during the three months ended September 30, 2009, from $15.0 million during the three months ended September 30, 2008. The decrease was primarily the result of a decrease of $0.5 million in compensation related expense, primarily due to a shift in our collection workforce from the United States to India and a change in our compensation plan structure.

Total salaries and employee benefits decreased by $2.4 million, or 5.2%, to $43.1 million during the nine months ended September 30, 2009, from $45.5 million during the nine months ended September 30, 2008. The decrease was primarily the result of a decrease of $2.5 million in compensation related expense, primarily due to a shift in our collection workforce from the United States to India and a change in our compensation plan structure, and a decrease of $0.4 million related to deferred compensation expense which was fully amortized in 2008, offset by an increase of $0.2 million in personnel severance costs and an increase of $0.5 million in health related expenses.

Stock-Based Compensation Expenses

Stock-based compensation expense increased by $0.4 million, or 46.6%, to $1.3 million during the three months ended September 30, 2009, from $0.9 million for the three months ended September 30, 2008. This increase was a result of recent equity grants.

Stock-based compensation expense increased by $0.1 million, or 4.8%, to $3.3 million during the nine months ended September 30, 2009, from $3.2 million for the nine months ended September 30, 2008. This increase was a result of recent equity grants, offset by the effect of the decreased fair value of stock options granted in recent years.

Cost of Legal Collections

The cost of legal collections increased $0.7 million, or 2.8%, to $26.1 million during the three months ended September 30, 2009, compared to $25.4 million during the three months ended September 30, 2008. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in the cost of legal collections was primarily the result of an increase of $5.8 million, or 11.7%, in gross collections through our legal channel, offset by decreased upfront litigation costs. Gross legal collections amounted to $55.6 million during the three months ended September 30, 2009, up from $49.8 million collected during the three months ended September 30, 2008. The cost of legal collections decreased as a percent of gross collections through this channel to 46.9% during the three months ended September 30, 2009, from 51.0% during the three months ended September 30, 2008, primarily due to the improvement in our ability to identify accounts that are more likely to result in collections through the legal channel, resulting in decreased court cost expense.

The cost of legal collections increased $15.2 million, or 21.8%, to $84.7 million during the nine months ended September 30, 2009, compared to $69.5 million during the nine months ended September 30, 2008. These costs represent contingent fees paid to our nationwide network of attorneys and costs of litigation. The increase in the cost of legal collections was primarily the result of an increase of $29.2 million, or 20.3%, in gross collections through our legal channel and upfront litigation costs. Gross legal collections amounted to $173.5 million during the nine months ended September 30, 2009, compared to $144.2 million collected during the nine months ended September 30, 2008. The cost of legal collections as a percent of gross collections through this channel increased to 48.8% during the nine months ended September 30, 2009, from 48.2% during the nine months ended September 30, 2008, due to an increase in upfront court cost expensed, as a percentage of collections, (and an increase in total dollars expensed) associated with our pursuit of legal collections.

 

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Table of Contents

The following table summarizes our external collection channel performance and related direct costs (in thousands, except percentages):

 

     Legal Collections and related costs
Three Months Ended September 30,
    Legal Collections and related costs
Nine Months Ended September 30,
 
     2009     2008     2009     2008  

Collections

   $ 55,584      100.0   $ 49,765      100.0   $ 173,451      100.0   $ 144,241      100.0

Court costs advanced

     14,038      25.3     16,860      33.9     50,390      29.0     46,033      31.9

Court costs deferred

     (6,056   (10.9 )%      (6,500   (13.1 )%      (18,552   (10.7 )%      (19,656   (13.6 )% 

Deferred court costs reversal(1)

     1,696      3.0     —        0.0     1,696      1.0     —        0.0
                                                        

Court cost expense(2)

     9,678      17.4     10,360      20.8     33,534      19.3     26,377      18.3

Other(3)

     590      1.0     578      1.2     1,618      0.9     1,711      1.2

Commissions

     15,824      28.5     14,452      29.0     49,512      28.6     41,437      28.7
                                                        

Total Costs

   $ 26,092      46.9   $ 25,390      51.0   $ 84,664      48.8   $ 69,525      48.2
                                                        

 

(1)

Primarily related to our arbitration settlement with Jefferson Capital in September 2009. As part of the settlement with Jefferson Capital, we returned accounts that were subject to Jefferson Capital’s settlement with the FTC. A portion of those accounts were in our legal channel and, when these were returned, resulted in the reversal of court costs previously deferred. See Note 10 to our unaudited condensed consolidated financial statements for further information.

 

(2)

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 be ultimately uncollectible. This amount includes changes in our anticipated recovery rate of court costs expensed.

 

(3)

Other costs consist of costs related to counter claims and legal network subscription fees.

Other Operating Expenses

Other operating expenses remained consistent at $6.0 million during the three months ended September 30, 2009 and 2008.

Other operating expenses increased $0.9 million, or 5.4%, to $18.6 million during the nine months ended September 30, 2009, from $17.7 million during the nine months ended September 30, 2008. The increase was primarily the result of an increase of $0.4 million in skip tracing expenses, an increase of $0.3 million in direct mail campaign expenses, an increase of $0.2 million in bank charges, an increase of $0.2 million in recruiting costs, and an increase of $0.2 million in telephone expenses. The increase was partially offset by a decrease of $0.4 million in credit report notification costs.

Collection Agency Commissions

During the three months ended September 30, 2009, we incurred $5.8 million in commissions to third party collection agencies, or 29.4% of the related gross collections of $19.7 million compared to $3.0 million in commissions, or 38.0% of the related gross collections of $7.9 million, during the three months ended September 30, 2008. The increase in commissions was due to the increase in collections through this channel, partially offset by a lower net commission rate. The decrease in the net commission rate as a percentage of the related gross collections was 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. Generally, freshly charged-off accounts have a lower commission rate than accounts that have been charged off for a longer period of time. During the three months ended September 30, 2009, the Company placed more freshly charged-off accounts with the agencies as compared to the same period in the prior year.

During the nine months ended September 30, 2009, we incurred $13.5 million in commissions to third party collection agencies, or 31.4% of the related gross collections of $42.9 million, compared to $10.8 million in commissions, or 37.5% of the related gross collections of $28.9 million, during the nine months ended September 30, 2008. The increase in commissions was due to the increase in collections through this channel, partially offset by a lower net commission rate. The decrease in the net commission rate as a percentage of the related gross collections was 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. Generally, freshly charged-off accounts have a lower commission rate than accounts that have been charged off for a longer period of time. During the nine months ended September 30, 2009, the Company placed more freshly charged-off accounts with the agencies as compared to the same period in the prior year.

 

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General and Administrative Expenses

General and administrative expenses increased $2.4 million, or 49.7%, to $7.3 million during the three months ended September 30, 2009, from $4.9 million during the three months ended September 30, 2008. The increase was primarily the result of an increase of $2.2 million in corporate legal expenses related primarily to our settled Jefferson Capital arbitration and an increase of $0.5 million in building rent, primarily in India where we have developed a larger site as described below under India Expansion. The increase was partially offset by a net decrease of $0.3 million in other general and administrative expenses.

General and administrative expenses increased $6.2 million, or 44.4%, to $20.1 million during the nine months ended September 30, 2009, from $13.9 million during the nine months ended September 30, 2008. The increase was primarily the result of an increase of $5.5 million in corporate legal expenses related primarily to our settled Jefferson Capital arbitration and an increase of $0.7 million in building rent.

Depreciation and Amortization

Depreciation and amortization expense remained consistent at $0.7 million during the three months ended September 30, 2009 and 2008.

Depreciation and amortization expense decreased $0.3 million, or 12.4%, to $1.9 million during the nine months ended September 30, 2009, from $2.2 million during the nine months ended September 30, 2008. Depreciation expense was $1.4 million for the nine months ended September 30, 2009, compared to $1.6 million for the nine months ended September 30, 2008. Amortization expense relating to intangible assets acquired in conjunction with the acquisition of Ascension was $0.5 million for the nine months ended September 30, 2009, compared to $0.6 million for the nine months ended September 30, 2008.

Cost per Dollar Collected

The following table summarizes our cost per dollar collected (in thousands, except percentages):

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2009     2008     2009     2008  

Gross collections

   $ 125,710      $ 97,777      $ 363,316      $ 304,262   

Operating expenses(1)

   $ 57,026      $ 51,041      $ 171,781      $ 149,382   

Cost per dollar collected

     45.4     52.2     47.3     49.1

 

(1)

Represent all operating expenses excluding stock-based compensation expense ($1.3 million and $0.9 million for the three months ended September 30, 2009 and 2008, and $3.3 million and $3.2 million for the nine months ended September 30, 2009 and 2008, respectively) and costs related to Ascension ($3.2 million and $3.9 million for the three months ended September 30, 2009 and 2008, and $10.1 million and $10.2 million for the nine months ended September 30, 2009 and 2008, respectively).

During the three months ended September 30, 2009, cost per dollar collected decreased to 45.4% of gross collections from 52.2% of gross collections during the three months ended September 30, 2008. This decrease was primarily due to several factors, including:

 

   

salaries and employee benefits, as a percentage of total collections, decreased to 9.9% from 13.1%, primarily due to a shift in our collection workforce from the United States to India and a change in our compensation plan structure

 

   

cost of legal collections, as a percentage of total collections, decreased from 26.0% to 20.8%, primarily due to a decrease in upfront court costs expensed, associated with our pursuit of legal collections. As discussed above, we continue to improve our ability to identify accounts that are more likely to result in collections through the legal channel and, as a result, court cost expense decreased during the three months ended September 30, 2009 when compared to the same period in 2008

 

   

the decrease was offset by increased general and administrative expenses, as a percentage of total collections. The increase in general and administrative expenses per dollar collected was primarily due to an increase of $2.2 million in corporate legal expenses related primarily to our settled Jefferson Capital arbitration

 

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During the nine months ended September 30, 2009, cost per dollar collected decreased to 47.3% of gross collections from 49.1% of gross collections during the nine months ended September 30, 2008. This decrease was primarily due to several factors, including:

 

   

salaries and employee benefits, as a percentage of total collections, decreased from 13.0% to 10.2%, primarily due to a shift in our collection workforce from the United States to India and a change in our compensation plan structure

 

   

the decrease was offset by increased general and administrative expenses, as a percentage of total collections. the increase in general and administrative expenses per dollar collected, was primarily due to an increase of $5.5 million in corporate legal expenses related primarily to our settled Jefferson Capital arbitration

India Expansion

Due to the strong performance of our team in India and our ability to reduce our overall site cost to collect through the expansion of our offshore collection efforts, on April 22, 2009, we signed a lease for a new, larger site in India. This facility, which is located in Gurgaon, India, will allow us to expand our collector headcount from approximately 350 (capacity at our previous site) to 1,100. Our India team relocated to this new site in September 2009. We have and will continue to incur lease costs at our previous and new sites from April 2009 through October 2009. This has and will result in incremental lease expense totaling approximately $1.0 million during that period. Additionally, we have and will continue to incur costs associated with expanding our workforce in India.

Our plan is to continue to maintain headcount at current levels in our domestic collection sites and focus our future growth on India. As we ramp up headcount in our new, larger India site and migrate more of our collections there, we expect that our overall variable cost to collect will increase and our overall collector productivity will decline. Once we are fully ramped up, we expect that this expansion will have a positive long-term impact on both our overall cost to collect and our productivity.

Interest Expense

Total interest expense decreased $1.1 million, or 22.8%, to $4.0 million during the three months ended September 30, 2009, from $5.1 million during the three months ended September 30, 2008.

Total interest expense decreased $3.0 million, or 19.6%, to $12.2 million during the nine months ended September 30, 2009, from $15.2 million during the nine months ended September 30, 2008.

The following tables summarize our interest expense (in thousands, except percentages):

 

     For the Three Months Ended September 30,  
     2009    2008    $ Change     % Change  
          Adjusted             

Stated interest on debt obligations

   $ 3,029    $ 3,498    $ (469   (13.4 )% 

Amortization of loan fees and other loan costs

     290      340      (50   14.7

Amortization of debt discount – convertible notes

     651      1,302      (651   (50.0 )% 
                        

Total interest expense

   $ 3,970    $ 5,140    $ (1,170   (22.8 )% 
                        
     For the Nine Months Ended September 30,  
     2009    2008    $ Change     % Change  
          Adjusted             

Stated interest on debt obligations

   $ 9,101    $ 10,420    $ (1,319   (12.7 )% 

Amortization of loan fees and other loan costs

     889      860      29      3.4

Amortization of debt discount – convertible notes

     2,211      3,891      (1,680   (43.2 )% 
                        

Total interest expense

   $ 12,201    $ 15,171    $ (2,970   (19.6 )% 
                        

Interest expense during the three and nine months ended September 30, 2008 was retrospectively adjusted as a result of a change in accounting principle. Effective January 1, 2009, we adopted the provisions of FASB ASC Subtopic 470-20 (“Subtopic 470-20”) “Debt with Conversion and Other Options” (prior authoritative literature: FASB Staff Position APB 14-1

 

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Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement”). In accordance with the provisions of Subtopic 470-20, we adjusted our prior years’ financial statements to separately account for the liability and equity components of our convertible senior notes in a manner that reflects our nonconvertible debt borrowing rate at the time of the issuance. As a result, we created a debt discount for our convertible senior notes and incurred additional interest expense due to the amortization of debt discount. See Note 12 to our unaudited condensed consolidated financial statements for a further discussion of this change in accounting principle.

The following table summarizes the impact of adopting Subtopic 470-20 on our interest expense, net debt balance and total stockholders’ equity related to our Convertible Notes during the previous reporting periods (in thousands):

 

     Interest Expense For the
Three Months ended
   Net Convertible Note
Balance
   Total Stockholders’ Equity
     As Previously
Reported
   As Adjusted    As Previously
Reported
   As Adjusted    As Previously
Reported
   As Adjusted

September 30, 2005

   $ 101    $ 230    $ 100,000    $ 73,347    $ 111,078    $ 137,211

December 31, 2005

     842      1,914      100,000      74,419      118,352      143,439

March 31, 2006

     857      1,912      100,000      75,474      125,890      149,948

June 30, 2006

     844      1,942      100,000      76,572      135,296      158,282

September 30, 2006

     844      1,963      100,000      77,691      142,561      164,454

December 31, 2006

     844      2,031      100,000      78,878      151,136      171,870

March 31, 2007

     844      2,011      100,000      80,045      158,137      177,730

June 30, 2007

     844      2,059      100,000      81,260      159,675      178,079

September 30, 2007

     844      2,081      100,000      82,497      166,042      183,235

December 31, 2007

     844      2,150      100,000      83,803      171,520      187,435

March 31, 2008

     844      2,143      100,000      85,102      179,804      194,446

June 30, 2008

     809      2,099      95,000      82,124      189,987      202,644

September 30, 2008

     801      2,103      95,000      83,426      195,248      206,628

December 31, 2008

     704      1,920      71,422      63,758      195,890      203,426

Stated interest on debt obligations decreased $0.5 million during the three months ended September 30, 2009, as compared to the same period in the prior year. Stated interest on debt obligations decreased $1.3 million during the nine months ended September 30, 2009, as compared to the same period in the prior year. The decreases in stated interest on debt obligations for the three and nine months ended September 30, 2009, were primarily due to decreases in our variable interest rate on our Revolving Credit Facility and decreased stated interest expense on our convertible senior notes due to a reduced principal balance as a result of buybacks of a portion of our convertible senior notes, offset by increases in amounts borrowed under our Revolving Credit Facility to fund our purchases of receivable portfolios, to fund our repurchases of a portion of our convertible senior notes and for general working capital needs.

Other Income and Expense

During the three months ended September 30, 2009, total other income was less than $0.1 million, compared to other expense of less than $0.1 million during the three months ended September 30, 2008.

During the nine months ended September 30, 2009, total other expense was less than $0.1 million, compared to other income of $0.3 million for the nine months ended September 30, 2008. The other income of $0.3 million during the nine months ended September 30, 2008, was primarily attributable to a $0.3 million gain recognized in connection with the early termination of a contract.

Provision for Income Taxes

During the three months ended September 30, 2009, we recorded an income tax provision of $5.9 million, reflecting an effective tax rate of 39.8% of pretax income. Our effective tax rate for the three months ended September 30, 2009, differed from the federal statutory rate, primarily due to the net effect of state taxes, the effect of permanent book versus tax differences and a state tax refund. Effective January 1, 2009, we retrospectively adjusted our prior years’ income tax provisions upon adoption of Subtopic 470-20. See interest expense above and Note 12 to our unaudited condensed consolidated financial statements for a further discussion of the change in accounting principle related to the adoption of Subtopic 470-20. The adjusted income tax provision for the three months ended September 30, 2008, was $2.4 million, which reflected an effective rate of 44.3% of pretax income. Our effective tax rate for the three months ended September 30, 2008, differed from the federal statutory rate, primarily due to the net effect of state taxes and the effect of permanent book versus tax differences.

 

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During the nine months ended September 30, 2009, we recorded an income tax provision of $16.1 million, reflecting an effective tax rate of 39.5% of pretax income. Our effective tax rate for the nine months ended September 30, 2009, differed from the federal statutory rate primarily due to the net effect of state taxes, the effect of permanent book verses tax differences and a state tax refund. For the nine months ended September 30, 2008, as a result of adopting Subtopic 470-20, we retrospectively adjusted our income tax provision to $11.1 million, reflecting an effective rate of 41.1% of pretax income. Our effective tax rate for the nine months ended September 30, 2008, differed from the federal statutory rate primarily due to the net effect of state taxes and the effect of permanent book versus tax differences. See Note 8 to the unaudited condensed consolidated financial statements for a further discussion of income taxes.

 

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Supplemental Performance Data

Cumulative Collections to Purchase Price Multiple

The following table summarizes our purchases and related gross collections by year of purchase (in thousands, except multiples):

 

    Cumulative Collections through September 30, 2009    

Year of
Purchase

  Purchase
Price(1)
    <2003   2003   2004   2005   2006   2007   2008   2009   Total(2)   CCM(3)
<2003      $ 195,661 (4)    $ 331,683   $ 126,730   $ 105,982   $ 74,843   $ 54,248   $ 24,055   $ 12,880   $ 6,507   $ 736,928   3.8
2003     88,505        —       59,038     86,958     69,932     55,131     26,653     13,897     6,375     317,984   3.6
2004     101,330        —       —       39,400     79,845     54,832     34,625     19,116     8,964     236,782   2.3
2005     192,591        —       —       —       66,491     129,809     109,078     67,346     34,259     406,983   2.1
2006     141,973        —       —       —       —       42,354     92,265     70,743     36,406     241,768   1.7
2007     204,318        —       —       —       —       —       68,048     145,272     89,091     302,411   1.5
2008     227,991        —       —       —       —       —       —       69,049     128,905     197,954   0.9
2009     215,015        —       —       —       —       —       —       —       52,523     52,523   0.2
                                                                 
Total   $ 1,367,384      $ 331,683   $ 185,768   $ 232,340   $ 291,111   $ 336,374   $ 354,724   $ 398,303   $ 363,030   $ 2,493,333   1.8
                                                                 

 

(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 September 30, 2009, excluding collections on behalf of others.

 

(3)

Cumulative Collections Multiple (“CCM”) through September 30, 2009 – collections as a multiple of purchase price.

 

(4)

From inception through December 31, 2002.

Total Estimated Collections to Purchase Price Multiple

The following table summarizes our purchases, resulting historical collections and estimated remaining gross collections, by year of purchase (in thousands, except multiples):

 

     Purchase Price(1)     Historical
Collections(2)
   Estimated
Remaining
Collections(3)
   Total Estimated
Gross Collections
   Total Estimated Gross
Collections to Purchase
Price
<2003    $ 195,661 (4)    $ 736,928    $ 728    $ 737,656    3.8
   2003      88,505        317,984      3,127      321,111    3.6
   2004      101,330        236,782      10,542      247,324    2.4
   2005      192,591        406,983      65,492      472,475    2.5
   2006      141,973        241,768      103,642      345,410    2.4
   2007      204,318        302,411      171,601      474,012    2.3
   2008      227,991        197,954      383,066      581,020    2.5
   2009      215,015        52,523      449,857      502,380    2.3
                                 
   Total    $ 1,367,384      $ 2,493,333    $ 1,188,055    $ 3,681,388    2.7
                                 

 

(1)

Adjusted for Put-Backs, Recalls, purchase price rescissions, and the impact of an acquisition in 2000.

 

(2)

Cumulative collections from inception through September 30, 2009, excluding collections on behalf of others.

 

(3)

Includes $0.5 million in expected collections for the healthcare portfolios on cost recovery.

 

(4)

From inception through December 31, 2002.

 

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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
     2009(2)    2010    2011    2012    2013    2014    2015    2016    Total
<2003(1)    $ 450    $ 225    $ 53    $ —      $ —      $ —      $ —      $ —      $ 728
   2003(1)      1,065      2,062      —        —        —        —        —        —        3,127

   2004

     2,236      6,262      2,044      —        —        —        —        —        10,542

   2005

     8,490      30,303      19,714      6,985      —        —        —        —        65,492

   2006

     9,159      37,088      27,550      20,050      9,795      —        —        —        103,642

   2007

     22,089      64,582      40,001      26,105      14,829      3,995      —        —        171,601

   2008

     36,428      137,884      89,175      56,592      35,939      20,092      6,956      —        383,066

   2009

     33,592      135,976      117,403      73,484      44,920      26,105      14,340      4,037      449,857
                                                              

   Total

   $ 113,509    $ 414,382    $ 295,940    $ 183,216    $ 105,483    $ 50,192    $ 21,296    $ 4,037    $ 1,188,055
                                                              

 

(1)

Estimated remaining collections for Zero Basis Portfolios can extend beyond the 84-month accrual basis collection forecast.

 

(2)

2009 amount consists of data for the three-month period from October 1, 2009 to December 31, 2009.

Unamortized Balances of Portfolios

The following table summarizes the remaining unamortized balances of our purchased receivable portfolios by year of purchase, as of September 30, 2009 (in thousands, except percentages):

 

     Unamortized Balance
as of

September 30, 2009(1)
   Purchase Price(2)    Unamortized Balance
as a Percentage of
Purchase Price
    Unamortized Balance
as a Percentage of
Total
 

2003

     967      88,505    1.1   0.2

2004

     5,688      101,330    5.6   1.1

2005

     33,805      192,591    17.6   6.3

2006

     46,932      141,973    33.1   8.8

2007

     79,562      204,318    38.9   14.8

2008

     170,640      227,991    74.8   31.9

2009

     197,062      215,015    91.7   36.9
                          

Total

   $ 534,656    $ 1,171,723    45.6   100.0
                          

 

(1)

Includes $0.5 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, plus an allocation of our forward flow asset (if applicable), and less the purchase price for accounts that were sold at the time of purchase to another debt purchaser.

Changes in 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 Three Months Ended September 30, 2009  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 506,155      $ 553      $ —       $ 506,708   

Purchases of receivable portfolios

     77,734              —         77,734   

Gross collections(1)

     (123,498     (25     (2,113     (125,636

Put-backs and recalls

     (598     —         —         (598

Revenue recognized

     78,680        —         2,100        80,780   

(Impairment) impairment reversals, net

     (4,345     —         13        (4,332
                                

Balance, end of period

   $ 534,128      $ 528      $ —       $ 534,656   
                                

Revenue as a percentage of collections(2)

     63.7     0.0     99.4     64.3
                                
     For the Three Months Ended September 30, 2008  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 413,256      $ 1,303      $ —        $ 414,559   

Purchases of receivable portfolios

     66,107        —          —          66,107   

Gross collections(1)

     (95,349     (89     (2,259     (97,697

Put-backs and recalls

     (562     (1     —          (563

Revenue recognized(3)

     67,566        —          2,259        69,825   

Impairment, net(3)

     (7,268     —          —          (7,268
                                

Balance, end of period

   $ 443,750      $ 1,213      $ —        $ 444,963   
                                

Revenue as a percentage of collections(2)

     70.9     0.0     100.0     71.5
                                
     For the Nine Months Ended September 30, 2009  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 460,598      $ 748      $ —       $ 461,346   

Purchases of receivable portfolios

     215,680        —         —         215,680   

Gross collections(1)

     (355,812     (220     (6,998     (363,030

Put-backs and recalls

     (2,024     —         (4     (2,028

Revenue recognized

     230,054        —         6,957        237,011   

(Impairment) impairment reversals, net

     (14,368     —         45        (14,323
                                

Balance, end of period

   $ 534,128      $ 528      $ —       $ 534,656   
                                

Revenue as a percentage of collections(2)

     64.7     0.0     99.4     65.3
                                
     For the Nine Months Ended September 30, 2008  
     Accrual Basis
Portfolios
    Cost Recovery
Portfolios
    Zero Basis
Portfolios
    Total  

Balance, beginning of period

   $ 390,564      $ 1,645      $ —        $ 392,209   

Purchases of receivable portfolios

     166,501        —          —          166,501   

Gross collections(1)

     (296,178     (419     (7,440     (304,037

Put-backs and recalls

     (2,597     (13     —          (2,610

Revenue recognized(3)

     201,453        —          7,440        208,893   

Impairment, net(3)

     (15,993     —          —          (15,993
                                

Balance, end of period

   $ 443,750      $ 1,213      $ —        $ 444,963   
                                

Revenue as a percentage of collections(2)

     68.0     0.0     100.0     68.7
                                

 

(1)

Does not include amounts collected on behalf of others.

 

(2)

Revenue as a percentage of collections excludes the effects of net impairment or net impairment reversals.

 

(3)

Reflects additional revenue of $0.1 million and a lower net impairment of $3.1 million, as a result of extending the collection curves from 72 to 84 months.

 

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Table of Contents

As of September 30, 2009, we had $534.7 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

2009(1)

     33,263

2010

     157,103

2011

     138,529

2012

     94,148

2013

     60,585

2014

     31,796

2015

     15,611

2016

     3,621
      

Total

   $ 534,656
      

 

(1)

2009 amount consists of data for the three-month period from October 1, 2009 to December 31, 2009.

Analysis of Changes in Revenue

The following tables analyze the components of the increase in revenue from our receivable portfolios for the three and nine months ended September 30, 2009, compared to the three and nine months ended September 30, 2008 (in thousands, except percentages):

 

     For The Three Months Ended September 30,  

Variance Component

   2009     2008     Change     Revenue
Variance
 

Average portfolio balance

   $ 499,104      $ 407,153      $ 91,951      $ 15,259   

Weighted average effective interest rate(1)

     63.1     66.4     (3.3 )%      (4,145