-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, OilPXRtxTwTtVoqeMu36N1HUcQPUlbetY/ubdv0CYNInuwfa6zhXxg4mRIV7epvQ xAyzdPsWKRGulyVk5+jE0Q== 0000950116-99-002084.txt : 19991117 0000950116-99-002084.hdr.sgml : 19991117 ACCESSION NUMBER: 0000950116-99-002084 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991115 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NCO GROUP INC CENTRAL INDEX KEY: 0001022608 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-CONSUMER CREDIT REPORTING, COLLECTION AGENCIES [7320] IRS NUMBER: 232858652 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-21639 FILM NUMBER: 99754385 BUSINESS ADDRESS: STREET 1: 515 PENNSYLVANIA AVE CITY: FT WASHINGTON STATE: PA ZIP: 19034 BUSINESS PHONE: 2157939300 10-Q 1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q /X/ Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 30, 1999, 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 -------------------------------------------------------------- (State or other jurisdiction of incorporation or organization) 515 Pennsylvania Avenue, Fort Washington, Pennsylvania ------------------------------------------------------ (Address of principal executive offices) 23-2858652 ------------------------------------ (IRS Employer Identification Number) 19034 ---------- (Zip Code) 215-793-9300 --------------------------------------------------- (Registrant's telephone number including area code) --------------------------------------------------- (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, and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- The number of shares outstanding of each of the issuer's classes of common stock was 25,374,145 shares common stock, no par value, outstanding as of November 12, 1999. -1- NCO GROUP, INC. INDEX PAGE Part I FINANCIAL INFORMATION Item 1 CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Consolidated Balance Sheets - December 31, 1998 and September 30, 1999 3 Consolidated Statements of Income - Three months and nine months ended September 30, 1998 and 1999 4 Consolidated Statements of Cash Flows - Nine months ended September 30, 1998 and 1999 5 Notes to Consolidated Financial Statements 6 Item 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 15 Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 20 PART II 21 Item 1. Legal Proceedings Item 2. Changes in 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 8-K -2- Part 1 - Financial Information Item 1 - Financial Statements NCO GROUP, INC. Consolidated Balance Sheets (Unaudited) (Amounts in thousands)
December 31, September 30, ASSETS 1998 1999 ------------ ------------- Current assets: Cash and cash equivalents $ 23,560 $ 48,845 Accounts receivable, trade, net of allowance for doubtful accounts of $3,998 and $5,284, respectively 54,443 84,003 Purchased accounts receivable 1,597 5,771 Deferred taxes 1,348 1,617 Other current assets 2,930 5,822 --------- -------- Total current assets 83,878 146,058 Funds held in trust for clients Property and equipment, net 27,062 45,020 Other assets: Intangibles, net of accumulated amortization 297,347 571,491 Other assets 6,522 6,024 --------- -------- Total other assets 303,869 577,515 --------- -------- Total assets $ 414,809 $768,593 ========= ======== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Long-term debt, current portion $ 8,288 $ 2,054 Corporate taxes payable 7,737 18,007 Accounts payable 8,485 13,694 Accrued expenses 13,346 28,096 Accrued compensation and related expenses 10,507 18,280 --------- -------- Total current liabilities 48,363 80,131 Funds held in trust for clients Long-term liabilities: Long term debt, net of current portion 143,910 323,792 Deferred taxes 6,832 11,625 Other long-term liabilities 4,357 11,101 Redeemable preferred stock 11,882 - Commitments and contingencies Shareholders' equity: Preferred stock 1,853 - Common stock, no par value, 37,500 shares authorized, 20,100 and 25,189 shares issued, respectively, and 19,744 and 25,189 shares outstanding, respectively 177,835 300,962 Unexercised warrants 5,450 2,800 Foreign currency translation adjustment (2,169) (974) Retained earnings 20,604 39,156 Treasury stock, at cost (4,108) - --------- -------- Total shareholders' equity 199,465 341,944 --------- -------- Total liabilities and shareholders' equity $ 414,809 $768,593 ========= ========
The accompanying notes are an integral part of these consolidated financial statements. -3- NCO GROUP, INC. Consolidated Statements of Income (Unaudited) (Amounts in thousands, except per share data)
For the Three Months Ended For the Nine Months Ended September 30, September 30, ---------------------------- -------------------------- 1998 1999 1998 1999 -------- --------- --------- --------- Revenue $ 63,585 $ 136,078 $ 156,126 $ 342,646 Operating costs and expenses: Payroll and related expenses 33,173 71,465 80,782 181,077 Selling, general and administrative expenses 18,767 37,105 45,544 94,339 Depreciation and amortization expense 2,725 6,386 6,375 15,749 Non-recurring acquisition costs - - - 4,601 -------- --------- --------- --------- Total operating costs and expenses 54,665 114,956 132,701 295,766 -------- --------- --------- --------- Income from operations 8,920 21,122 23,425 46,880 Other income (expense): Interest and investment income 322 366 818 866 Interest expense (911) (5,869) (2,347) (13,126) -------- --------- --------- --------- Total other income (expense) (589) (5,503) (1,529) (12,260) -------- --------- --------- --------- Income before provision for income taxes 8,331 15,619 21,896 34,620 Income tax expense 3,951 6,717 9,145 15,691 -------- --------- --------- --------- Net income 4,380 8,902 12,751 18,929 Accretion of preferred stock to redemption value (626) - (1,231) (377) -------- --------- --------- --------- Net income applicable to common shareholders $ 3,754 $ 8,902 $ 11,520 $ 18,552 ======== ========= ========= ========= Net income per share: Basic $ 0.19 $ 0.38 $ 0.65 $ 0.84 Diluted $ 0.17 $ 0.37 $ 0.61 $ 0.81 Weighted average shares outstanding: Basic 20,289 23,169 17,641 22,034 Diluted 21,606 24,152 19,006 22,992
The accompanying notes are an integral part of these consolidated financial statements. -4- NCO GROUP, INC. Consolidated Statements of Cash Flows (Unaudited) (Amounts in thousands)
For the Nine Months Ended September 30, ------------------------------ 1998 1999 ---------- ------- Cash flows from operating activities: Net income $12,751 $18,929 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 2,628 5,733 Amortization of intangibles 3,747 10,016 Write-off of deferred financing costs - 353 Provision for doubtful accounts 635 1,172 Compensation expense on stock options granted 652 34 Changes in assets and liabilities, net of acquisitions: Accounts receivable, trade (6,697) (17,366) Purchased accounts receivable 432 (4,174) Deferred taxes 1,902 2,521 Other assets 749 (1,100) Accounts payable and accrued expenses (1,330) 4,191 Corporate taxes payable 2,792 4,821 Other long-term liabilities 2,403 1,028 -------- -------- Net cash provided by operating activities 20,664 26,158 Cash flows from investing activities: Purchase of property and equipment (5,977) (14,348) Net cash paid for acquisitions (107,127) (130,897) -------- -------- Net cash used in investing activities (113,104) (145,245) Cash flows from financing activities: Repayment of notes payable (1,181) (7,672) Repayment of acquired notes payable (21,919) (42,000) Borrowings under revolving credit agreement 109,279 196,965 Repayment of borrowings under revolving credit agreement (84,193) (4,000) Payment of fees to acquire new debt (493) (3,565) Issuance of common stock, net 91,281 4,588 Redemption of common stock, net (11) - -------- -------- Net cash provided by financing activities 92,763 144,316 Effect of exchange rate on cash (659) 56 -------- -------- Net increase in cash and cash equivalents (336) 25,285 Cash and cash equivalents at beginning of period 30,379 23,560 -------- -------- Cash and cash equivalents at end of period $ 30,043 $ 48,845 ======== ========
The accompanying notes are an integral part of these consolidated financial statements. -5- NCO GROUP, INC. Notes to Consolidated Financial Statements (Unaudited) 1. Nature of Operations: NCO Group, Inc. (the "Company") is a leading provider of accounts receivable management and other outsourced revenue cycle management services. The Company's client base is comprised of companies located throughout North America, the United Kingdom and in Puerto Rico in the financial services, healthcare, retail, commercial, education, utilities, government and telecommunications sectors. 2. Summary of Significant Accounting Policies: Interim Financial Information: The accompanying 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. Operating results for the three month period and nine month period ended September 30, 1999 are not necessarily indicative of the results that may be expected for the year ending December 31, 1999 or for any other interim period. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Current Report on Form 8-K/A filed with the Securities and Exchange Commission on June 11, 1999. Principles of Consolidation: The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of significant intercompany accounts and transactions. Revenue Recognition: The Company generates revenues from contingency fees and contractual services. Contingency fee revenue is recognized upon collection of funds on behalf of clients. Contractual services revenue is recognized as services are performed. Income Taxes: The Company accounts for income taxes using an asset and liability approach. The asset and liability approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial reporting basis and the tax basis of assets and liabilities. Income taxes were computed after giving effect to the non-deductible portion of goodwill expenses attributable to certain acquisitions and non-recurring acquisition costs attributable to the acquisition of JDR Holdings, Inc. on March 31, 1999. Credit Policy: The Company has two types of arrangements under which it collects its contingency fee revenue. For certain clients, the Company remits funds collected on behalf of the client net of the related contingency fees while, for other clients, the Company remits gross funds collected on behalf of clients and bills the client separately for its contingency fees. Management carefully monitors its client relationships in order to minimize its credit risk and generally does not require collateral. 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. -6- Goodwill: Goodwill represents the excess of purchase price over the fair market value of the net assets of the acquired businesses based on their respective fair values at the date of acquisition. Goodwill is amortized on a straight-line basis over its estimated useful life. The estimated useful lives of goodwill ranges from 15 to 40 years. For certain acquisitions, such allocations have been based on estimates which may be revised at a later date. The recoverability of goodwill is periodically reviewed by the Company. In making such determination with respect to goodwill, the Company evaluates the operating results of the underlying business which gave rise to such amount. Estimates Utilized in the Preparation of Financial Statements: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Reclassifications: Certain amounts for December 31, 1998 and for the three months and nine months ended September 30, 1998 have been reclassified for comparative purposes. 3. Acquisitions: Pooling-of-Interests Transaction: On March 31, 1999, the Company acquired all of the outstanding shares of JDR Holdings, Inc. ("JDR") for approximately 3.4 million shares of NCO common stock. The transaction was accounted for as a pooling-of-interests and a tax-free reorganization. Accordingly, the historical financial information of the Company has been restated to include the historical information of JDR. The following reconciles the amounts originally reported for revenue, net income applicable to common shareholders and diluted net income per common share for the three months and nine months ended September 30, 1998 to the restated amounts, and discloses the amount of revenue and net income applicable to common shareholders separately for each company for the period prior to the acquisition for the three months and nine months ended September 30, 1999 (amounts in thousands, except per share data):
For the three months ended For the nine months ended September 30, September 30, ----------------------------- ----------------------------- 1998 1999 1998 1999 ------------ ------------ ------------ ------------- Revenue: NCO (as originally reported for 1998) $ 51,420 $136,078 $ 118,019 $ 328,169 JDR (for the period prior to the acquisition) 12,165 - 38,107 14,477 -------- ------- --------- --------- Combined $ 63,585 $ 136,078 $ 156,126 $ 342,646 ======== ========= ========= ========= Net income applicable to common shareholders: NCO (as originally reported for 1998) $ 4,324 $ 8,902 $ 9,914 $ 21,668 JDR (for the period prior to the acquisition) (570) - 1,606 578 Non-recurring acquisition costs, net of taxes - - - (3,694) -------- ------- --------- --------- Combined $ 3,754 $ 8,902 $ 11,520 $ 18,552 ======== ======= ========= ========= Diluted net income per share: NCO (as originally reported) $ 0.24 $ 0.63 JDR (0.07) (0.02) ======== ========= Combined $ 0.17 $ 0.61 ======== =========
-7- For the nine months ended September 30, 1999, the Company incurred $4.6 million of non-recurring acquisition costs in connection with the JDR acquisition. These costs consisted primarily of investment banking, accounting, and legal fees, and printing costs. Theses costs were predominantly non-deductible for tax purposes and as a result, in conjunction with the amortization expense from non-deductible goodwill, caused the effective tax rate to increase from 42.0% for the year ended December 31, 1998 to 45.3% for the nine months ended September 30, 1999. Purchase Transactions: All of the following acquisitions have been accounted for under the purchase method of accounting. As part of the purchase accounting, the Company recorded accruals for acquisition related expenses. The accruals for acquisition related expenses include professional fees related to the acquisition, termination costs related to certain redundant personnel immediately eliminated at the time of the acquisitions, and certain future rental obligations attributable to facilities which were closed at the time of the acquisitions. On December 31, 1997, effective January 1, 1998, the Company purchased the net assets of American Financial Enterprises, Inc. Collections Division ("AFECD") for $1.7 million in cash. On February 6, 1998, the Company purchased the net assets of The Response Center ("TRC"), which was an operating division of TeleSpectrum Worldwide, Inc., for $15.0 million in cash plus a performance based earn-out. On May 5, 1998, the Company purchased all of the outstanding common shares of FCA International Ltd. ("FCA") at $9.60 per share, Canadian (equivalent to $6.77 in U.S. dollars based upon the exchange rate at the date of the agreement). The purchase price was valued at approximately $69.9 million. On July 1, 1998, the Company purchased all of the outstanding stock of MedSource, Inc. ("MedSource") for $18.4 million in cash. In connection with the acquisition, the Company repaid debt of $17.3 million. On November 30, 1998, the Company acquired all of the outstanding stock of Medaphis Services Corporation ("MSC"), a wholly owned subsidiary of Medaphis Corporation, for $107.5 million, plus an earn-out of up to $10.0 million based on MSC achieving operational targets during 1999. On May 21, 1999, the Company acquired all of the outstanding stock of Co-Source Corporation ("Co-Source") for approximately $122.7 million in cash plus a warrant to purchase 250,000 shares of NCO common stock. The purchase price was valued at approximately $124.6 million. The allocation of the fair market value to the acquired assets and liabilities of Co-Source was based on preliminary estimates and may be subject to change. On August 20, 1999, the Company acquired all of the outstanding shares of Compass International Services Corporation ("Compass") for approximately 3.3 million shares of NCO common stock and stock options to purchase approximately 215,000 shares of NCO common stock. The purchase price was valued at approximately $103.0 million. The allocation of the fair market value to the acquired assets and liabilities of Compass was based on preliminary estimates and may be subject to change. The following summarizes the unaudited pro forma results of operations for the nine months ended September 30, 1998 and 1999, assuming the above acquisitions 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: For the nine months ended September 30, ------------------------- 1998 1999 --------- --------- Revenue $ 389,099 $ 432,279 Net income $ 10,216 $ 16,952 Earnings per share - basic $ 0.38 $ 0.68 Earnings per share - diluted $ 0.36 $ 0.66 -8- 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 under generally accepted accounting principles. The Company's comprehensive income is as follows (amounts in thousands):
For the three months For the nine months ended September 30, ended September 30, ------------------------- -------------------------- 1998 1999 1998 1999 ----------- ------------ ------------ ------------ Net income $ 4,380 $ 8,902 $ 12,751 $ 18,929 Foreign currency translation adjustment (392) 182 (658) 1,195 --------- --------- --------- --------- Comprehensive income $ 3,988 $ 9,084 $ 12,093 $ 20,124 ========= ========= ========= =========
5. Funds Held in Trust for Clients: In the course of the Company's regular business activities as an accounts receivable management company, 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 in trust for clients of $32.2 million and $50.8 million at December 31, 1998 and September 30, 1999, respectively, have been shown net of their offsetting liability for financial statement presentation purposes. 6. Long-Term Debt: In May 1999, the Company's credit agreement with Mellon Bank, N.A., for itself and as administrative agent for other participating lenders, was amended to, among other things, increase the Company's credit facility to provide for borrowings up to $350.0 million, structured as a $350.0 million revolving credit facility. Borrowings bear interest at a rate equal to, at the option of the Company, Mellon Bank's prime rate plus a margin from 0.00% to 0.25% depending on the Company's consolidated funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio (Mellon Bank's prime rate was 8.25% at September 30, 1999) or LIBOR plus a margin from 1.00% to 2.00% depending on the Company's consolidated funded debt to EBITDA ratio (LIBOR was 5.40% at September 30, 1999). Borrowings are collateralized by substantially all the assets of the Company. The balance under the revolving credit facility will be due upon the expiration of the five year term. 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, capital expenditures and distributions to shareholders. Prior to the acquisition on March 31, 1999, JDR had $12.5 million of borrowings outstanding against its revolving credit facility (the "JDR Credit Facility"). On March 31, 1999, the Company repaid the outstanding balance on the JDR Credit Facility with borrowings from its revolving credit agreement with Mellon Bank, N.A, and cancelled the JDR Credit Facility. Deferred financing costs of $353,000 were written-off on March 31, 1999 as a result of the cancellation of the JDR Credit Facility. Under the terms of the JDR Credit Facility, dated May 30, 1997, the Company could borrow up to the lessor of $20 million less any outstanding letters of credit, or an amount equal to: (i) adjusted EBITDA times the leverage multiple, as defined, which ranged from 3.0 to 4.0; (ii) less outstanding senior debt; and (iii) less any outstanding letters of credit. Previously, advances under the JDR Credit Facility would bear interest at optional borrowing rates of either the then current prime rate plus a margin that ranged from 0.50% to 1.50 % or LIBOR, plus a margin that ranged from 2.00% to 3.00%, depending on certain conditions specified in the JDR Credit Facility agreement. The Company also paid a commitment fee of .375% on the unused borrowing capacity. The Credit Facility made available to the Company letters of credit, which could be issued on the unused portion of the JDR Credit Facility. The letters of credit could not exceed $1.0 million and had a fee equal to 2.00% per year on the face amount of each letter of credit. Borrowings under the JDR Credit Facility were secured by substantially all of the assets of JDR. The JDR Credit Facility agreement contained various financial and non-financial covenants and would have terminated on May 31, 2001. -9- On May 29, 1997, JDR entered into a credit agreement (hereinafter referred to as the "JDR Bridge Loan") whereby JDR borrowed $11.0 million to redeem common stock owned by two stockholders and repay all outstanding indebtedness of JDR. Borrowings under the JDR Bridge Loan bore interest at 10%. In connection with the JDR Bridge Loan, the Company recorded debt issuance costs of $185,000, which were fully amortized upon conversion and repayment of the JDR Bridge Loan. On May 30, 1997, $8.3 million of borrowings under the JDR Bridge Loan were converted into redeemable preferred stock (see Note 7) and $2.7 million was repaid with borrowings under the JDR Credit Facility. On February 15, 1999, the $900,000 convertible note issued in connection with the Goodyear acquisition was converted into 63,755 shares of NCO common stock. 7. Redeemable Preferred Stock:
December 31, 1998 --------------- Redeemable Series A Preferred stock, no par value, 416,645 shares authorized, 271,148 shares issued and outstanding $ 5,394,000 Convertible Series A Preferred stock, no par value, 554,970 shares authorized, 362,725 shares issued and outstanding 4,601,000 Convertible Series B Preferred stock, no par value, 204,033 shares authorized, 148,758 shares issued and outstanding 1,887,000 ============== $ 11,882,000 ==============
JDR issued 271,148 shares of Redeemable Series A stock to repay $6.6 million of borrowings under the JDR Bridge Loan (see Note 6) and for cash proceeds of $476,000. The Redeemable Series A stock required a dividend (payable in kind) of 7.0% per year, payable quarterly in arrears. The holders of the Redeemable Series A stock could have redeemed these shares for their liquidation preference, plus accrued and unpaid dividends, beginning on May 30, 2003. JDR would have been obligated to redeem these shares on the earlier of their initial public offering or May 30, 2004. The Redeemable Series A stock had limited voting rights, was senior to the Series C Preferred stock and common stock and had a liquidation value of $7.9 million, including dividends of $819,000, at December 31, 1998. All of the Redeemable Series A Preferred stock was converted into NCO common stock on March 31, 1999. JDR issued 37,986 shares of Series A Preferred stock to repay $438,000 of borrowings under the JDR Bridge Loan (see Note 6). In addition, JDR issued 12,660 shares of Series A Preferred stock in exchange for certain Redeemable Series A and Series B Preferred stock. The Series A Preferred required a dividend (payable in kind) of 6.0% per year, payable quarterly in arrears. The holders of the Series A Preferred stock could have converted their shares at any time into voting common stock. In addition, the holders of the Series A Preferred stock could have redeemed their shares for their liquidation preference, plus accrued but unpaid dividends, beginning on May 30, 2002. The Series A Preferred stock had limited voting rights, was senior to the Series C Preferred stock and common stock and had a liquidation value of $4.6 million, including dividends of $414,000, at December 31, 1998. All of the Series A Preferred stock was converted into NCO common stock on March 31, 1999. JDR issued 125,227 shares of Series B Preferred stock to repay $1.3 million of borrowings under the JDR Bridge Loan (see Note 6) and for cash proceeds of $127,000. The Series B Preferred stock required a dividend (payable in kind) of 6.0% per year, payable quarterly in arrears. The holders of the Series B Preferred stock could have converted their shares at any time into nonvoting common stock. In addition, the holders of the Series B Preferred stock could have redeemed these shares for their liquidation preference, plus accrued but unpaid dividends, beginning on May 30, 2002. The Series B Preferred stock had limited voting rights, was senior to the Series C Preferred stock and common stock and had a liquidation value of $1.9 million, including dividends of $170,000, at December 31, 1998. All of the Series B Preferred stock was converted into NCO common stock on March 31, 1999. -10- 8. Shareholders' Equity: Preferred Stock At December 31, 1998, JDR had 236,678 shares designated as Series C Preferred stock, of which 146,091 shares were issued and outstanding. The Series C Preferred stock required a dividend (payable in kind) of 6.0% per year, payable quarterly in arrears. JDR could have, at its option, redeemed the Series C Preferred, at any time, for its liquidation value. The holders of the Series C Preferred stock could have converted their shares at any time after May 30, 2000, or at the time any shares of Series A Preferred stock or Series B Preferred stock were converted into common stock, into nonvoting common stock. The Series C Preferred stock had a liquidation value of $1.9 million, including dividends of $167,000, at December 31, 1998. All of the Series C Preferred stock was converted into NCO common stock on March 31, 1999. Nonvoting Common Stock At December 31, 1998, JDR had 4,896,795 shares of nonvoting common stock authorized, of which 1,088,000 shares were issued and 1,044,000 shares were outstanding. All of the nonvoting common stock was converted into NCO common stock on March 31, 1999. Common Stock Warrants On May 30, 1997, JDR issued warrants to purchase 620,841 shares of nonvoting common stock at a nominal value in connection with the sale of capital stock and the JDR Credit Facility (see Note 6). All of the warrants were exercised and converted into NCO common stock on March 31, 1999. On May 21, 1999, the Company issued warrants to purchase a total of 250,000 shares of common stock at an exercise price of $32.97 per share as part of the purchase price from the Co-Source Corporation acquisition. The warrants expire on May 20, 2009. Treasury Stock JDR had 44,000 shares of nonvoting common stock and 312,000 shares of voting common stock in Treasury at December 31, 1998. All of the treasury shares were retired on March 31, 1999. 9. Earnings Per Share: Basic earnings per share was computed by dividing the net income available to common shareholders for the three months and nine months ended September 30, 1998 and 1999 by the weighted average number of shares outstanding. Diluted earnings per share were computed by dividing the net income available to common shareholders for the three months and nine months ended September 30, 1998 and 1999 by the weighted average number of shares outstanding including all common equivalent shares. The diluted earnings per share computations for the three months and nine months ended September 30, 1998 and the nine months ended September 30, 1999 have also been adjusted for the effects of interest expense attributable to convertible debt. Outstanding options, warrants and convertible securities have been utilized in calculating diluted net income per share only when their effect would be dilutive. -11- The reconciliation of basic to diluted earnings per share ("EPS") consists of the following (amounts in thousands, except per share amounts):
For the three months ended For the nine months ended September 30, September 30, ----------------------------------------- ----------------------------------------- 1998 1999 1998 1999 -------------------- -------------------- -------------------- -------------------- Shares EPS Shares EPS Shares EPS Shares EPS --------- ---------- --------- ---------- --------- ---------- --------- ---------- Basic 20,289 $ 0.19 23,169 $ 0.38 17,641 $ 0.65 22,034 $ 0.84 Dilutive effect of warrants 725 (0.01) 266 - 730 (0.02) 203 (0.01) Dilutive effect of options 528 (0.01) 717 (0.01) 571 (0.02) 744 (0.02) Dilutive effect of convertible notes 64 - - - 64 - 11 - -------- --------- ------- -------- ------- --------- ------- --------- Diluted 21,606 $ 0.17 24,152 $ 0.37 19,006 $ 0.61 22,992 $ 0.81 ======== ========= ======= ======== ======= ======== ======= =========
10. Supplemental Cash Flow Information: The following are supplemental disclosures of cash flow information for the nine months ended September 30, 1998 and 1999 (amounts in thousands):
1998 1999 ----------- ----------- Non-cash investing and financing activities: Fair value of assets acquired $ 40,772 $ 30,339 Liabilities assumed from acquisitions 39,653 52,422 Common stock issued for acquisitions - 101,526 Stock options issued for acquisitions - 1,500 Convertible note payable, exercised for common stock - 900 Warrants issued for acquisitions - 1,925 Warrants exercised 247 4,575
11. Segment Reporting: As of December 31, 1998, the Company adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). SFAS 131 establishes standards for reporting financial information about operating segments in annual financial statements and requires reporting of selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. The adoption of SFAS 131 did not affect results of operations or financial position but did affect the disclosure of segment information. The accounting policies of the segments are the same as those described in Note 2, "Summary of Significant Accounting Policies." Segment data includes a charge allocating corporate overhead costs to each of the operating segments based on revenue and employee headcount. The Company is currently organized into market segment specific operating divisions that are responsible for all aspects of client sales, client service and operational delivery of services. The operating divisions, which are each headed by a divisional chief executive officer, include Accounts Receivable Management Services, Technology-Based Outsourcing Services, Healthcare Services, Commercial Services, International Operations and Marketing Strategy. -12- The Accounts Receivable Management division provides accounts receivable management and collection services to consumer accounts for all market segments, serving clients of all sizes in local, regional and national markets. With the acquisition of JDR, the Technology-Based Outsourcing Services division was created. This division continues the growth of the client relationship beyond bad debt recovery and delinquency management, delivering cost-effective receivables and customer relationship management solutions to all market segments, serving clients of all sizes in local, regional and national markets. The Healthcare Services division primarily focuses on providing comprehensive outsourcing services for the hospital market. In addition, the Healthcare Services division provides receivable management programs for physician groups and allied health service providers. With the acquisition of Co-Source, the Commercial Services division was created. The Commercial Services division focuses on providing accounts receivable management and collection services to the commercial market. The International Operations division provides accounts receivable management services across Canada and the United Kingdom. The Marketing Strategy division provides full-service custom market research services to the telecommunications, financial services, utilities, healthcare, pharmaceutical, and consumer products sectors. In addition, the Marketing Strategy division provides telemarketing services for clients including lead generation and qualification, and the actual booking of appointments for a client's sales representatives. 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 for the three and nine months ended September 30, 1998 and 1999. 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 generally accepted accounting principles.
For the three months ended September 30, 1998 (amounts in thousands) ------------------------------------------------------------------------- Payroll and Selling General Related and Admin. Revenue Expenses Expenses EBITDA ----------------- ------------------ ------------------ ----------------- A/R Management $35,018 $17,331 $10,588 $ 7,099 Tech-Based Outsourcing 10,532 5,779 3,152 1,601 Healthcare Services 6,154 2,878 1,954 1,322 Commercial Services -- -- -- -- International Operations 6,925 4,105 1,780 1,040 Marketing Strategy 4,956 3,080 1,293 583 ------- ------- ------- ------- Total $63,585 $33,173 $18,767 $11,645 ======= ======= ======= =======
For the three months ended September 30, 1999 (amounts in thousands) ------------------------------------------------------------------------- Payroll and Selling General Related and Admin. Revenue Expenses Expenses EBITDA ---------------- ------------------ ------------------ ----------------- A/R Management $ 46,716 $ 22,572 $ 13,890 $ 10,254 Tech-Based Outsourcing 16,360 8,573 4,603 3,184 Healthcare Services 36,000 19,080 9,898 7,022 Commercial Services 20,072 11,723 3,994 4,355 International Operations 7,952 4,579 2,093 1,280 Marketing Strategy 8,978 4,938 2,627 1,413 --------- --------- ---------- --------- Total $ 136,078 $ 71,465 $ 37,105 $ 27,508 ========= ========= ========== =========
-13-
For the nine months ended September 30, 1998 (amounts in thousands) ------------------------------------------------------------------------- Payroll and Selling General Related and Admin. Revenue Expenses Expenses EBITDA ----------------- ------------------ ------------------ ----------------- A/R Management $92,181 $45,699 $27,900 $18,582 Tech-Based Outsourcing 33,416 17,381 9,177 6,858 Healthcare Services 6,154 2,878 1,954 1,322 Commercial Services -- -- -- -- International Operations 11,259 6,470 3,119 1,670 Marketing Strategy 13,116 8,354 3,394 1,368 -------- ------- ------- ------- Total $156,126 $80,782 $45,544 $29,800 ======== ======= ======= =======
For the nine months ended September 30, 1999 (amounts in thousands) ------------------------------------------------------------------------- Selling Non- Payroll and General and Recurring Related Admin. Acquisition Revenue Expenses Expenses Costs EBITDA -------------- -------------- --------------- -------------- -------------- A/R Management $ 123,570 $ 60,342 $ 36,104 $ - $ 27,124 Tech-Based Outsourcing 41,189 22,285 10,935 - 7,969 Healthcare Services 103,013 54,739 28,965 - 19,309 Commercial Services 29,403 17,076 6,195 - 6,132 International Operations 23,408 13,597 6,349 - 3,462 Marketing Strategy 22,063 13,038 5,791 - 3,234 Other - - - 4,601 (4,601) ---------- -------- -------- -------- --------- Total $ 342,646 $181,077 $ 94,339 $ 4,601 $ 62,629 ========== ======== ======== ======== =========
12. Recent Accounting Pronouncements: In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which was subsequently amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133" (collectively "SFAS No. 133"). SFAS No. 133 is effective for the fiscal years beginning after June 15, 2000 and requires that an entity recognize all derivative instruments as either assets or liabilities on its balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction, and, if it is, the type of hedge transaction. The Company will adopt SFAS No. 133 by the first quarter of 2001. Due to the Company's limited use of derivative instruments, SFAS No. 133 is not expected to have a material impact on the consolidated results of operations, financial condition or cash flows of the Company. -14- 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 objective to focus on internal growth, strategic acquisitions and alliances, and integration, fluctuations in quarterly operating results, the impact of acquisitions on the Company's earnings, the Company's ability to realize operating efficiencies in the integration of its acquisitions, trends in the Company's future operating performance, year 2000 compliance, the effects of legal or governmental proceedings, the effects of changes in accounting pronouncements and statements as to 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 which 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 risks associated with growth and future acquisitions, risks relating to year 2000 compliance and the 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, filed on March 31, 1999, and the Company's Registration Statement on Form S-3, filed on September 3, 1999, can cause actual results and developments to be materially different from those expressed or implied by such forward-looking statements. A copy of the Annual Report on Form 10-K can be obtained, without charge except for exhibits, by written request to Steven L. Winokur, Executive Vice President, Finance/CFO, NCO Group, Inc., 515 Pennsylvania Avenue, Ft. Washington, PA 19034. Three Months Ended September 30, 1999 Compared to Three Months Ended September 30, 1998 Revenue. Revenue increased $72.5 million or 114.0% to $136.1 million for the three months ended September 30, 1999 from $63.6 million for the comparable period in 1998. $14.5 million of the increase was attributable to the addition of new clients and growth in business from existing clients. The $14.5 million increase includes $3.8 million attributable to JDR Holdings, Inc. ("JDR") which was acquired on March 31, 1999 and was accounted for under the pooling-of-interests method of accounting. The remainder of the increase was attributable to the following: $11.2 million was attributable to the acquisition of Compass International Services Corporation ("Compass") on August 20, 1999; $17.4 million was attributable to the acquisition of Co-Source Corporation ("Co-Source") on May 21, 1999; $28.4 million was attributable to the acquisition of Medaphis Services Corporation ("MSC") on November 30, 1998; and $1.0 million was attributable to the acquisition of FCA International Ltd. ("FCA") on May 5, 1998. Payroll and related expenses. Payroll and related expenses increased $38.3 million to $71.5 million for the three months ended September 30, 1999 from $33.2 million for the comparable period in 1998, and slightly increased as a percentage of revenue to 52.5% from 52.2%. Payroll and related expenses increased as a percentage of revenue primarily as a result of higher payroll costs from the MSC, JDR, Co-Source and Compass acquisitions during their transition into the NCO operating cost model. In addition, the market research division and the commercial services division have higher payroll cost structures than that of the remainder of the Company. These increases were partially offset by spreading the cost of management and administrative personnel over a larger revenue base. Selling, general and administrative expenses. Selling, general and administrative expenses increased $18.3 million to $37.1 million for the three months ended September 30, 1999 from $18.8 million for the comparable period in 1998, but decreased as a percentage of revenue to 27.3% from 29.5%. The decrease as a percentage of revenue was, in part, the result of additional operating efficiencies obtained when selling, general and administrative expenses were spread over a larger revenue base. In addition, a portion of the decrease was attributable to the market research division and the commercial services division having lower selling, general and administrative expense structures than that of the Company's core business. These decreases as a percentage of revenue were partially offset by the higher cost structures of some of the acquired companies. -15- Depreciation and amortization. Depreciation and amortization increased to $6.4 million for the three months ended September 30, 1999 from $2.7 million for the comparable period in 1998. Of this increase, $385,000 was attributable to the Compass acquisition, $784,000 was attributable to the Co-Source acquisition, $687,000 was attributable to the MSC acquisition, and $239,000 was attributable to the FCA acquisition. The remaining $1.6 million primarily consisted of depreciation resulting from normal capital expenditures incurred in the ordinary course of business. Other income (expense). Interest and investment income increased $44,000 to $366,000 for the three months ended September 30, 1999 from $322,000 for the comparable period in 1998. Interest expense increased to $5.9 million for the three months ended September 30, 1999 from $911,000 for the comparable period in 1998. The increase was primarily attributable to the Company financing a portion of the MedSource acquisition and all of the MSC and Co-Source acquisitions with borrowings of $25.5 million, $107.5 million and $126.2 million, respectively, under the revolving credit facility. Additionally, a portion of the increase was attributable to borrowings under the revolving credit facility of $29.5 million that were used to repay debt that was assumed as a result of the Compass acquisition. Income tax expense. Income tax expense increased to $6.7 million, or 43.0% of income before taxes, for the three months ended September 30, 1999 from $4.0 million, or 47.4% of income before taxes, for the comparable period in 1998. The decrease in the effective tax rate was primarily attributable to the increase in net income diluting the effects of the non-deductible goodwill related to certain acquisitions. Net income. Net income increased $4.5 million or 103.2% to $8.9 million for the three months ended September 30, 1999 from $4.4 million for the comparable period in 1998. Accretion of preferred stock to redemption value. The accretion of preferred stock to the redemption value in the third quarter of 1998 relates to JDR's preferred stock that was outstanding prior to its conversion into NCO common stock on March 31, 1999. This non-cash accretion represents the periodic amortization of the difference between the original carrying amount and the mandatory redemption amount. Nine Months Ended September 30, 1999 Compared to Nine Months Ended September 30, 1998 Revenue. Revenue increased $186.5 million or 119.5% to $342.6 million for the nine months ended September 30, 1999 from $156.1 million for the comparable period in 1998. $33.2 million of the increase was attributable to the addition of new clients and growth in business from existing clients. The $33.2 million increase includes $7.0 million attributable to JDR which was acquired on March 31, 1999 and was accounted for under the pooling-of-interests method of accounting. The remainder of the increase was attributable to the following: $11.2 million was attributable to the acquisition of Compass; $25.0 million was attributable to the acquisition of Co-Source; $84.3 million was attributable to the acquisition of MSC; $13.0 million was attributable to the acquisition of MedSource; and $19.8 million was attributable to the acquisition of FCA. Payroll and related expenses. Payroll and related expenses increased $100.3 million to $181.1 million for the nine months ended September 30, 1999 from $80.8 million for the comparable period in 1998, and increased as a percentage of revenue to 52.8% from 51.7%. Payroll and related expenses increased as a percentage of revenue primarily as a result of higher payroll costs from the MSC, JDR, Co-source and Compass acquisitions during their transition into the NCO operating cost model. In addition, the market research division and the commercial services division have higher payroll cost structures than that of the remainder of the Company. These increases were partially offset by spreading the cost of management and administrative personnel over a larger revenue base. Selling, general and administrative expenses. Selling, general and administrative expenses increased $48.8 million to $94.3 million for the nine months ended September 30, 1999 from $45.5 million for the comparable period in 1998, but decreased as a percentage of revenue to 27.5% from 29.2%. The decrease as a percentage of revenue was, in part, the result of additional operating efficiencies obtained when selling, general and administrative expenses were spread over a larger revenue base. In addition, a portion of the decrease was attributable to the market research division and the commercial services division having lower selling, general and administrative expense structures than that of the Company's core business. These decreases as a percentage of revenue were partially offset by the higher cost structures of some of the acquired companies. -16- Depreciation and amortization. Depreciation and amortization increased to $15.7 million for the nine months ended September 30, 1999 from $6.4 million for the comparable period in 1998. Of this increase, $385,000 was attributable to the Compass acquisition, $1.0 million was attributable to the Co-Source acquisition, $2.1 million was attributable to the MSC acquisition, $707,000 was attributable to the MedSource acquisition, and $1.2 million was attributable to the FCA acquisition. The remaining $3.9 million primarily consisted of depreciation resulting from normal capital expenditures incurred in the ordinary course of business. Non-recurring acquisition costs. In the first quarter of 1999, the Company incurred $4.6 million of non-recurring acquisition costs in connection with the acquisition of JDR. These costs consisted primarily of investment banking, legal, and accounting fees, and printing costs. Other income (expense). Interest and investment income increased $48,000 to $866,000 for the nine months ended September 30, 1999 from $818,000 for the comparable period in 1998. Interest expense increased to $13.1 million for the nine months ended September 30, 1999 from $2.3 million for the comparable period in 1998. The increase was primarily attributable to the Company financing a portion of the MedSource acquisition and all of the MSC and Co-Source acquisitions with borrowings of $25.5 million, $107.5 million and $126.2 million, respectively, under the revolving credit facility. Additionally, a portion of the increase was attributable to borrowings under the revolving credit facility of $29.5 million that were used to repay debt that was assumed as a result of the Compass acquisition. Income tax expense. Income tax expense increased to $15.7 million, or 45.3% of income before taxes, for the nine months ended September 30, 1999 from $9.1 million, or 41.8% of income before taxes, for the comparable period in 1998. The increase in the effective tax rate was partially attributable to the $4.6 million of non-recurring acquisition costs, a portion of which were non-deductible for tax purposes, incurred in the first quarter of 1999. In addition, the increase in the effective tax rate was also related to the impact of the non-deductible goodwill related to certain acquisitions. Net income. Net income increased $6.1 million or 48.5% to $18.9 million for the nine months ended September 30, 1999 from $12.8 million for the comparable period in 1998. Included in net income for the nine months ended September 30, 1999 was $3.4 million of expenses attributable to the non-recurring acquisition costs net of taxes. Without these costs, net income would have been $22.4 million or $0.96 per share on a diluted basis, an increase of $9.6 million or 75.3%. Accretion of preferred stock to redemption value. The accretion of preferred stock to the redemption value relates to JDR's preferred stock that was outstanding prior to its conversion into NCO common stock on March 31, 1999. This non-cash accretion represents the periodic amortization of the difference between the original carrying amount and the mandatory redemption amount. Liquidity and Capital Resources Since 1996, the Company's primary sources of cash have been public offerings, cash flows from operations and bank borrowings. Cash has been used for acquisitions, purchases of equipment and working capital to support the Company's growth. In June 1998, the Company completed a public offering (the "1998 Offering"), selling 4.0 million shares of common stock and received net proceeds of approximately $81.7 million. In July 1998, the Company sold 469,366 shares of common stock in connection with the underwriters' exercise of the over-allotment option granted in accordance with the 1998 Offering. The Company received net proceeds of approximately $9.6 million. -17- Cash provided by operating activities was $26.2 million during the nine months ended September 30, 1999 compared to $20.7 million for the comparable period in 1998. The increase in cash provided by operating activities was primarily due the increase in net income to $18.9 million for the nine months ended September 30, 1999 compared to $12.8 million for the comparable period in 1998, and the increase in depreciation and amortization, to $15.7 million for the nine months ended September 30, 1999 compared to $6.4 million for the comparable period in 1998. Additionally, a portion of the increase was attributable to a $4.2 million increase in accounts payable and accrued expenses for the nine months ended September 30, 1999 as compared to a decrease of $1.3 million for the comparable period in 1998. These increases were partially offset by a $17.4 million increase in accounts receivable for the nine months ended September 30, 1999 as compared to an increase of $6.3 million for the comparable period in 1998, and a $4.2 million increase in purchased accounts receivable for the nine months ended September 30, 1999 as compared to a decrease of $432,000 for the comparable period in 1998. In addition a portion of the increase was offset by $4.6 million of non-recurring acquisition costs paid in the second quarter of 1999 as a result of the acquisition of JDR on March 31, 1999. Cash used in investing activities was $145.2 million during the nine months ended September 30, 1999 compared to $113.1 million for the comparable period in 1998. The increase was primarily due to the cash portion of the purchase price of Co-Source and the acquisition related expenses from MSC and Compass paid during the first nine months of 1999 compared to the cash portion of the purchase prices for the acquisitions of AFECD, TRC, FCA and MedSource during the first nine months of 1998. During the nine months ended September 30, 1999, capital expenditures were $14.3 million compared to $6.0 million for the comparable period in 1998. Cash provided by financing activities was $144.3 million during the nine months ended September 30, 1999 compared to $92.8 million for the comparable period in 1998. This increase was primarily attributable to the borrowings under the Company's revolving credit facility during the first nine months of 1999 that were used to finance the acquisition of Co-Source and repay debt that was assumed as a result of the Compass acquisition compared to the borrowings under the Company's revolving credit facility during the first nine months of 1998 that were used to finance the acquisition of MSC. In May 1999, the Company's credit agreement with Mellon Bank, N.A., for itself and as administrative agent for other participating lenders, was amended to, among other things, increase the Company's credit facility to provide for borrowings up to $350.0 million, structured as a $350.0 million revolving credit facility. Borrowings bear interest at a rate equal to, at the option of the Company, Mellon Bank's prime rate plus a margin from 0.00% to 0.25% depending on the Company's consolidated funded debt to EBITDA ratio (Mellon Bank's prime rate was 8.25% at September 30, 1999) or LIBOR plus a margin from 1.00% to 2.00% depending on the Company's consolidated funded debt to EBITDA ratio (LIBOR was 5.40% at September 30, 1999). Borrowings are collateralized by substantially all the assets of the Company. The balance under the revolving credit facility will be due upon the expiration of the five year term. 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, capital expenditures and distributions to shareholders. The Company believes that funds generated from operations, together with existing cash and available borrowings under its current credit agreement will be sufficient to finance its current operations, planned capital expenditure requirements and internal growth at least through the next twelve months. However, the Company could require additional debt or equity financing if it were to make any other significant acquisitions for cash during that period. Market Risk The Company is 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. The Company employs 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. The Company does not hold derivatives for trading purposes. -18- Goodwill The Company's balance sheet includes amounts designated as "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. GAAP requires that this and all other intangible assets be amortized over the period benefited. Management has determined that period to range from 15 to 40 years based on the attributes of each acquisition. As of September 30, 1999, the Company's balance sheet included goodwill that represented approximately 73.5% of total assets and 165.2% of shareholders' equity. If management has incorrectly overestimated the length of the amortization period for goodwill, earnings reported in periods immediately following the acquisition would be overstated. In later years, NCO would be burdened by a continuing charge against earnings without the associated benefit to income valued by management in arriving at the consideration paid for the business. Earnings in later years also could be significantly affected if management determined then that the remaining balance of goodwill was impaired. Management concluded that the anticipated future cash flows associated with intangible assets recognized in the acquisitions will continue indefinitely, and there is no persuasive evidence that any material portion will dissipate over a period shorter than the respective amortization period. Year 2000 System Modifications NCO has implemented a program to evaluate and address the impact of the year 2000 on its information technology systems in order to insure that its network and software will manage and manipulate data involving the transition of dates from 1999 to 2000 without functional or data abnormality and without inaccurate results related to such data. This program includes steps to: (a) identify software that require date code remediation; (b) establish timelines for availability of corrective software releases; (c) implement the fix to a test environment and test the remediated product; (d) integrate the updated software to NCO's production environment; (e) communicate and work with clients to implement year 2000 compliant data exchange formats; and (f) provide management with assurance of a seamless transition to the year 2000. The identification phase has been completed and the final software updates have been received. In addition, the testing and acceptance procedures have been completed. The Company will continue to coordinate the year 2000 compliance effort throughout the balance of 1999 to synchronize data exchange formats with clients. NCO has also implemented a program to evaluate and address the impact of year 2000 on its non-information technology systems, which include the Company's telecommunications systems, business machines, and building and premises systems. This program includes steps to: (a) review existing systems to identify potential issues; (b) review these issues with major external suppliers; and (c) develop a contingency plan. The Company has identified the issues and reviewed them with its external suppliers. As a result, a contingency plan was developed that includes procedures designed to: (i) re-route inbound and outbound telephone calls; (ii) switch to alternative providers of telecommunications services; (iii) utilize power generators at certain facilities; and (iv) arrange for alternative transportation for employees dependent on public transportation. As of September 30, 1999, the Company has incurred total pre-tax expenses of approximately $1.1 million in connection with the year 2000 compliance program. This amount does not include expenses incurred by companies prior to their acquisition by the Company. For the remainder of 1999 and for 2000, the Company expects to incur total pre-tax expenses of approximately $503,000 and $185,000, per year, respectively. These costs are associated with both internal and external staffing resources for the necessary planning, coordination, remediation, testing and other expenses to prepare its systems for the year 2000. However, a portion of these expenses will not be incremental, but rather represent a redeployment of existing information technology resources. The Company's software has been provided by third-party vendors and the third-party vendors are incorporating the necessary modifications as part of their normal system maintenance. The majority of the costs will be incurred through the modification and testing of electronic data interchange formats with the Company's clients and the testing of modifications performed by its third-party vendors. The cost of planning and initial remediation incurred to date has not been significant. -19- The Company does not expect the impact of the year 2000 to have a material adverse impact on the Company's business or results of operations. As part of its due diligence process, the Company reviewed the impact of year 2000 on all completed and pending acquisitions. No assurance can be given, however, that unanticipated or undiscovered year 2000 compliance problems will not have a material adverse effect on the Company's business or results of operations. In addition, if the Company's clients or significant suppliers and contractors do not successfully achieve year 2000 compliance, the Company's business and results of operations could be adversely affected, resulting from, among other things, the Company's inability to properly exchange and/or receive data with its clients. Recent Accounting Pronouncements: In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," which was subsequently amended by SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133" (collectively "SFAS No. 133"). SFAS No. 133 is effective for the fiscal years beginning after June 15, 2000 and requires that an entity recognize all derivative instruments as either assets or liabilities on its balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction, and, if it is, the type of hedge transaction. The Company will adopt SFAS No. 133 by the first quarter of 2001. Due to the Company's limited use of derivative instruments, SFAS No. 133 is not expected to have a material impact on the consolidated results of operations, financial condition or cash flows of the Company. 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. -20- Part II. Other Information Item 1. Legal Proceedings ----------------- The Company is involved in legal proceedings from time to time in the ordinary course of its business. Management believes that none of these legal proceedings will have a materially adverse effect on the financial condition or results of operations of the Company. Item 2. Changes in Securities --------------------- None - not applicable Item 3. Defaults Upon Senior Securities ------------------------------- None - not applicable Item 4. Submission of Matters to a Vote of Shareholders ----------------------------------------------- None - not applicable Item 5. Other Information ----------------- None - not applicable Item 6. Exhibits and Reports on 8-K --------------------------- (a) Exhibits 27.1 Financial Data Schedule (b) Reports on Form 8-K Date of Report Item Reported -------------- ------------- 9/1/99 Item 2 and Item 7 - Compass International Services Corporation acquisition -21- 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: November 15, 1999 By: /s/ Michael J. Barrist ------------------------------------ Michael J. Barrist Chairman of the Board, President and Chief Executive Officer (principal executive officer) Date: November 15, 1999 By: /s/ Steven L. Winokur ------------------------------------ Steven L. Winokur Executive Vice President, Finance, Chief Financial Officer and Treasurer -22- EX-27 2 FINANCIAL DATA SCHEDULE
5 9-MOS DEC-31-1999 JAN-01-1999 SEP-30-1999 48,845,000 0 89,287,000 5,284,000 0 146,058,000 57,571,000 12,551,000 768,593,000 80,131,000 0 0 0 300,962,000 40,982,000 768,593,000 342,646,000 342,646,000 0 294,594,000 0 1,172,000 12,260,000 34,620,000 15,691,000 18,929,000 0 0 0 18,552,000 0.84 0.81
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