10-Q 1 ten-q.txt 10-Q 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 March 31, 2004, or / / Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from to -------------------------------------------------------------------------------- COMMISSION FILE NUMBER 0-21639 -------------------------------------------------------------------------------- NCO GROUP, INC. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) PENNSYLVANIA 23-2858652 -------------------------------------------------------------------------------- (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization) 507 Prudential Road, Horsham, Pennsylvania 19044 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) 215-441-3000 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) Not Applicable -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No --- --- The number of shares outstanding of each of the issuer's classes of common stock as of May 6, 2004 was: 31,472,272 shares of common stock, no par value. NCO GROUP, INC. INDEX PAGE PART I - FINANCIAL INFORMATION Item 1 FINANCIAL STATEMENTS (Unaudited) Condensed Consolidated Balance Sheets - December 31, 2003 and March 31, 2004 1 Condensed Consolidated Statements of Income - Three months ended March 31, 2003 and 2004 2 Condensed Consolidated Statements of Cash Flows - Three months ended March 31, 2003 and 2004 3 Notes to Condensed Consolidated Financial Statements 4 Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 19 Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 25 Item 4 CONTROLS AND PROCEDURES 25 PART II - OTHER INFORMATION 26 Item 1. LEGAL PROCEEDINGS Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES Item 3. DEFAULTS UPON SENIOR SECURITIES Item 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS Item 5. OTHER INFORMATION Item 6. EXHIBITS AND REPORTS ON FORM 8-K SIGNATURES 29 PART 1 - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS
NCO GROUP, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (AMOUNTS IN THOUSANDS) MARCH 31, DECEMBER 31, 2004 ASSETS 2003 (UNAUDITED) ------------ ----------- Current assets: Cash and cash equivalents $ 45,644 $ 64,010 Restricted cash 5,850 1,382 Accounts receivable, trade, net of allowance for doubtful accounts of $7,447 and $8,287, respectively 80,640 86,457 Purchased accounts receivable, current portion 59,371 51,244 Deferred income taxes 12,280 12,163 Bonus receivable, current portion 7,646 10,609 Prepaid expenses and other current assets 18,021 14,708 -------- -------- Total current assets 229,452 240,573 Funds held on behalf of clients Property and equipment, net 74,085 74,848 Other assets: Goodwill 506,370 520,710 Other intangibles, net of accumulated amortization 12,375 11,269 Purchased accounts receivable, net of current portion 93,242 87,604 Bonus receivable, net of current portion 320 1,407 Other assets 30,267 31,473 -------- -------- Total other assets 642,574 652,463 -------- -------- Total assets $946,111 $967,884 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Long-term debt, current portion $ 66,523 $ 65,966 Income taxes payable - 2,691 Accounts payable 4,281 5,235 Accrued expenses 25,901 30,579 Accrued compensation and related expenses 15,601 17,773 Deferred revenue, current portion 10,737 14,346 -------- -------- Total current liabilities 123,043 136,590 Funds held on behalf of clients Long-term liabilities: Long-term debt, net of current portion 248,964 231,140 Deferred revenue, net of current portion 13,819 12,622 Deferred income taxes 38,676 39,867 Other long-term liabilities 4,344 4,231 Minority interest 26,848 - Shareholders' equity: Preferred stock, no par value, 5,000 shares authorized, no shares issued and outstanding - - Common stock, no par value, 50,000 shares authorized, 25,988 and 27,866 shares issued and outstanding, respectively 323,511 364,916 Other comprehensive income 6,646 6,275 Retained earnings 160,260 172,243 -------- -------- Total shareholders' equity 490,417 543,434 -------- -------- Total liabilities and shareholders' equity $946,111 $967,884 ======== ========
See accompanying notes. -1-
NCO GROUP, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA) FOR THE THREE MONTHS ENDED MARCH 31, --------------------------- 2003 2004 -------- -------- Revenue $189,017 $201,231 Operating costs and expenses: Payroll and related expenses 88,298 91,039 Selling, general and administrative expenses 68,958 76,645 Depreciation and amortization expense 7,856 7,778 -------- -------- Total operating costs and expenses 165,112 175,462 -------- -------- Income from operations 23,905 25,769 Other income (expense): Interest and investment income 836 996 Interest expense (5,819) (5,288) -------- -------- Total other income (expense) (4,983) (4,292) -------- -------- Income before income tax expense 18,922 21,477 Income tax expense 7,179 8,888 -------- -------- Income before minority interest 11,743 12,589 Minority interest (551) (606) -------- -------- Net income $ 11,192 $ 11,983 ======== ======== Net income per share: Basic $ 0.43 $ 0.46 Diluted $ 0.41 $ 0.43 Weighted average shares outstanding: Basic 25,908 26,125 Diluted 29,718 30,234
See accompanying notes. -2-
NCO GROUP, INC CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (AMOUNTS IN THOUSANDS) FOR THE THREE MONTHS ENDED MARCH 31, --------------------------- 2003 2004 -------- -------- Cash flows from operating activities: Net income $ 11,192 $ 11,983 Adjustments to reconcile income from operations to net cash provided by operating activities: Depreciation 6,658 6,669 Amortization of intangibles 1,198 1,109 Provision for doubtful accounts 1,345 1,269 Impairment of purchased accounts receivable 330 388 Accrued noncash interest 882 1,456 Gain on disposal of property and equipment - 38 Changes in non-operating income - (594) Minority interest 551 606 Changes in operating assets and liabilities, net of acquisitions: Restricted cash - 4,468 Accounts receivable, trade (8,626) (7,049) Deferred income taxes 2,819 1,481 Bonus receivable (2,980) (4,050) Other assets (3,362) 351 Accounts payable and accrued expenses 806 7,478 Income taxes payable 2,809 6,178 Deferred revenue 4,020 2,412 Other long-term liabilities (321) (714) -------- -------- Net cash provided by operating activities 17,321 33,479 Cash flows from investing activities: Purchases of accounts receivable (16,870) (6,586) Collections applied to principal of purchased accounts receivable 19,109 22,110 Purchases of property and equipment (5,506) (7,485) Net distribution from joint venture - 55 Proceeds from notes receivable - 305 Net cash paid for acquisitions and related costs - (2,552) -------- -------- Net cash (used in) provided by investing activities (3,267) 5,847 Cash flows from financing activities: Repayment of notes payable (6,717) (11,239) Borrowings under notes payable 6,054 - Borrowings under revolving credit agreement 1,000 - Repayment of borrowings under revolving credit agreement (9,130) (11,250) Payment of fees to acquire debt (15) (4) Issuance of common stock, net - 1,445 -------- -------- Net cash used in financing activities (8,808) (21,048) Effect of exchange rate on cash 287 88 -------- -------- Net increase in cash and cash equivalents 5,533 18,366 Cash and cash equivalents at beginning of the period 25,159 45,644 -------- -------- Cash and cash equivalents at end of the period $ 30,692 $ 64,010 ======== ========
See accompanying notes. -3- NCO GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. NATURE OF OPERATIONS: NCO Group, Inc. (the "Company" or "NCO") is a leading provider of accounts receivable management and collection services. The Company also purchases and manages past due consumer accounts receivable from consumer creditors such as banks, finance companies, retail merchants, and other consumer-oriented companies. The Company's client base includes companies in the financial services, healthcare, retail and commercial, telecommunications, utilities, education, and government sectors. These clients are primarily located throughout the United States of America, Canada, the United Kingdom, and Puerto Rico. The Company's largest client is in the financial services sector and represented 13.3 percent of the consolidated revenue for the three months ended March 31, 2004. 2. ACCOUNTING POLICIES: Interim Financial Information: The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of only normal recurring accruals) considered necessary for a fair presentation have been included. Because of the seasonal nature of the Company's business, operating results for the three-month period ended March 31, 2004, are not necessarily indicative of the results that may be expected for the year ending December 31, 2004, or for any other interim period. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2004. Principles of Consolidation: The condensed consolidated financial statements include the accounts of the Company and all affiliated subsidiaries and entities controlled by the Company. All significant intercompany accounts and transactions have been eliminated. The Company does not control InoVision-MEDCLR NCOP Ventures, LLC (see note 13) and, accordingly, its financial condition and results of operations are not consolidated with the Company's financial statements. Revenue Recognition: Contingency Fees: Contingency fee revenue is recognized upon collection of funds on behalf of clients. Contractual Services: Fees for contractual services are recognized as services are performed and accepted by the client. -4- 2. ACCOUNTING POLICIES (CONTINUED): Revenue Recognition (continued): Long-Term Collection Contract: The Company has a long-term collection contract with a large client to provide collection services that includes guaranteed collections, subject to limits. The Company also earns a bonus to the extent collections are in excess of the guarantees. The Company is required to pay the client, subject to limits, if collections do not reach the guarantees. Any guarantees in excess of the limits will only be satisfied with future collections. The Company is entitled to recoup at least 90 percent of any such guarantee payments from subsequent collections in excess of any remaining guarantees. The Company defers all of the base service fees, subject to the limits, until the collections exceed the collection guarantees. At the end of each reporting period, the Company assesses the need to record an additional liability if deferred fees are less than the estimated guarantee payments, if any, due to the client, subject to the limits. There was no additional liability recorded as of December 31, 2003 and March 31, 2004. Purchased Accounts Receivable: The Company accounts for its investment in purchased accounts receivable on an accrual basis under the guidance of American Institute of Certified Public Accountants' Practice Bulletin 6, "Amortization of Discounts on Certain Acquired Loans," using unique and exclusive portfolios. Portfolios are established with accounts having similar attributes. Typically, each portfolio consists of an individual acquisition of accounts that are initially recorded at cost, which includes external costs of acquiring portfolios. Once a portfolio is acquired, the accounts in the portfolio are not changed. Proceeds from the sale of accounts and return of accounts within a portfolio are accounted for as collections in that portfolio. The discount between the cost of each portfolio and the face value of the portfolio is not recorded since the Company expects to collect a relatively small percentage of each portfolio's face value. Collections on the portfolios are allocated to revenue and principal reduction based on the estimated internal rate of return ("IRR") for each portfolio. The IRR for each portfolio is derived based on the expected monthly collections over the estimated economic life of each portfolio (generally five years, based on the Company's collection experience), compared to the original purchase price. Revenue on purchased accounts receivable is recorded monthly based on applying each portfolio's effective IRR for the quarter to its carrying value. To the extent collections exceed the revenue, the carrying value is reduced and the reduction is recorded as collections applied to principal. Because the IRR reflects collections for the entire economic life of the portfolio, and those collections are not constant, lower collection rates, typically in the early months of ownership, can result in a situation where the actual collections are less than the revenue accrual. In this situation, the carrying value of the portfolio may be increased by the difference between the revenue accrual and collections. To the extent actual collections differ from estimated projections, the Company prospectively adjusts the IRR. If the carrying value of a particular portfolio exceeds its expected future collections, a charge to income would be recognized in the amount of such impairment. Additional impairments on each quarter's previously impaired portfolios may occur if the current estimated future cash flow projection, after being adjusted prospectively for actual collection results, is less than the current carrying value recorded. After the impairment of a portfolio, all collections are recorded as a return of capital and no income is recorded on that portfolio until the full carrying value of the portfolio has been recovered. Once the full cost of the carrying value has been recovered, all collections are recorded as revenue. The estimated IRR for each portfolio is based on estimates of future collections, and actual collections will vary from current estimates. The difference could be material. -5- 2. ACCOUNTING POLICIES (CONTINUED): Credit Policy: The Company has two types of arrangements under which it collects its contingent fee revenue. For certain clients, the Company remits funds collected on behalf of the client net of the related contingent fees while, for other clients, the Company remits gross funds collected on behalf of clients and bills the client separately for its contingent fees. Management carefully monitors its client relationships in order to minimize the Company's credit risk and maintains a reserve for potential collection losses when such losses are deemed to be probable. The Company generally does not require collateral and it does not charge finance fees on outstanding trade receivables. In many cases, in the event of collection delays from clients, management may, at its discretion, change from the gross remittance method to the net remittance method. Trade accounts receivable are written off to the allowance for doubtful accounts when collection appears highly unlikely. Goodwill: Goodwill represents the excess of purchase price over the fair market value of the net assets of the acquired businesses based on their respective fair values at the date of acquisition. The Company accounts for goodwill pursuant to Statement of Financial Accounting Standard No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). Under SFAS 142, goodwill is no longer amortized but instead must be tested for impairment at least annually and as triggering events occur, including an initial test that was completed in connection with the adoption of SFAS 142. The test for impairment uses a fair-value based approach, whereby if the implied fair value of a reporting unit's goodwill is less than its carrying amount, goodwill would be considered impaired. Fair value estimates are based upon the discounted value of estimated cash flows. The Company did not incur any impairment charges in connection with the adoption of SFAS 142 or the subsequent annual impairment tests, and does not believe that goodwill is impaired as of March 31, 2004. The annual impairment analysis is completed on October 1st of each year (see note 7). Other Intangible Assets: Other intangible assets consist primarily of customer lists and deferred financing costs, which relate to debt issuance costs incurred. Customer lists are amortized over five years and deferred financing costs are amortized over the term of the debt (see note 7). -6- 2. ACCOUNTING POLICIES (CONTINUED): Stock Options: The Company accounts for stock option grants in accordance with APB Opinion 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations. Under APB 25, because the exercise price of the stock options equaled the fair value of the underlying common stock on the date of grant, no compensation cost was recognized. In accordance with SFAS 123, "Accounting for Stock-Based Compensation," the Company does not recognize compensation cost based on the fair value of the options granted at the grant date. If the Company had elected to recognize compensation cost based on the fair value of the options granted at the grant date, net income and net income per share would have been reduced to the pro forma amounts indicated in the following table (amounts in thousands, except per share amounts): For the Three Months Ended March 31, ------------------ 2003 2004 ------- ------- Net income - as reported $11,192 $11,983 Pro forma compensation cost, net of taxes 986 846 ------- ------- Net income - pro forma $10,206 $11,137 ======= ======= Net income per share - as reported: Basic $ 0.43 $ 0.46 Diluted $ 0.41 $ 0.43 Net income per share - pro forma: Basic $ 0.39 $ 0.43 Diluted $ 0.37 $ 0.40 Income Taxes: The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," which requires that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance, if it is more likely than not that some portion or all of the deferred tax asset will not be realized. Deferred taxes have not been provided on the cumulative undistributed earnings of foreign subsidiaries because such amounts are expected to be reinvested indefinitely. Use of Estimates: 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 amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. In the ordinary course of accounting for the long-term collection contract, estimates are made by management as to the payments due to the client. Actual results could differ from those estimates and a material change could occur within one reporting period. In the ordinary course of accounting for purchased accounts receivable, estimates are made by management as to the amount and timing of future cash flows expected from each portfolio. The estimated future cash flow of each portfolio is used to compute the IRR for the portfolio and any impairment. The IRR is used to allocate collections between revenue and principal reduction of the carrying values of the purchased accounts receivable. -7- 2. ACCOUNTING POLICIES (CONTINUED): Use of Estimates (continued): On an ongoing basis, the Company compares the historical trends of each portfolio to projected collections. Future projected collections are then increased within preset limits or decreased based on the actual cumulative performance of each portfolio. Management reviews each portfolio's adjusted projected collections to determine if further upward or downward adjustment is warranted. Management regularly reviews the trends in collection patterns and uses its best efforts to improve the collections of under-performing portfolios. However, actual results will differ from these estimates and a material change in these estimates could occur within one reporting period (see note 5). Reclassifications: Certain amounts for the three months ended March 31, 2003 have been reclassified for comparative purposes. 3. BUSINESS COMBINATIONS: The following acquisition has been accounted for under the purchase method of accounting. As part of the purchase accounting, the Company recorded accruals for acquisition-related expenses. These accruals included professional fees and other costs related to the acquisition. On March 26, 2004, the Company completed the merger of NCO Portfolio Management, Inc., referred to as NCO Portfolio, with a wholly owned subsidiary of the Company. The Company owned approximately 63.3 percent of the outstanding stock of NCO Portfolio prior to the merger and pursuant to the merger acquired all NCO Portfolio shares that it did not own for 1.8 million shares of NCO common stock valued at $39.9 million. The value of the stock issued was based on the average closing price of the Company's common stock for the period beginning two days before and ending two days after the announcement of the merger on December 15, 2003. The Company recorded goodwill of $14.8 million. The goodwill is not deductible for tax purposes. The allocation of the fair market value to the acquired assets and liabilities of NCO Portfolio was based on preliminary estimates and may be subject to change. As a result of the acquisition, the Company expects to expand its portfolio base and reduce the cost of operations through economies of scale. Therefore, the Company believes the allocation of a portion of the purchase price to goodwill is appropriate. The following is a preliminary allocation of the net purchased assets of the minority interest of NCO Portfolio (amounts in thousands): As of March 26, 2004 -------------- Purchase price $ 39,808 Transaction costs 2,136 Fair value adjustment to purchased accounts receivable 288 Minority interest (27,454) -------- Goodwill $ 14,778 ======== -8- 3. BUSINESS COMBINATIONS (CONTINUED): The following summarizes the unaudited pro forma results of operations, assuming the NCO Portfolio merger occurred as of the beginning of the respective periods. The pro forma information is provided for informational purposes only. It is based on historical information, and does not necessarily reflect the actual results that would have occurred, nor is it indicative of future results of operations of the consolidated entities (amounts in thousands, except per share data): For the Three Months Ended March 31, -------------------- 2003 2004 -------- -------- Revenue $189,017 $201,231 Net income $ 11,743 $ 12,589 Earnings per share - basic $ 0.42 $ 0.45 Earnings per share - diluted $ 0.40 $ 0.42 4. COMPREHENSIVE INCOME: Comprehensive income consists of net income from operations, plus certain changes in assets and liabilities that are not included in net income but are reported as a separate component of shareholders' equity. The Company's comprehensive income was as follows (amounts in thousands): For the Three Months Ended March 31, ------------------- 2003 2004 ------- ------- Net income $11,192 $11,983 Other comprehensive income (expense): Foreign currency translation adjustment 2,869 (371) Unrealized gain on interest rate swap 168 - ------- ------- Comprehensive income $14,229 $11,612 ======= ======= The foreign currency translation adjustment was attributable to changes in the exchange rates used to translate the financial statements of the Canadian and United Kingdom subsidiaries into U.S. dollars. -9- 5. PURCHASED ACCOUNTS RECEIVABLE: The Company's Portfolio Management and International Operations divisions purchase defaulted consumer accounts receivable at a discount from the actual principal balance. On certain international portfolios, Portfolio Management and International Operations jointly purchase defaulted consumer accounts receivable. The following summarizes the change in purchased accounts receivable (amounts in thousands):
For the Three For the Year Ended Months Ended December 31, 2003 March 31, 2004 ------------------- ------------------ Balance at beginning of period $ 152,448 $ 152,613 Purchases of accounts receivable 74,299 8,989 Collections on purchased accounts receivable (154,121) (44,008) Revenue recognized 76,735 21,898 Impairment of purchased accounts receivable (1,751) (388) Residual purchased accounts receivable from previously unconsolidated subsidiary 4,515 - Noncash purchase accounting adjustment - (187) Foreign currency translation adjustment 488 (69) --------- --------- Balance at end of period $ 152,613 $ 138,848 ========= =========
During the three months ended March 31, 2003 and 2004, impairment charges of $330,000 and $388,000, respectively, were recorded as charges to income on portfolios where the carrying values exceeded the expected future cash flows. As of December 31, 2003 and March 31, 2004, the combined carrying values on all impaired portfolios aggregated $11.4 million and $7.7 million, respectively, or 7.5 percent and 5.5 percent of total purchased accounts receivable, respectively, representing their net realizable value. As of December 31, 2003 and March 31, 2004, one portfolio with a carrying value of $4.2 million and $3.2 million, respectively, which was acquired in connection with the dissolution of an off-balance sheet securitization, was also being accounted for under the cost recovery method. Included in collections for the three months ended March 31, 2003 was $1.5 million in proceeds from the sale of accounts. There were no sales proceeds included in collections for the three months ended March 31, 2004. 6. FUNDS HELD ON BEHALF OF CLIENTS: In the course of the Company's regular business activities as a provider of accounts receivable management services, the Company receives clients' funds arising from the collection of accounts placed with the Company. These funds are placed in segregated cash accounts and are generally remitted to clients within 30 days. Funds held on behalf of clients of $59.3 million and $74.3 million at December 31, 2003 and March 31, 2004, respectively, have been shown net of their offsetting liability for financial statement presentation. -10- 7. INTANGIBLE ASSETS: Goodwill: SFAS 142 requires goodwill to be allocated and tested at the reporting unit level. The Company's reporting units under SFAS 142 are U.S. Operations, Portfolio Management and International Operations, and had the following goodwill (amounts in thousands): December 31, 2003 March 31, 2004 --------------------- ------------------- U.S. Operations $ 471,558 $ 471,558 Portfolio Management - 14,778 International Operations 34,812 34,374 --------- --------- Total $ 506,370 $ 520,710 ========= ========= Portfolio Management's goodwill resulted from the purchase of the minority interest of NCO Portfolio (see note 3). The change in International Operations' goodwill balance from December 31, 2003 to March 31, 2004 was due to changes in the exchange rates used for the foreign currency translation. Other Intangible Assets: Other intangible assets consist primarily of deferred financing costs and customer lists. The following represents the other intangible assets (amounts in thousands):
December 31, 2003 March 31, 2004 ---------------------------------- --------------------------------- Gross Carrying Accumulated Gross Carrying Accumulated Amount Amortization Amount Amortization ----------------- --------------- ---------------- --------------- Deferred financing costs $ 15,321 $ 9,687 $ 15,325 $ 10,327 Customer lists 8,761 2,104 8,761 2,542 Other intangible assets 900 816 900 848 -------- -------- -------- -------- Total $ 24,982 $ 12,607 $ 24,986 $ 13,717 ======== ======== ======== ========
The Company recorded amortization expense for all other intangible assets of $1.2 million and $1.1 million during the three months ended March 31, 2003 and 2004, respectively. The following represents the Company's expected amortization expense from these other intangible assets over the next five years (amounts in thousands): For the Years Ended Estimated December 31, Amortization Expense ----------------------- ----------------------- 2004 $ 4,381 2005 4,255 2006 2,341 2007 1,402 -11- 8. LONG-TERM DEBT: Long-term debt consisted of the following (amounts in thousands):
December 31, 2003 March 31, 2004 ----------------- -------------- Credit facility $132,500 $121,250 Convertible notes 125,000 125,000 Securitized nonrecourse debt 33,210 28,225 Other nonrecourse debt 17,591 14,452 Capital leases and other 7,186 8,179 Less current portion (66,523) (65,966) -------- -------- $248,964 231,140 ======== ========
Credit Facility: On August 13, 2003, the Company amended its credit agreement with Citizens Bank of Pennsylvania ("Citizens Bank"), for itself and as administrative agent for other participating lenders. The amendment extended the maturity date from May 20, 2004 to March 15, 2006 (the "Maturity Date"). The amended credit facility is structured as a $150 million term loan and a $50 million revolving credit facility. The Company is required to make quarterly repayments of $6.3 million on the term loan until the Maturity Date. The remaining balance outstanding under the term loan and the balance under the revolving credit facility will become due on the Maturity Date. The availability of the revolving credit facility is reduced by any unused letters of credit. As of March 31, 2004, the Company had unused letters of credit of $2.1 million and $47.9 million remaining availability under the revolving credit facility. Prior to February 28, 2004, all borrowings carried interest at a rate equal to either, at the option of the Company, Citizens Bank's prime rate plus a margin of 1.25 percent (Citizens Bank's prime rate was 4.00 percent at March 31, 2004), or the London InterBank Offered Rate ("LIBOR") plus a margin of 3.00 (LIBOR was 1.09 percent at March 31, 2004). After February 28, 2004, all borrowings carried interest at a rate equal to either, at the option of the Company, Citizens Bank's prime rate plus a margin of 0.75 percent to 1.25 percent, which is determined quarterly based upon the Company's consolidated funded debt to earnings before interest, taxes, depreciation, and amortization ("EBITDA") ratio, or LIBOR plus a margin of 2.25 percent to 3.00 percent depending on the Company's consolidated funded debt to EBITDA ratio. The Company is charged a fee on the unused portion of the credit facility of 0.50 percent until February 28, 2004, and ranging from 0.38 percent to 0.50 percent depending on the Company's consolidated funded debt to EBITDA ratio after February 28, 2004. The effective interest rate on credit facility was approximately 4.44 percent and 3.99 percent for the three months ended March 31, 2003 and 2004. Borrowings under the credit agreement are collateralized by substantially all the assets of the Company. The credit agreement contains certain financial covenants such as maintaining net worth and funded debt to EBITDA requirements, and includes restrictions on, among other things, acquisitions, the incurrence of additional debt, the issuance of equity, and distributions to shareholders. If an event of default, such as failure to perform covenants, material adverse change, or change of control, were to occur under the credit agreement, the lenders would be entitled to declare all amounts outstanding under it immediately due and payable and foreclose on the pledged assets. As of March 31, 2004, the Company was in compliance with all required financial covenants and the Company was not aware of any events of default. Convertible Debt: In April 2001, the Company completed the sale of $125.0 million aggregate principal amount of 4.75 percent Convertible Subordinated Notes due 2006 ("Notes") in a private placement pursuant to Rule 144A and Regulation S under the Securities Act of 1933. The Notes are convertible into NCO common stock at an initial conversion price of $32.92 per share. The Company will be required to repay the $125.0 million of aggregate principal if the Notes are not converted prior to their maturity in April 2006. -12- 8. LONG-TERM DEBT (CONTINUED): Securitized Nonrecourse Debt: NCO Portfolio has two securitized nonrecourse notes that are reflected in long-term debt, current portion. These notes were originally established to fund the purchase of accounts receivable. Each of the notes payable is nonrecourse to the Company, is secured by a portfolio of purchased accounts receivable, and is bound by an indenture and servicing agreement. The Company is servicer for each portfolio of purchased accounts receivable within these securitized notes. These are term notes without the ability to re-borrow. Monthly principal payments on the notes equal all collections after servicing fees, collection costs, interest expense, and administrative fees. The first securitized note was established in September 1998 through a special purpose finance subsidiary. This note carries a floating interest rate of LIBOR plus 0.65 percent per annum. The final due date of all payments under the facility is the earlier of March 2005, or satisfaction of the note from collections. A liquidity reserve of $5.4 million and $900,000 was included in restricted cash as of December 31, 2003 and March 31, 2004, respectively. As of December 31, 2003 and March 31, 2004, the amount outstanding on the facility was $13.9 million and $9.1 million, respectively. The note issuer was guaranteed against loss by NCO Portfolio for up to $4.5 million. In December 2003, the $4.5 million guarantee was funded using $3.3 million of restricted cash from another securitization and $1.2 million of operating cash. In January 2004, the $4.5 million from the guarantee was used to pay down a portion of the securitized note. The second securitized note was established in August 1999 and carries interest at 15.00 percent per annum. The final due date of all payments under the facility is the earlier of December 2004, or satisfaction of the note from collections. As of December 31, 2003 and March 31, 2004, the amount outstanding on the facility was $19.3 million and $19.1 million, respectively. Other Nonrecourse Debt: In August 2002, NCO Portfolio entered into a four-year exclusivity agreement with CFSC Capital Corp. XXXIV ("Cargill"). The agreement stipulates that all purchases of accounts receivable by NCO Portfolio with a purchase price in excess of $4.0 million must be first offered to Cargill for financing at its discretion. The agreement has no minimum or maximum credit authorization. NCO Portfolio may terminate the agreement at any time after August 2004 for a cost of $125,000 per month for each remaining month. If Cargill chooses to participate in the financing of a portfolio of accounts receivable, the financing will be at 90 percent of the purchase price, unless otherwise negotiated, with floating interest at the prime rate plus 3.25 percent (prime rate was 4.00 percent at March 31, 2004). Each borrowing is due two years after the loan is made. Debt service payments equal collections less servicing fees and interest expense. As additional interest, Cargill will receive 40 percent of the residual cash flow, unless otherwise negotiated, which is defined as all cash collections after servicing fees, floating rate interest, repayment of the note, and the initial investment by NCO Portfolio, including imputed interest. The effective interest rate on these notes, including the residual interest component was approximately 24.6 percent and 34.8 percent for the three months ended March 31, 2003 and 2004, respectively. Borrowings under this financing agreement are nonrecourse to the Company, except for the assets within the special purpose entities established in connection with the financing agreement. This loan agreement contains a collections performance requirement, among other covenants, that, if not met, provides for cross-collateralization with any other Cargill financed portfolios, in addition to other remedies. Total debt outstanding under this facility was $17.6 million and $14.5 million as of December 31, 2003 and March 31, 2004, respectively, which included $4.7 million and $5.5 million of accrued residual interest, respectively. As of March 31, 2004, NCO Portfolio was in compliance with all required covenants. -13- 9. EARNINGS PER SHARE: Basic earnings per share ("EPS") was computed by dividing the net income for the three months ended March 31, 2003 and 2004, by the weighted average number of common shares outstanding. Diluted EPS was computed by dividing the adjusted net income for the three months ended March 31, 2003 and 2004, by the weighted average number of common shares outstanding plus all common equivalent shares. Net income is adjusted to add-back interest expense on the convertible debt, net of taxes, if the convertible debt is dilutive. The interest expense on the convertible debt, net of taxes, included in the diluted EPS calculation was $920,000 and $905,000 for the three months ended March 31, 2003 and 2004, respectively. Outstanding options, warrants, and convertible securities have been utilized in calculating diluted amounts only when their effect would be dilutive. The reconciliation of basic to diluted weighted average shares outstanding was as follows (amounts in thousands): For the Three Months Ended March 31, ------------------- 2003 2004 ------ ------ Basic 25,908 26,125 Dilutive effect of convertible debt 3,797 3,797 Dilutive effect of options 13 312 ------ ------ Diluted 29,718 30,234 ====== ====== 10. SUPPLEMENTAL CASH FLOW INFORMATION: The following are supplemental disclosures of cash flow information (amounts in thousands):
For the Three Months Ended March 31, -------------------- 2003 2004 -------- ------- Noncash investing and financing activities: Common stock issued for acquisitions $ - $39,808 Deferred portion of purchased accounts receivable 911 2,403
11. COMMITMENTS AND CONTINGENCIES: Purchase Commitments: The Company enters into noncancelable agreements with various telecommunications and other vendors that require minimum purchase commitments. These agreements expire between 2004 and 2007. The following represents the future minimum payments, by year and in the aggregate, under noncancelable purchase commitments (amounts in thousands): 2004 $ 19,196 2005 16,693 2006 12,053 2007 5,100 -------- $ 53,042 ======== The Company incurred $3.2 million and $7.2 million of expense in connection with these purchase commitments for the three months ended March 31, 2003 and 2004, respectively. -14- 11. COMMITMENTS AND CONTINGENCIES (CONTINUED): Long-Term Collection Contract: The Company has a long-term collection contract with a large client to provide collection services that includes guaranteed collections, subject to limits. The Company is required to pay the client the difference between actual collections and the guaranteed collections on May 31, 2004 and May 31, 2005, subject to limits of $6.0 million and $13.5 million, respectively. Any guarantees in excess of the limits will only be satisfied with future collections. The Company is entitled to recoup at least 90 percent of any such guarantee payments from subsequent collections in excess of any remaining guarantees. Forward-Flow Agreement: In May 2003, NCO Portfolio renewed a fixed price agreement ("forward-flow") with a major financial institution that obligates NCO Portfolio to purchase, on a monthly basis, portfolios of charged-off accounts receivable meeting certain criteria. As of March 31, 2004, NCO Portfolio was obligated to purchase accounts receivable at a maximum of $2.5 million per month through May 2004. A portion of the purchase price is deferred for 24 months, including a nominal rate of interest. The deferred purchase price payable is included in long-term debt and as of December 31, 2003 and March 31, 2004, was $6.5 million and $7.5 million, respectively. Litigation and Investigations: The Company is party, from time to time, to various legal proceedings, regulatory investigations and tax examinations incidental to its business. The Company continually monitors these legal proceedings, regulatory investigations and tax examinations to determine the impact and any required accruals. FTC: In October 2003, the Company was notified by the Federal Trade Commission ("FTC") that it intends to pursue a claim against the Company for violations of the Fair Credit Reporting Act ("FCRA") relating to certain aspects of the Company's credit reporting practices during 1999 and 2000. The allegations relate primarily to a large group of consumer accounts from one client that were transitioned to the Company for servicing during 1999. The Company received incorrect information from the prior service provider at the time of transition. The Company became aware of the incorrect information during 2000 and ultimately removed the incorrect information from the consumers' credit files. During the first quarter of 2004, the Company made a settlement offer for this matter to the FTC, although no assurance can be given that a settlement will be reached. In the event that the Company is required to pay an assessment, it may assert certain claims for indemnification from the owners of the consumer accounts. In connection with the proposed settlement offer made in the first quarter of 2004, the Company recorded its expected exposure to this claim. The Company is also a party to a class action litigation regarding this group of consumer accounts. A tentative settlement of the class action litigation has been agreed to, and is subject to court approval. The Company believes that the class action litigation is covered by insurance, subject to applicable deductibles. The FTC is also alleging that certain reporting violations occurred on a small subset of the Company's purchased accounts receivable. The Company believes that the resolution of the above matters will not have a material adverse effect on its financial position, results of operations or business. -15- 11. COMMITMENTS AND CONTINGENCIES (CONTINUED): Litigation and Investigations (continued): Fort Washington Flood: In June 2001, the first floor of the Company's Fort Washington, Pennsylvania, headquarters was severely damaged by a flood caused by remnants of Tropical Storm Allison. As previously reported, during the third quarter of 2001, the Company decided to relocate its corporate headquarters to Horsham, Pennsylvania. The Company filed a lawsuit in the Court of Common Pleas, Montgomery County, Pennsylvania (Civil Action No. 01-15576) against the current landlord and the former landlord of the Fort Washington facilities to terminate the leases and to obtain other relief. The landlord and the former landlord filed counter-claims against the Company. Due to the uncertainty of the outcome of the lawsuit, the Company recorded the full amount of rent due under the remaining terms of the leases during the third quarter of 2001. In April 2003, the former landlord defendants filed a joinder complaint against Michael J. Barrist, the Chairman, President and Chief Executive Officer of the Company, Charles C. Piola, Jr., a director and former Executive Vice President of the Company, and Bernard R. Miller, a former Executive Vice President and director of the Company, to name such persons as additional defendants and alleging, among other things, that they breached their fiduciary duties to the Company. In January 2004, the Court, in ruling on the preliminary objections, allowed the former landlord defendants' suit to proceed, but struck from the complaint the breach of fiduciary duty allegations asserting violations of duties owed by individual officers to the Company. Other: The Company is involved in other legal proceedings, regulatory investigations and tax examinations from time to time in the ordinary course of its business. Management believes that none of these other legal proceedings, regulatory investigations or tax examinations will have a materially adverse effect on the financial condition or results of operations of the Company. 12. SEGMENT REPORTING: As March 31, 2004, the Company's business consisted of three operating divisions: U.S. Operations, Portfolio Management and International Operations. The accounting policies of the segments are the same as those described in note 2, "Accounting Policies." U.S. Operations provides accounts receivable management services to consumer and commercial accounts for all market sectors including financial services, healthcare, retail and commercial, telecommunications, utilities, education, and government. The U.S. Operations serves clients of all sizes in local, regional, and national markets. In addition to traditional accounts receivable collections, these services include developing the client relationship beyond bad debt recovery and delinquency management, and delivering cost-effective accounts receivable and customer relationship management solutions to all market sectors. U.S. Operations had total assets, net of any intercompany balances, of $714.2 million and $745.4 million at December 31, 2003 and March 31, 2004, respectively. U.S. Operations had capital expenditures of $4.6 million and $6.9 million for the three months ended March 31, 2003 and 2004, respectively. U.S. Operations also provides accounts receivable management services to Portfolio Management. U.S. Operations recorded revenue of $12.3 million and $15.1 million for these services for the three months ended March 31, 2003 and 2004, respectively. The accounting policies used to record the revenue from Portfolio Management are the same as those described in note 2, "Accounting Policies." Portfolio Management purchases and manages defaulted consumer accounts receivable from consumer creditors such as banks, finance companies, retail merchants, and other consumer oriented companies. Portfolio Management had total assets, net of any intercompany balances, of $170.4 million and $160.2 million at December 31, 2003 and March 31, 2004, respectively. -16- 12. SEGMENT REPORTING (CONTINUED): International Operations provides accounts receivable management services across Canada and the United Kingdom. International Operations had total assets, net of any intercompany balances, of $61.5 million and $62.3 million at December 31, 2003 and March 31, 2004, respectively. International Operations had capital expenditures of $825,000 and $567,000 for the three months ended March 31, 2003 and 2004, respectively. International Operations also provides accounts receivable management services to U.S. Operations. International Operations recorded revenue of $5.8 million and $9.7 million for these services for the three months ended March 31, 2003 and 2004, respectively. The accounting policies used to record the revenue from U.S. Operations are the same as those described in note 2, "Accounting Policies." The following tables represent the revenue, payroll and related expenses, selling, general, and administrative expenses, and earnings before interest, taxes, depreciation, and amortization ("EBITDA") for each segment. EBITDA is used by the Company's management to measure the segments' operating performance and is not intended to report the segments' operating results in conformity with accounting principles generally accepted in the United States.
For the Three Months Ended March 31, 2003 (amounts in thousands) ------------------------------------------------------------- Payroll and Selling, General Related and Admin. Revenue Expenses Expenses EBITDA -------- -------- -------------- ------- U.S. Operations $ 173,105 $ 84,501 $ 64,387 $ 24,217 Portfolio Management 18,232 480 13,121 4,631 International Operations 15,754 9,084 3,757 2,913 Eliminations (18,074) (5,767) (12,307) - --------- -------- -------- -------- Total $ 189,017 $ 88,298 $ 68,958 $ 31,761 ========= ======== ======== ========
For the Three Months Ended March 31, 2004 (amounts in thousands) ------------------------------------------------------------- Payroll and Selling, General Related and Admin. Revenue Expenses Expenses EBITDA -------- -------- -------------- ------- U.S. Operations $ 183,419 $ 87,779 $ 71,227 $ 24,413 Portfolio Management 21,602 647 16,091 4,864 International Operations 21,011 12,334 4,407 4,270 Eliminations (24,801) (9,721) (15,080) - --------- -------- -------- -------- Total $ 201,231 $ 91,039 $ 76,645 $ 33,547 ========= ======== ======== ========
-17- 13. INVESTMENTS IN UNCONSOLIDATED SUBSIDIARY: NCO Portfolio has a 50 percent ownership interest in a joint venture, InoVision-MEDCLR NCOP Ventures, LLC ("Joint Venture"), with IMNV Holdings, LLC ("IMNV"). The Joint Venture was established in 2001 to purchase utility, medical and various other small balance accounts receivable and is accounted for using the equity method of accounting. Included in "other assets" on the Balance Sheets was NCO Portfolio's investment in the Joint Venture of $4.0 million and $5.1 million as of December 31, 2003 and March 31, 2004, respectively. Included in the Statements of Income, as "interest and investment income," was $473,000 and $594,000 for the three months ended March 31, 2003 and 2004, respectively, representing NCO Portfolio's 50 percent share of operating income from this unconsolidated subsidiary. NCO Portfolio received distributions of $55,000 during the three months ended March 31, 2004. NCO Portfolio's 50 percent share of the Joint Venture's retained earnings was $1.3 million and $1.8 million as of December 31, 2003 and March 31, 2004, respectively. The Company performs collection services for the Joint Venture and recorded service fee revenue of $1.5 million and $1.7 million for the three months ended March 31, 2003 and 2004, respectively. The Company had receivables of $269,000 and $377,000 on its balance sheets as of December 31, 2003 and March 31, 2004, respectively, for these service fees. The Company also performs collection services for an affiliate of IMNV and recorded service fee revenue of $2.5 million and $3.1 million for the three months ended March 31, 2003 and 2004, respectively. The following tables summarize the financial information of the Joint Venture (amounts in thousands): As of -------------------------------------------- December 31, 2003 March 31, 2004 -------------------- --------------------- Total assets $ 15,344 $ 15,755 Total liabilities 7,415 6,752 For the Three Months Ended March 31, -------------------------- 2003 2004 ------------ ----------- Revenue $ 3,360 $ 3,918 Net income 946 1,188 14. SUBSEQUENT EVENT: On April 2, 2004, the Company completed the acquisition of RMH Teleservices, Inc., referred to as RMH, a provider of customer relationship management services. The Company issued 3.4 million shares of NCO common stock valued at $82.9 million for all of the outstanding shares of RMH. -18- ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements included in this Report on Form 10-Q, other than historical facts, are forward-looking statements (as such term is defined in the Securities Exchange Act of 1934, and the regulations thereunder) which are intended to be covered by the safe harbors created thereby. Forward-looking statements include, without limitation, statements as to the Company's expected future results of operations, the Company's growth strategy, fluctuations in quarterly operating results, the integration of acquisitions, the long-term collection contract, the final outcome of the environmental liability, the final outcome of the Company's litigation with its former landlord, the final outcome of the Federal Trade Commission investigation, the effects of terrorist attacks, war and the economy on the Company's business, expected increases in operating efficiencies, anticipated trends in the accounts receivable management industry, estimates of future cash flows of purchased accounts receivable, estimates of goodwill impairments and amortization expense for other intangible assets, the effects of legal or governmental proceedings, the effects of changes in accounting pronouncements, and statements as to trends or the Company's or management's beliefs, expectations and opinions. Forward-looking statements are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially from those in the forward-looking statements. In addition to the factors discussed in this report, certain risks, uncertainties and other factors, including, without limitation, the risk that the Company will not be able to achieve expected future results of operations, the risk that the Company will not be able to implement its growth strategy as and when planned, risks associated with growth and future acquisitions, the risk that the Company will not be able to realize operating efficiencies in the integration of its acquisitions, fluctuations in quarterly operating results, risks relating to the timing of contracts, risks related to purchased accounts receivable, risks related to possible impairments of goodwill and other intangible assets, risks associated with technology, risks related to the ERP implementation, risks related to the final outcome of the environmental liability, risks related to the final outcome of the Company's litigation with its former landlord, risks related to the final outcome of the Federal Trade Commission investigation, risks relating to the Company's litigation, regulatory investigations and tax examinations, risks related to past or possible future terrorist attacks, risks related to the threat or outbreak of war or hostilities, risks related to the domestic and international economy, risks related to the Company's international operations, and other risks detailed from time to time in the Company's filings with the Securities and Exchange Commission, including the Company's Annual Report on Form 10-K for the year ended December 31, 2003, can cause actual results and developments to be materially different from those expressed or implied by such forward-looking statements. The Company disclaims any intent or obligation to publicly update or revise any forward-looking statements, regardless of whether new information becomes available, future developments occur, or otherwise. The Company's website is www.ncogroup.com. The Company makes available, free of charge, on its website, its Annual Report on Form 10-K, including all amendments. In addition, the Company will provide additional paper or electronic copies of its Annual Report on Form 10-K for 2003, as filed with the Securities and Exchange Commission, without charge except for exhibits to the report. Requests should be directed to: Steven L. Winokur, Executive Vice President of Finance, Chief Financial Officer, and Chief Operating Officer of Shared Services, NCO Group, Inc., 507 Prudential Rd., Horsham, PA 19044. The information on the website listed above is not and should not be considered part of this Quarterly Report on Form 10-Q and is not incorporated by reference in this document. This website is and is only intended to be an inactive textual reference. THREE MONTHS ENDED MARCH 31, 2004, COMPARED TO THREE MONTHS ENDED MARCH 31, 2003 Revenue. Revenue increased $12.2 million, or 6.5 percent, to $201.2 million for the three months ended March 31, 2004, from $189.0 million for the three months ended March 31, 2003. U.S. Operations, Portfolio Management, and International Operations accounted for $183.4 million, $21.6 million, and $21.0 million, respectively, of the first quarter of 2004 revenue. U.S. Operations' revenue included $15.1 million of intercompany revenue earned on services performed for Portfolio Management that was eliminated upon consolidation. International Operations' revenue included $9.7 million of intercompany revenue earned on services performed for the U.S. Operations that was eliminated upon consolidation. -19- U.S. Operations' revenue increased $10.3 million, or 6.0 percent, to $183.4 million for the three months ended March 31, 2004, from $173.1 million for the three months ended March 31, 2003. The increase in U.S. Operations revenue was partially attributable to growth in business from existing clients and the addition of new clients. An increase in fees from collection services performed for Portfolio Management also contributed to the increase. U.S. Operations' revenue for the three months ended March 31, 2003 and 2004 included revenue recorded from a long-term collection contract. The method of recognizing revenue for this long-term collection contract defers certain revenues into future periods until collections exceed collection guarantees, subject to limits. During the three months ended March 31, 2004, U.S. Operations recognized $1.6 million of previously deferred revenue, on a net basis, compared to an additional deferral of revenue of $1.0 million for the three months ended March 31, 2003. Portfolio Management's revenue increased $3.4 million, or 18.5 percent, to $21.6 million for the three months ended March 31, 2004, from $18.2 million for the three months ended March 31, 2003. Portfolio Management's collections increased $6.8 million, or 18.6 percent, to $43.5 million for the three months ended March 31, 2004, from $36.7 million for the three months ended March 31, 2003. Portfolio Management's revenue represented 50 percent of collections for the three months ended March 31, 2004, as compared to 49 percent of collections for the three months ended March 31, 2003. Collections for the three months ended March 31, 2003, included sales proceeds of $1.5 million. Excluding these proceeds, revenue would have represented 51 percent of collections. Revenue increased due to the increase in collections from new purchases of receivables. The effect of the increase in collections on revenue was partially offset by the decrease in the percentage of collections recorded as revenue, excluding the sales proceeds for the three months ended March 31, 2003. Revenue as a percentage of collections declined principally due to a number of factors, including an increase in the average age of the portfolios, timing of collections, and lower targeted returns on more recent portfolios due to the current economic environment. In addition, portfolios with $10.3 million in carrying value, or 7.6 percent of total purchased accounts receivable as of March 31, 2004, were being accounted for under the cost recovery method, compared to $6.7 million, or 4.6 percent as of March 31, 2003. Accordingly, no revenue was recorded on these portfolios. Of the $10.3 million of portfolios, $7.4 million represented impaired portfolios, and $2.9 million represented portfolios acquired in connection with the dissolution of an off-balance sheet securitization. International Operations' revenue increased $5.3 million, or 33.4 percent, to $21.0 million for the three months ended March 31, 2004, from $15.8 million for the three months ended March 31, 2004. The increase in International Operations' revenue was primarily attributable to an increase in the services provided to our U.S. Operations and favorable changes in the foreign currency exchange rates used to translate the International Operations' results of operations into U.S. dollars. In addition, a portion of the increase was attributable to the addition of new clients and growth in business from existing clients. Payroll and related expenses. Payroll and related expenses increased $2.7 million to $91.0 million for the three months ended March 31, 2004, from $88.3 million for the three months ended March 31, 2003, but decreased as a percentage of revenue to 45.2 percent from 46.7 percent. U.S Operations' payroll and related expenses increased $3.3 million to $87.8 million for the three months ended March 31, 2004, from $84.5 million for the three months ended March 31, 2003, but decreased as a percentage of revenue to 47.9 percent from 48.8 percent. The decrease in payroll and related expenses as a percentage of revenue was partially due to the shift of more of our collection work to outside attorneys and other third-party service providers, and the continued rationalization of staff. This shift was associated with the continuing efforts to maximize collections for clients. The costs associated with the increase in the use of outside attorneys and other third-party service providers are included in selling, general and administrative expenses. A portion of the decrease in the payroll and related expenses as a percentage of revenue was attributable to the recognition of $1.6 million of previously deferred revenue from the long-term collection contract for the three months ended March 31, 2004, as compared to an additional deferral of revenue of $1.0 million that was recorded for the three months ended March 31, 2003. Because the expenses associated with this revenue are expensed as incurred, the recognition of previously deferred revenue decreases the payroll and related expenses as a percentage of revenue. -20- Portfolio Management's payroll and related expenses increased $167,000 to $647,000 for the three months ended March 31, 2004, from $480,000 for the three months ended March 31, 2003, and increased as a percentage of revenue to 3.0 percent from 2.6 percent. Portfolio Management outsources all of the collection services to U.S. Operations and, therefore, has a relatively small fixed payroll cost structure. International Operations' payroll and related expenses increased $3.2 million to $12.3 million for the three months ended March 31, 2004, from $9.1 million for the three months ended March 31, 2003, and increased as a percentage of revenue to 58.7 percent from 57.7 percent. The increase as a percentage of revenue was primarily attributable to an increase in staff to handle an expected increase in volume from certain existing clients that was experienced at the end of the first quarter. Selling, general and administrative expenses. Selling, general and administrative expenses increased $7.6 million to $76.6 million for the three months ended March 31, 2004, from $69.0 million for the three months ended March 31, 2003, and increased as a percentage of revenue to 38.1 percent from 36.5 percent. The increase in the percentage of revenue was primarily attributable to the shift of more of the collection work to outside attorneys and other third-party service providers. The increase in the percentage of revenue was partially offset by the recognition of $1.6 million of previously deferred revenue from the long-term collection contract for the three months ended March 31, 2004, as compared to an additional deferral of revenue of $1.0 million that was recorded for the three months ended March 31, 2003. Because the expenses associated with this revenue are expensed as incurred, the recognition of previously deferred revenue decreases the selling, general and administrative expenses as a percentage of revenue. Depreciation and amortization. Depreciation and amortization decreased slightly to $7.8 million for the three months ended March 31, 2004, from $7.9 million for the three months ended March 31, 2003. This decrease was the result of lower depreciation resulting from less capital expenditures made during 2003 than in prior years. The lower capital expenditures in 2003 were due to significant capital expenditures made in prior years that do not need to repeated each year. These significant capital expenditures included expenditures related to the relocation of our corporate headquarters and purchases of predictive dialers and other equipment required to expand our infrastructure to handle future growth. Other income (expense). Interest and investment income included investment income of $594,000 for the three months ended March 31, 2004, as compared to $473,000 for the three months ended March 31, 2003, from the 50 percent ownership interest in a joint venture that purchases utility, medical and other various small balance accounts receivable. Interest expense decreased to $5.3 million for the three months ended March 31, 2004, from $5.8 million for the three months ended March 31, 2003. This decrease was due to lower principal balances as a result of debt repayments made in excess of borrowings against the credit facility during 2003 and 2004, and lower interest rates. This decrease was partially offset by Portfolio Management's additional nonrecourse borrowings from CFSC Capital Corp. XXXIV to purchase accounts receivable. Income tax expense. Income tax expense for the three months ended March 31, 2004, increased to $8.9 million, or 41.4 percent of income before income tax expense, from $7.2 million, or 37.9 percent of income before income tax expense, for the three months ended March 31, 2003. The increase in the effective tax rate was primarily attributable to the liability recorded related to the proposed settlement offer we made during the three months ended March 31, 2004 related to the Federal Trade Commission's claim against us for violations of the Fair Credit Reporting Act relating to certain aspects of our credit reporting practices during 1999 and 2000. The Company received incorrect information from the prior service provider at the time of transition and we believe that we may assert certain claims for indemnification from the owners of the consumer accounts. The expense recorded for the claim is not deductible for taxes purposes. However, the reimbursement from the indemnification, if any, may be taxable. As a result, the nondeductible expense results in an increase in the effective rate for the first quarter of 2004. LIQUIDITY AND CAPITAL RESOURCES Historically, our primary sources of cash have been bank borrowings, equity and debt offerings, and cash flows from operations. Cash has been used for acquisitions, repayments of bank borrowings, purchases of equipment, purchases of accounts receivable, and working capital to support our growth. -21- We believe that funds generated from operations, together with existing cash and available borrowings under our credit agreement, will be sufficient to finance our current operations, planned capital expenditure requirements, and internal growth at least through the next twelve months. However, we could require additional debt or equity financing if we were to make any significant acquisitions for cash during that period. The cash flow from our contingency collection business and our purchased portfolio business is dependent upon our ability to collect from consumers and businesses. Many factors, including the economy and our ability to hire and retain qualified collectors and managers, are essential to our ability to generate cash flows. Fluctuations in these trends that cause a negative impact on our business could have a material impact on our expected future cash flows. Cash Flows from Operating Activities. Cash provided by operating activities was $33.5 million for the three months ended March 31, 2004, compared to $17.3 million for the three months ended March 31, 2003. The increase in cash provided by operations was partially attributable to a $7.5 million increase in accounts payable and accrued expenses for the three months ended March 31, 2004, as compared to an $806,000 increase for the same period in the prior year. A portion of the increase was also attributable to the transfer of $4.5 million out of restricted cash during the first quarter of 2004 to repay a portion of the securitized nonrecourse debt. A portion of the increase in cash provided by operations was partially attributable to a $6.2 million increase in income taxes payable for the three months ended March 31, 2004, as compared to a $2.8 million increase for the same period in the prior year. The increase in income taxes payable for the three months ended March 31, 2004 was larger than the same period in 2003 because there was an overpayment of income taxes as of December 31, 2003, due to favorable tax adjustments during 2003. Cash Flows from Investing Activities. Cash provided by investing activities was $5.8 million for the three months ended March 31, 2004, compared to cash used in investing activities of $3.3 million for the three months ended March 31, 2003. The increase in cash from investing activities was primarily attributable to a reduction in purchases of accounts receivable. The lower purchases during the three months ended March 31, 2004, were primarily a result of a purchase entered into during the first quarter of 2004 for $9.2 million that was not completed until April 1, 2004. In addition, $2.4 million of the purchase price of portfolios acquired during the first quarter of 2004 were deferred into future periods, compared to $911,000 of purchase price deferrals during the first quarter of 2003. Cash Flows from Financing Activities. Cash used in financing activities was $21.0 million for the three months ended March 31, 2004, compared to $8.8 million for the three months ended March 31, 2003. The increase in cash used in financing activities the first quarter of 2004 resulted from higher repayments of borrowings under our senior credit facility, nonrecourse debt used to purchase large accounts receivable portfolios, and securitized nonrecourse debt. The increase in cash used in financing activities was also attributable to borrowings of nonrecourse debt during the first quarter of 2003 to fund purchases of accounts receivable portfolios by NCO Portfolio. Credit Facility. On August 13, 2003, we amended our credit agreement with Citizens Bank of Pennsylvania, ("Citizens Bank"), for itself and as administrative agent for other participating lenders. The amendment extended the maturity date from May 20, 2004 to March 15, 2006, referred to as the Maturity Date. The amended credit facility is structured as a $150 million term loan and a $50 million revolving credit facility. We are required to make quarterly repayments of $6.3 million on the term loan until the Maturity Date. The remaining balance outstanding under the term loan and the balance under the revolving credit facility will become due on the Maturity Date. As of March 31, 2004, there was $47.9 million available under the revolving credit facility. The credit agreement contains certain financial and other covenants, such as maintaining net worth and funded debt to EBITDA requirements, and includes restrictions on, among other things, acquisitions, the incurrence of additional debt, the issuance of equity, and distributions to shareholders. If an event of default, such as failure to comply with covenants, material adverse change, or change of control, were to occur under the credit agreement, the lenders would be entitled to declare all amounts outstanding under it immediately due and payable. As of March 31, 2004, we were in compliance with all required financial covenants and we were not aware of any events of default. -22- Convertible Notes. In April 2001 we completed the sale of $125.0 million aggregate principal amount of 4.75 percent convertible subordinated notes due 2006, referred to as Notes, in a private placement pursuant to Rule 144A and Regulation S under the Securities Act of 1933. The Notes are convertible into our common stock at an initial conversion price of $32.92 per share. We used the $121.3 million of net proceeds from this offering to repay debt under our credit agreement. Nonrecourse Debt. In August 2002, NCO Portfolio entered into a four-year financing agreement with CFSC Capital Corp. XXXIV, referred to as Cargill, to provide financing for larger purchases of accounts receivable at 90 percent of the purchase price, unless otherwise negotiated. Cargill, at their sole discretion, has the right to finance any purchase of $4.0 million or more. Cargill may or may not choose to finance a transaction. This agreement gives NCO Portfolio the financing to purchase larger portfolios that they may not otherwise be able to purchase, and has no minimum or maximum credit authorization. Borrowings carry interest at the prime rate plus 3.25 percent (prime rate was 4.00 percent at March 31, 2004) and are nonrecourse to NCO Portfolio and us, except for the assets financed through Cargill. Debt service payments equal total collections less servicing fees and expenses until each individual borrowing is fully repaid and NCO Portfolio's original investment is returned, including interest. Thereafter, Cargill is paid a residual of 40 percent of collections, less servicing costs, unless otherwise negotiated. Individual loans are required to be repaid based on collections, but not more than two years from the date of borrowing. Total debt outstanding under this facility as of March 31, 2004, was $14.5 million, including $5.5 million of accrued residual interest. As of March 31, 2004, NCO Portfolio was in compliance with all of the financial covenants. OFF-BALANCE SHEET ARRANGEMENTS NCO Portfolio has a 50 percent ownership interest in a joint venture, InoVision-MEDCLR-NCOP Ventures, LLC, referred to as the Joint Venture, with IMNV Holdings, LLC, referred to as IMNV. The Joint Venture was established in 2001 to purchase utility, medical and other various small balance accounts receivable and is accounted for using the equity method of accounting. Included in "other assets" on the balance sheets was NCO Portfolio's investment in the Joint Venture of $4.0 million and $5.1 million as of December 31, 2003 and March 31, 2004, respectively. Included in the statements of income, in "interest and investment income," was $473,000 and $594,000 for the three months ended March 31, 2003 and 2004, respectively, representing NCO Portfolio's 50 percent share of operating income from this unconsolidated subsidiary. MARKET RISK We are exposed to various types of market risk in the normal course of business, including the impact of interest rate changes, foreign currency exchange rate fluctuations, and changes in corporate tax rates. A material change in these rates could adversely affect our operating results and cash flows. A 25 basis-point increase in interest rates could increase our annual interest expense by $250,000 for each $100 million of variable debt outstanding for the entire year. A 10 percent change in the foreign currency exchange rates is not expected to have a material impact on our business. We employ risk management strategies that may include the use of derivatives, such as interest rate swap agreements, interest rate ceilings and floors, and foreign currency forwards and options to manage these exposures. CRITICAL ACCOUNTING POLICIES The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates. We believe that the following accounting policies include the estimates that are the most critical and could have the most potential impact on our results of operations: goodwill, revenue recognition for purchased accounts receivable, allowance for doubtful accounts, notes receivable and deferred taxes. These and other critical accounting policies are described in note 2 to these financial statements, and in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and note 2 to our 2003 financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2003. During the three months ended March 31, 2004, we did not make any material changes to our estimates or methods by which estimates are derived with regard to our critical accounting policies. -23- IMPACT OF RECENTLY ISSUED AND PROPOSED ACCOUNTING PRONOUNCEMENTS SOP 03-3 Accounting for Certain Loans or Debt Securities Acquired in a Transfer. We currently follow the accounting guidance in Practice Bulletin #6 for the accounting for purchased accounts receivable portfolios. Practice Bulletin #6 has been superceded by SOP 03-3 - Accounting for Certain Loans or Debt Securities Acquired in a Transfer. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004, although early adoption is permitted. SOP 03-3 applies to all companies that acquire loans for which it is probable at the acquisition date that all contractual amounts due under the acquired loans will not be collected. SOP 03-3 addresses accounting for differences between contractual and expected cash flows from an investor's initial investment in certain loans when such differences are attributable, in part, to credit quality. SOP 03-3 also addresses such loans acquired in purchased business combinations. SOP 03-3 limits the revenue that may be accrued to the excess of the estimate of expected cash flows over a portfolio's initial cost of accounts receivable acquired. SOP 03-3 requires that the excess of the contractual cash flows over expected cash flows not be recognized as an adjustment of revenue, expense, or on the balance sheet. SOP 03-3 freezes the internal rate of return, referred to as the IRR, originally estimated when the accounts receivable are purchased for subsequent impairment testing. Rather than lower the estimated IRR if the original collection estimates are not received, the carrying value of a portfolio is written down to maintain the original IRR. Increases in expected cash flows are to be recognized prospectively through adjustment of the IRR over a portfolio's remaining life. Loans acquired in the same fiscal quarter with common risk characteristics may be aggregated for the purpose of applying this SOP. We are in the process of determining the effect SOP 03-3 will have on our financial position and results of operations. FASB Interpretation No. 46, "Consolidation of Variable Interest Entities". In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities," referred to as FIN 46. The objective of FIN 46 is to improve financial reporting by companies involved with variable interest entities. FIN 46 defines variable interest entities and requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities, or is entitled to receive a majority of the entity's residual returns, or both. The consolidation requirements apply immediately to variable interest entities created after January 31, 2003, and apply to existing variable interest entities in the first fiscal year or interim period beginning after June 15, 2003. On January 1, 2004, we adopted FIN 46. We have a $10.9 million note receivable and a $5.6 million note receivable included in our balance sheet under current and long-term other assets as of March 31, 2004. These notes receivable are from two separate companies that comprised our Market Strategy division that were sold during 2000. Under FIN 46, the companies that issued these notes receivable are considered variable interest entities. Based on our evaluation of these variable interest entities, we are not required to consolidate theses entities under FIN 46. -24- ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Included in Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operations, of this Report on Form 10-Q. ITEM 4 CONTROLS AND PROCEDURES Our management, with participation of our chief executive officer and chief financial officer, conducted an evaluation as of the end of the period covered by this report, of the effectiveness of our disclosure controls and procedures, as defined in Exchange Act Rule 13a-15(e). Based on that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective in reaching a reasonable level of assurance that management is timely alerted to material information relating to us during the period when our periodic reports are being prepared. During the quarter ended March 31, 2004, there has not occurred any change in our internal control over financial reporting, as defined in Exchange Act Rule 13a-15(f), that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. -25- PART II. OTHER INFORMATION Item 1. Legal Proceedings ----------------- FTC: In October 2003, the Company was notified by the Federal Trade Commission ("FTC") that it intends to pursue a claim against the Company for violations of the Fair Credit Reporting Act ("FCRA") relating to certain aspects of the Company's credit reporting practices during 1999 and 2000. The allegations relate primarily to a large group of consumer accounts from one client that were transitioned to the Company for servicing during 1999. The Company received incorrect information from the prior service provider at the time of transition. The Company became aware of the incorrect information during 2000 and ultimately removed the incorrect information from the consumers' credit files. During the first quarter of 2004, the Company made a settlement offer for this matter to the FTC, although no assurance can be given that a settlement will be reached. In the event that the Company is required to pay an assessment, it may assert certain claims for indemnification from the owners of the consumer accounts. In connection with the proposed settlement offer made in the first quarter of 2004, the Company recorded its expected exposure to this claim. The Company is also a party to a class action litigation regarding this group of consumer accounts. A tentative settlement of the class action litigation has been agreed to, and is subject to court approval. The Company believes that the class action litigation is covered by insurance, subject to applicable deductibles. The FTC is also alleging that certain reporting violations occurred on a small subset of the Company's purchased accounts receivable. The Company believes that the resolution of the above matters will not have a material adverse effect on its financial position, results of operations or business. Fort Washington Flood: In June 2001, the first floor of the Company's Fort Washington, Pennsylvania, headquarters was severely damaged by a flood caused by remnants of Tropical Storm Allison. As previously reported, during the third quarter of 2001, the Company decided to relocate its corporate headquarters to Horsham, Pennsylvania. The Company filed a lawsuit in the Court of Common Pleas, Montgomery County, Pennsylvania (Civil Action No. 01-15576) against the current landlord and the former landlord of the Fort Washington facilities to terminate the leases and to obtain other relief. The landlord and the former landlord filed counter-claims against the Company. Due to the uncertainty of the outcome of the lawsuit, the Company recorded the full amount of rent due under the remaining terms of the leases during the third quarter of 2001. In April 2003, the former landlord defendants filed a joinder complaint against Michael J. Barrist, the Chairman, President and Chief Executive Officer of the Company, Charles C. Piola, Jr., a director and former Executive Vice President of the Company, and Bernard R. Miller, a former Executive Vice President and director of the Company, to name such persons as additional defendants and alleging, among other things, that they breached their fiduciary duties to the Company. In January 2004, the Court, in ruling on the preliminary objections, allowed the former landlord defendants' suit to proceed, but struck from the complaint the breach of fiduciary duty allegations asserting violations of duties owed by individual officers to the Company. -26- Other: The Company is involved in other legal proceedings and regulatory investigations from time to time in the ordinary course of its business. Management believes that none of these other legal proceedings or regulatory investigations will have a materially adverse effect on the financial condition or results of operations of the Company. Item 2. Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities ---------------------------------------------------------------------- None - not applicable Item 3. Defaults Upon Senior Securities ------------------------------- None - not applicable Item 4. Submission of Matters to a Vote of Shareholders ----------------------------------------------- A special meeting of shareholders of the Company was held on March 26, 2004. At this meeting, the shareholders approved the merger contemplated by agreement dated December 12, 2003 among NCO Group, Inc., NCPM Acquisition Corporation, a wholly-owned subsidiary of NCO Group, Inc., and NCO Portfolio Management, Inc. as follows: For Against Abstain --- ------ ------- 19,304,035 41,211 3,637 Item 5. Other Information ----------------- None - not applicable Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) promulgated under the Exchange Act. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) promulgated under the Exchange Act. 32.1 Certification of the Company's Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. -27- (b) Reports on Form 8-K
Date of Filing / Furnishing Item Reported ------------------- ------------- 3/29/04 Item 5 and Item 7 - Press release announcing completion of the acquisition of the minority interest of NCO Portfolio Management, Inc. 3/8/04 Item 7, Item 9 and Item 12 - Press release announcing presentation at the JMP Securities Conference on March 10, 2004. 3/3/04 Item 5 and Item 7 - Announcement of the second amendment to the acquisition agreement for RMH Teleservices, Inc. 2/13/04 Item 7, Item 9 and Item 12 - Conference call transcript from the earnings release for the fourth quarter of 2003. 2/10/04 Item 7, Item 9 and Item 12 - Press release regarding earnings for the fourth quarter of 2003. 1/23/04 Item 5 and Item 7 - Press release related to the first amendment to the acquisition agreement for RMH Teleservices, Inc.
-28- SIGNATURES Pursuant to the requirement of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: May 10, 2004 By: Michael J. Barrist ------------------ Michael J. Barrist Chairman of the Board, President and Chief Executive Officer (principal executive officer) Date: May 10, 2004 By: Steven L. Winokur ------------------ Steven L. Winokur Executive Vice President of Finance, Chief Financial Officer, Chief Operating Officer of Shared Services and Treasurer (principal financial and accounting officer)
-29- Exhibit Index Exhibit No. Description ----------- ----------- 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) promulgated under the Exchange Act. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) promulgated under the Exchange Act. 32.1 Certification of the Company's Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.