10-Q 1 c87488e10vq.txt QUARTERLY REPORT 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 June 27, 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:19594 INSURANCE AUTO AUCTIONS, INC. ----------------------------- (Exact name of registrant as specified in its charter) Illinois 95-3790111 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 850 East Algonquin Road, Suite 100, Schaumburg, Illinois 60173-3855 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (847) 839-3939 -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) 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 [_] No [X] APPLICABLE ONLY TO CORPORATE ISSUERS Number of shares outstanding of each of the issuer's classes of common stock, as of July 31, 2004: Class Outstanding ----- ----------- Common Stock, $0.001 Par Value 11,632,141 shares INDEX INSURANCE AUTO AUCTIONS, INC.
PAGE NUMBER ----------- PART I. FINANCIAL INFORMATION.............................................................. 3 Item 1. Financial Statements (Unaudited)................................................... 3 Condensed Consolidated Statements of Operations.................................... 3 Condensed Consolidated Balance Sheets.............................................. 4 Condensed Consolidated Statements of Cash Flows.................................... 5 Notes to Condensed Consolidated Financial Statements............................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..................................................... 10 Overview........................................................................... 10 Results of Operations.............................................................. 10 Financial Condition and Liquidity.................................................. 12 Summary Disclosure About Contractual Obligations .................................. 13 Factors That May Affect Future Results............................................. 13 Item 3. Quantitative and Qualitative Disclosures about Market Risk......................... 15 Item 4. Controls and Procedures............................................................ 15 PART II. OTHER INFORMATION................................................................. 15 Item 1. Legal Proceedings.................................................................. 15 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities... 15 Item 3. Defaults upon Senior Securities.................................................... 16 Item 4. Submission of Matters to a Vote of Security Holders................................ 16 Item 5. Other Information.................................................................. 17 Item 6. Exhibits and Reports on Form 8-K................................................... 17 SIGNATURES ............................................................................... 18
2 INSURANCE AUTO AUCTIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (dollars in thousands except per share amounts)
THREE MONTH PERIODS ENDED SIX MONTH PERIODS ENDED --------------------------- --------------------------- JUNE 27, JUNE 29, JUNE 27, JUNE 29, 2004 2003 2004 2003 --------- --------- --------- --------- (UNAUDITED) (UNAUDITED) Revenues: Vehicle sales $ 8,225 $ 10,192 $ 15,352 $ 23,496 Fee income 51,777 43,146 101,841 85,882 --------- --------- --------- --------- 60,002 53,338 117,193 109,378 Cost of sales: Vehicle cost 7,187 9,425 13,171 21,196 Branch cost 39,598 32,845 77,993 65,809 --------- --------- --------- --------- 46,785 42,270 91,164 87,005 --------- --------- --------- --------- Gross profit 13,217 11,068 26,029 22,373 Operating expense: Selling, general and administrative 8,357 7,509 16,837 14,677 Business transformation costs - 921 - 1,718 --------- --------- --------- --------- Earnings from operations 4,860 2,638 9,192 5,978 Other (income) expense: Interest expense 410 503 887 558 Other income (29) (43) (41) (122) --------- --------- --------- --------- Earnings before income taxes 4,479 2,178 8,346 5,542 Provision for income taxes 1,824 898 3,390 2,286 --------- --------- --------- --------- Net earnings $ 2,655 $ 1,280 $ 4,956 $ 3,256 ========= ========= ========= ========= Net earnings per share: Basic $ .23 $ .11 $ .43 $ .28 ========= ========= ========= ========= Diluted $ .22 $ .11 $ .42 $ .27 ========= ========= ========= ========= Weighted average shares outstanding: Basic 11,545 11,517 11,541 11,784 Effect of dilutive securities 286 60 243 77 --------- --------- --------- --------- Diluted 11,831 11,577 11,784 11,861 ========= ========= ========= =========
See accompanying notes to condensed consolidated financial statements. 3 INSURANCE AUTO AUCTIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (dollars in thousands except per share amounts)
JUNE 27, DECEMBER 28, 2004 2003 ---------- ----------- ASSETS (Unaudited) Current assets: Cash and cash equivalents $ 17,628 $ 15,486 Accounts receivable, net 45,440 48,375 Inventories 13,393 13,602 Other current assets 2,961 3,099 --------- --------- Total current assets 79,422 80,562 --------- --------- Property and equipment, net 64,838 60,187 Deferred income taxes 10,205 9,788 Intangible assets, net 1,837 2,101 Goodwill, net 135,812 135,062 Other assets 477 93 --------- --------- $ 292,591 $ 287,793 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 36,288 $ 35,005 Accrued liabilities 13,794 13,195 Obligations under capital leases 2,205 2,822 Income taxes payable 1,410 - Current installments of long-term debt 7,547 7,547 --------- --------- Total current liabilities 61,244 58,569 --------- --------- Deferred income taxes 19,227 17,748 Other liabilities 3,130 3,612 Obligation under capital leases 1,069 1,891 Long-term debt, excluding current installments 13,114 16,887 --------- --------- Total liabilities 97,784 98,707 --------- --------- Shareholders' equity: Preferred stock, par value of $.001 per share Authorized 5,000,000 shares; none issued - - Common stock, par value of $.001 per share Authorized 20,000,000 shares; 12,425,708 shares issued and 11,618,499 outstanding as of June 27, 2004; and 12,325,482 shares issued and 11,518,273 outstanding as of December 28, 2003 12 12 Additional paid-in capital 146,217 145,856 Treasury stock, 807,209 shares (8,012) (8,012) Deferred compensation related to restricted stock (777) (892) Accumulated other comprehensive loss (335) (625) Retained earnings 57,702 52,747 --------- --------- Total shareholders' equity 194,807 189,086 --------- --------- $ 292,591 $ 287,793 ========= =========
See accompanying notes to condensed consolidated financial statements. 4 INSURANCE AUTO AUCTIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (dollars in thousands)
SIX MONTHS ENDED ------------------------- JUNE 27, JUNE 29, 2004 2003 -------- -------- (UNAUDITED) Cash flows from operating activities: Net earnings $ 4,956 $ 3,256 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 6,522 4,870 Gain on disposal of fixed assets (19) (31) Loss on change in fair market value of derivative unhedged portion - (307) Deferred compensation related to restricted stock 114 - Changes in assets and liabilities (excluding effects of acquired companies): (Increase) decrease in: Accounts receivable, net 2,935 7,370 Inventories 209 985 Other current assets 137 917 Other assets (1,117) (754) Increase (decrease) in: Accounts payable 1,282 (3,336) Accrued liabilities 407 (684) Income taxes, net 2,470 1,383 -------- -------- Total adjustments 12,940 10,412 -------- -------- Net cash provided by operating activities 17,896 13,669 -------- -------- Cash flows from investing activities: Capital expenditures (11,105) (6,498) Proceeds from disposal of property and equipment 200 44 Payments made in connection with acquisitions, net of cash acquired - (7,863) -------- -------- Net cash used in investing activities (10,905) (14,317) -------- -------- Cash flows from financing activities: Proceeds from issuance of common stock 361 227 Proceeds from term loan - 30,000 Principal payments on long-term debt (3,772) (1,896) Purchase of treasury stock - (8,012) Principal payments on capital leases (1,438) (1,191) -------- -------- Net cash provided (used) by financing activities (4,849) 19,128 -------- -------- Net increase in cash and cash equivalents 2,142 18,480 Cash and cash equivalents at beginning of period 15,486 10,027 -------- -------- Cash and cash equivalents at end of period $ 17,628 $ 28,507 ======== ======== Supplemental disclosures of cash flow information: Cash paid or refunded during the period for: Interest $ 1,025 $ 647 ======== ======== Income taxes paid $ 2,026 $ 797 ======== ======== Income taxes refunded $ 1,011 $ 1,250 ======== ======== Non-cash financing activities: Property and equipment additions resulting from capital leases $ - $ 3,375 ======== ========
See accompanying notes to condensed consolidated financial statements. 5 INSURANCE AUTO AUCTIONS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. GENERAL The unaudited condensed consolidated financial statements of Insurance Auto Auctions, Inc. and its subsidiaries (collectively, the "Company") have been prepared on the same basis as the annual audited consolidated financial statements and, in the opinion of the Company, reflect all adjustments necessary for a fair presentation for each of the periods presented. The results of operations for interim periods are not necessarily indicative of results for full fiscal years. As contemplated by the Securities and Exchange Commission ("SEC") under Rule 10-01 of Regulation S-X, the accompanying consolidated financial statements and related notes have been condensed and do not contain certain information that is included in the Company's annual consolidated financial statements and notes thereto. For further information, refer to the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 28, 2003. Fiscal year 2003 consisted of 52 weeks and ended December 28, 2003. Fiscal year 2004 will consist of 52 weeks and will end on December 26, 2004. Certain reclassifications have been made to the prior year financial information to conform to the current year presentation. 2. INCOME TAXES Income taxes were computed using the effective tax rates estimated to be applicable for the full fiscal years, which are subject to ongoing review and evaluation by the Company. 3. COMPUTATION OF EARNINGS PER SHARE The computation of basic earnings per share is made using the weighted average number of common shares outstanding during the period. Diluted earnings per share includes the number of additional shares that would have been outstanding if the dilutive common shares had been issued. The following table sets forth the computation of basic and diluted earnings per share:
THREE MONTHS ENDED SIX MONTHS ENDED ---------------------- ---------------------- JUNE 27, JUNE 29, JUNE 27, JUNE 29, 2004 2003 2004 2003 ------- ------- ------- ------- BASIC EARNINGS PER SHARE: Net income $ 2,655 $ 1,280 $ 4,956 $ 3,256 Average basic shares outstanding 11,545 11,517 11,541 11,784 Basic net income per share $ .23 $ .11 $ .43 $ .28 DILUTED EARNINGS PER SHARE: Net income $ 2,655 $ 1,280 $ 4,956 $ 3,256 Average basic shares outstanding 11,545 11,517 11,541 11,784 Effect of dilutive securities: Stock options 219 60 176 77 Restricted stock 67 - 67 - Average diluted shares outstanding 11,831 11,577 11,784 11,861 Diluted net income per share $ .22 $ .11 $ .42 $ .27
6 4. GOODWILL AND INTANGIBLES The Company performs its annual impairment test during the first quarter of each year. This year's annual impairment test did not indicate any impairment. Goodwill and other intangibles are recorded at cost less accumulated amortization and consist of the following at June 27, 2004 and December 28, 2003:
JUNE 27, DECEMBER 28, ASSIGNED LIFE 2004 2003 ------------- -------- ----------- (dollars in millions) Goodwill Indefinite $ 135.8 $ 135.1 Covenants not to compete 5 to 15 years 1.8 2.1 -------- -------- $ 137.6 $ 137.2 ======== ========
Amortization expense for the six months ended June 27, 2004 and June 29, 2003 was $0.3 million in 2004 and $0.2 million in 2003. This amount is included within selling, general and administration expense on the Company's Condensed Consolidated Statements of Operations. Based upon existing intangibles, the projected annual amortization expense is $0.5 million for each of the years 2004, 2005 and 2006, $0.4 million for 2007 and $0.2 million for 2008. 5. FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES The Company, as a matter of policy, does not enter into derivative contracts for trading or speculative purposes. During the first quarter of 2002, the Company entered into an interest rate swap to mitigate its exposure to interest rate fluctuations and to effectively fix its borrowing rate at 5.6%. Under the interest rate swap agreement, the Company pays a fixed rate of interest of 5.6% and receives a LIBOR-based floating rate. At June 27, 2004, the entire swap agreement qualified for hedge accounting. 6. COMPREHENSIVE INCOME Comprehensive income consists of net earnings and the change in fair value of the Company's interest rate swap agreement as follows (dollars in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED ----------------------- ----------------------- JUNE 27, JUNE 29, JUNE 27, JUNE 29, 2004 2003 2004 2003 ------- ------- ------- ------- Net earnings $ 2,655 $ 1,280 $ 4,956 $ 3,256 Other comprehensive income (loss) Change in fair value of interest rate swap agreement 426 (25) 470 (291) Income tax benefit (expense) (164) 10 (181) 110 ------- ------- ------- ------- Comprehensive income $ 2,917 $ 1,265 $ 5,245 $ 3,075 ======= ======= ======= =======
The changes in fair value of the Company's interest rate swap agreement were due to changes in interest rates. 7 7. STOCK OPTIONS The Company accounts for its fixed plan stock options under the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense would be recorded on the date of grant and amortized over the period of service only if the current market value of the underlying stock exceeded the exercise price. No stock-based employee compensation cost related to stock option grants is recognized in net earnings, as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. In 2003, the Company initiated a restricted stock program. Under the Company's restricted stock program, common stock of the Company may be granted at no cost to certain officers and key employees. Plan participants are entitled to cash dividends and to vote their respective shares. Restrictions limit the sale or transfer of these shares during a four year period whereby the restrictions lapse on 25% of the shares each year. Upon issuance of stock under the plan, unearned compensation equivalent to the market value of the shares at the date of the grant is charged to shareholders' equity and subsequently amortized to expense over the four-year restriction period. In 2003, 66,500 restricted shares were granted. Compensation expense in 2003 was less than $0.1 million and $0.1 million for the six months ended June 27, 2004. There were no forfeitures of restricted shares in 2003 and 2004. The following table illustrates the effect on net earnings if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," to the measurement of stock-based employee compensation relating to stock options and restricted stock, including straight-line recognition of compensation costs over the related vesting periods for fixed awards:
THREE MONTHS ENDED SIX MONTHS ENDED -------------------------------- ----------------------------- JUNE 27, JUNE 29, JUNE 27, JUNE 29, 2004 2003 2004 2003 ------------ ------------ ------------ --------- Net earnings as reported $ 2,655 $ 1,280 $ 4,956 $ 3,256 Add: Stock-based employee compensation expense included in reported net earnings, net of related tax effects 34 - 68 - ------------ ------------ ------------ --------- Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects 622 433 1,241 864 ------------ ------------ ------------ --------- Pro forma net earnings $ 2,067 $ 847 $ 3,783 $ 2,392 ============ ============ ============ ========= Earnings per share: Basic - as reported $ .23 $ .11 $ .43 $ .28 ============ ============ ============ ========= Basic - pro forma $ .18 $ .07 $ .33 $ .20 ============ ============ ============ ========= Diluted - as reported $ .22 $ .11 $ .42 $ .27 ============ ============ ============ ========= Diluted - pro forma $ .17 $ .07 $ .32 $ .20 ============ ============ ============ =========
8. RELATED PARTY TRANSACTION The Company leases certain properties from a member of its Board of Directors. The Company believes the terms of the leases are no less favorable than those available from unaffiliated third party lessors. In the second quarter of 2004 and 2003, the Company incurred $1.1 million and $0.6 million, respectively, of costs to upgrade properties owned by the related party. A portion of the investment to upgrade these facilities has been funded by the related party. The Company agreed to modify its future 8 lease payments to take into consideration the costs to be funded by the related party. The total amount of all future rent payments related to the related party's funding is $2.4 million. The Company also initiated a temporary lease agreement in March to expand the amount of property available at one of the facilities leased. The temporary lease agreement does not have a specified term, can be terminated by either party upon 30 days written notice and has an annual rental of less than $0.1 million. 9. COMMITMENTS AND CONTINGENCIES The Company leases its facilities and certain equipment under operating and capital leases. During the first two quarters of 2004, the Company entered into a number of operating leases, including its principal corporate office. The Company's principal corporate office is currently located in Schaumburg, Illinois and occupies a total of 39,000 square feet of space under an extended lease that expires in September 2004. In April 2004, the Company entered into a new lease agreement for 38,000 square feet of space for future use as its corporate offices in Westchester, Illinois. This lease commences in September 2004 and expires in August 2016. The Company has an allowance totaling $1.9 million from the lessor for the build-out of the office space. The Company does not expect rent expense related to its corporate office to increase as a result of this move. As of June 27, 2004, the Company had not entered into any capital leases in the current year. 10. SUBSEQUENT EVENTS On June 28, 2004, the Company sold its West Bridgewater, Massachusetts facility to Harvey Industries, Inc., a Massachusetts corporation, for $1.1 million in cash. On July 6, 2004, the Company announced the opening of a new greenfield facility in El Paso, Texas. On July 8, 2004, the Company announced the acquisition of Mid-South Salvage LLC located in Jackson, Mississippi. The acquisition is accounted for as a purchase business combination and the results of operations of the acquired business will be included in the Company's future consolidated financial statements from the date of acquisition. In July and August 2004, the Company purchased 55,200 shares pursuant to the authorization at an average price of $16.01 per share, or a total amount of $0.9 million. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This report contains forward-looking statements that are subject to certain risks, trends and uncertainties that could cause actual results to differ materially from those projected, expressed, or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by use of words such as "may, will, should, believes, expects, plans, future, intends, could, estimate, predict, projects, targeting, potential or contingent," the negative of these terms or other similar expressions. The Company's actual results could differ materially from those discussed or implied herein. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in "Factors That May Affect Future Results" and in the Company's Annual Report on Form 10-K for the fiscal year ended December 28, 2003. You should not place undue reliance on any forward-looking statements. Except as expressly required by the federal securities laws, the Company undertakes no obligation to publish, update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances, or any other reason. OVERVIEW Insurance Auto Auctions, Inc. offers insurance companies and other vehicle suppliers cost-effective salvage processing solutions on either a consignment or purchase agreement method of sale. Consignment method sales are consummated under either a fixed fee or percentage of sale basis. The percentage of sale consignment method offers potentially increased profits over fixed fee consignment by providing incentives to both the Company and the salvage provider to invest in vehicle enhancements, thereby maximizing vehicle selling prices. Under the fixed fee and percentage of sale consignment methods, the vehicle is not owned by the Company and only the fees associated with processing the vehicle are recorded as revenue. The proceeds from the sale of the vehicle itself are not included in revenue. Under the purchase agreement sales method, the vehicle is owned by the Company, and the proceeds from the sale of the vehicle are recorded as revenue. The Company has grown primarily through a series of acquisitions and opening of new sites to now include 77 sites. In January 2004, the Company established a new facility in Tucson, Arizona. In July 2004 the Company acquired Mid-South Salvage LLC located in Jackson, Mississippi and established a new facility in El Paso, Texas. The Company's operating results are subject to fluctuations, including quarterly fluctuations, that can result from a number of factors, some of which are more significant for sales under the purchase agreement method. See "Factors That May Affect Future Results" below for a further discussion of some of the factors that affect or could affect the Company's business, operating results and financial condition. RESULTS OF OPERATIONS Three Months Ended June 27, 2004 Compared to the Three Months Ended June 29, 2003 Revenues were $60.0 million for the three months ended June 27, 2004, up from $53.3 million for the same three month period in 2003. Fee income in the second quarter increased 20% to $51.8 million, versus $43.1 million in the second quarter of last year due to the Company's continued shift away from the purchase agreement method of sale, more favorable pricing and an increase in volumes sold. Vehicles sold under the purchase agreement method accounted for 3% of the total vehicles sold in the second quarter of 2004, versus 6% for the same quarter last year. Cost of sales increased $4.5 million to $46.8 million for the three months ended June 27, 2004, versus $42.3 million for the same period last year. Vehicle cost of $7.2 million was $2.2 million less than the $9.4 million incurred in the second quarter of 2003. This decrease was primarily related to the Company's shift away from vehicles sold under the purchase agreement method. Branch cost of $39.6 million increased $6.8 million from $32.8 million for the same period last year. This increase was primarily the result of higher volumes of vehicles processed for the quarter and higher per unit tow costs, along with the impact of new branches opened in 2003 and 2004. 10 Gross profit increased 19% to $13.2 million for the three months ended June 27, 2004, from $11.1 million for the comparable period in 2003. Selling, general and administrative expense of $8.4 million increased $0.9 million, or 12%, from the $7.5 million of expense incurred during the second quarter of last year. This increase is primarily due to performance-based bonus accruals and higher depreciation on the Company's new information technology system. Excluding the bonus accrual and increase in depreciation, selling, general and administrative expenses decreased in the second quarter of 2004 compared to the same period last year. Amortization of intangible assets is now included within this category of expense and amounted to $0.1 million in the second quarter of 2003 and 2004. There were no business transformation costs for the three months ended June 27, 2004 compared to $0.9 million in the same period last year. Business transformation costs included expenses related to data base conversions, training and other activity related to the roll out of the Company's new information technology system. Interest expense decreased to $0.4 million for the three months ended June 27, 2004, from $0.5 million for the comparable period in 2003. Included in interest expense for the three months ended June 29, 2003 was a non-cash benefit of $0.3 million related to the change in fair value of the Company's interest rate swap agreement. The Company's effective income tax rate was 40.7% and 41.2% in 2004 and 2003, respectively. Six Months Ended June 27, 2004 Compared to the Six Months Ended June 29,2003 Revenues were $117.2 million for the six months ended June 27, 2004, up from $109.4 million for the six month period ended June 29, 2003. Fee income increased to $101.8 million versus $85.9 million for the six month period ended June 29, 2003 due to the Company's continued shift away from the purchase agreement method of sale, more favorable pricing and an increase in volumes sold. Vehicles sold under the purchase agreement method accounted for 3% of the vehicles sold in the first six months of 2004, versus 7% for the same period last year. Cost of sales increased $4.2 million to $91.2 million for the six months ended June 27, 2004, versus $87.0 million for the same period last year. Vehicle cost of $13.2 million was $8.0 million less than last year's amount of $21.2 million. This decrease was primarily related to the Company's shift away from vehicles sold under the purchase agreement method. Branch cost of $78.0 million increased $12.2 million from $65.8 million for the same period last year. This increase was primarily the result of additional operating costs related to new branch facilities. Gross profit increased 16% to $26.0 million for the six months ended June 27, 2004, from $22.4 million for the comparable period in 2003. Selling, general and administration expense of $16.8 million increased 15% from last year's amount of $14.7 million. This increase is primarily due to performance based bonus accruals and depreciation on the Company's new information technology system. Amortization of intangible assets is now included within this category of expense and amounted to $0.3 million in 2004 and $0.2 million in 2003. There were no business transformation costs for the six months ended June 27, 2004 compared to $1.7 million in the same period last year. Business transformation costs included expenses related to data base conversions, training and other activity related to the roll out of the Company's new information technology system. Interest expense of $0.9 million for the six months ended June 27, 2004, increased $0.3 million from $0.6 million for the comparable period in 2003. The Company's effective income tax rate was 40.6% and 41.2% in 2004 and 2003, respectively. 11 FINANCIAL CONDITION AND LIQUIDITY At June 27, 2004, the Company had current assets of $79.4 million, which included $17.6 million of cash and cash equivalents. Current liabilities were $61.2 million. The Company had working capital of $18.2 million at June 27, 2004, a $3.8 million decrease from December 28, 2003. At June 27, 2004, the Company's long-term debt, including current installments, consisted of $20.7 million borrowed under its term credit facility. The term credit facility was a one-year revolver that converted on February 15, 2003 into a four-year term loan carrying a variable rate based upon LIBOR. The aggregate principal balance of the loan is required be paid in sixteen consecutive equal quarterly installments commencing on March 31, 2003. On March 19, 2004, the Company entered into a Second Amended and Restated Credit Agreement relating to its senior credit facility. The agreement amends certain financial covenants, provides that advances made under the facility will be subject to a monthly asset coverage test equal to 85% of eligible receivables and requires the Company to provide collateral for amounts due under the facility in the event it fails to meet certain financial projections for two consecutive quarters. At June 27, 2004, the Company was in compliance with its credit agreement covenants. Other long-term liabilities include the fair market on the Company's interest rate swap along with the Company's post-retirement benefits liability that relates to the acquisition of Underwriters Salvage Company in 1994. The amount recorded at June 27, 2004 for the post-retirement benefits liability was approximately $2.6 million. Capital expenditures were $11.1 million for the six months ended June 27, 2004. These capital expenditures consisted of various branch improvements, including upgrades to existing branches, the development of new facilities, and continued enhancements to the Company's new information technology system. The Company's Board of Directors authorized the purchase of 1,500,000 shares of the Company's common stock in September 2000 and an additional 750,000 shares in April 2003, for a combined authorization of 2,250,000 shares. Purchases may be made from time to time in the open market or in privately negotiated transactions, subject to the requirements of applicable laws, and will be financed with existing cash and cash equivalents, marketable securities, and cash from operations. In the first half of 2003, the Company purchased 807,209 shares pursuant to this authorization at an average price of $9.93 per share, or a total amount of $8.0 million. No shares were purchased during the second quarter or first six months of 2004. The Company believes that existing cash and cash equivalents, as well as cash generated from operations, will be sufficient to fund capital expenditures and provide adequate working capital for operations for the next twelve months. Part of the Company's plan is to pursue continued growth, possibly through new facility start-ups, acquisitions, and the development of new claims processing services. At some time in the future, the Company may require additional financing. There can be no assurance that additional financing, if required, will be available on favorable terms. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the related disclosures. The Company believes the critical accounting policies that require significant judgments and estimates are related to goodwill, deferred income taxes, and long-lived assets. For further information regarding these policies, refer to the Company's Form 10-K for the year ended December 28, 2003. 12 SUMMARY DISCLOSURE ABOUT CONTRACTUAL OBLIGATIONS With the exception of its lease obligation, the Company's contractual obligations have not changed materially since last reported. The Company's principal corporate office is currently located in Schaumburg, Illinois and occupies a total of 39,000 square feet of space under an extended lease that expires in September 2004. In April 2004, the Company entered into a new lease agreement for 38,000 square feet of space for future use as its corporate offices in Westchester, Illinois. This lease commences in September 2004 and expires in August 2016. The Company has an allowance totaling $1.9 million from the lessor for the build-out of the office space. The Company does not expect rent expense related to its corporate office to increase as a result of this move. The minimum future rent obligation associated with this new lease is as follows:
LEASE OBLIGATION ---------------------- (dollars in thousands) 2004 $ 130 2005 389 2006 528 2007 816 2008 844 Thereafter 7,602 -------- $10,309 =======
FACTORS THAT MAY AFFECT FUTURE RESULTS The Company operates in a changing environment that involves a number of risks, some of which are beyond the Company's control. The following discussion highlights some of these risks. Period Fluctuations. The Company's operating results have in the past and may in the future fluctuate significantly depending on a number of factors. These factors include, but are not limited to, the Actual Cash Value ("ACV") of salvage vehicles, changes in the market value of salvage vehicles, delays or changes in state title processing, general weather conditions, changes in regulations governing the processing of salvage vehicles, the availability and quality of salvage vehicles and buyer attendance at salvage auctions. The Company is also dependent upon receiving a sufficient number of total-loss vehicles as well as recovered theft vehicles to sustain its profit margins. Factors that can affect the number of vehicles received include, but are not limited to, driving patterns, reduction of policy writing by insurance providers, which would affect the number of claims over a period of time, and changes in direct repair procedures that would reduce the number of newer, less damaged total-loss vehicles, which tend to have the higher salvage values. Future decreases in the quality and quantity of vehicle inventory, and in particular the availability of newer and less-damaged vehicles, especially for inventory disposed of under the purchase agreement method of sale, would have a material adverse effect on the operating results and financial condition of the Company. Additionally, in the last few years there has been a declining trend in theft occurrences. As a result, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as an indication of future performance. Revenues for any future quarter are not predictable with any significant degree of accuracy, and the Company's operating results may vary significantly due to its relatively fixed expense levels. Due to all of the foregoing factors, it is likely that in some future quarters the Company's operating results will fall below the expectations of public market analysts and investors. Any failure to meet expectations of securities analysts or the market in general could adversely affect the market price of the Company's common stock. Competition. The Company faces intense competition for the supply of salvage vehicles as well as competition from processors of vehicles from other regional salvage pools. The Company may encounter further competition from existing competitors and new market entrants that are significantly larger and have greater financial and marketing resources. Other potential competitors include used car auction companies, providers of claims software to insurance companies, certain salvage buyer groups and insurance companies, some of which presently supply auto salvage to the Company. While most insurance companies have abandoned or reduced efforts to sell salvage vehicles without the use of service providers such as the Company, they may in the future decide to dispose of their salvage directly to end users. The Company may not be able to compete successfully against current or future competitors, which could impair its ability to grow and achieve or sustain profitability. Dependence on Key Insurance Company Suppliers. Historically, a limited number of insurance companies has accounted for a substantial portion of the Company's revenues. For example, in 2003, vehicles supplied by the Company's three largest suppliers accounted for approximately 36% of the Company's total unit sales. The largest suppliers, State Farm Insurance, Farmers Insurance, and Allstate, accounted for approximately 16%, 12%, and 8%, respectively, of the Company's unit sales. A loss or reduction in the number of vehicles from any of these suppliers, or adverse changes in the agreements that these suppliers have with the Company, could have a material adverse effect on the Company's operating results, financial condition and quantity or quality of inventory. Enterprise-Wide System Redesign Project. The Company developed a new enterprise-wide application to manage its salvage and auction process. The new Web-based system is intended to support and streamline vehicle registration and tracking, financial reporting, transaction settlement, vehicle title transfer, and branch/headquarters communications. Development and testing of the enterprise-wide application began in the third quarter of 2001. The Company began rolling out the new system to its branches during the third quarter of 2002. Though the Company encountered some unanticipated issues during the implementation phase, which delayed completion of the project and caused the Company to incur additional costs beyond the project's original estimates, the Company completed the roll-out of the new system by the end of 2003. However, there remain inherent risks associated with the application and continued enhancement of the new 13 system that could continue to adversely impact the Company's ability to achieve cost savings and increased profitability. Governmental Regulation. The Company's operations are subject to regulation, supervision and licensing under various federal, state and local agencies statutes and ordinances. The acquisition and sale of totaled and recovered theft vehicles is regulated by state motor vehicle departments in each of the locations in which the Company operates. Changes in law or governmental regulations or interpretations of existing law or regulations could result in increased costs, reduced salvage vehicle prices and decreased profitability for the Company. In addition to the regulation of sales and acquisitions of vehicles, the Company is also subject to various local zoning requirements with regard to the location of its auction and storage facilities. These zoning requirements vary from location to location. Failure to comply with present or future regulations or changes in existing regulations could have a material adverse effect on the Company's operating results and financial condition. Provision of Services as a National or Regional Supplier. The provision of services to insurance company suppliers on a national or regional basis requires that the Company expend resources and dedicate management to a small number of individual accounts, resulting in a significant amount of fixed costs. The development of a referral-based national network service, in particular, has required the devotion of financial resources without immediate reimbursement of these expenses by the insurance company suppliers. The Company may not realize sufficient revenue from these services to cover these expenses, in which case, its results of operations may be materially adversely affected. Expansion and Integration of Facilities. The Company seeks to increase sales and profitability through acquisitions of other salvage auction facilities, new site expansion and the increase of salvage vehicle volume at existing facilities. The Company may not be able to continue to acquire new facilities or add additional facilities on terms economically favorable to the Company, or at all, or increase revenues at newly-acquired facilities above levels realized prior to acquisition. The Company's ability to achieve these objectives is dependent on, among other things, the integration of new facilities, and their information systems, into its existing operations, the identification and lease of suitable premises, and the availability of capital. There can be no assurance that this integration will occur, that suitable premises will be identified or that additional capital will be available to fund the expansion and integration of the Company's business. Any delays or obstacles in this integration process could have a material adverse effect on the Company's operating results and financial condition. The Company has limited sources of additional capital available for acquisitions, expansions and start-ups. The Company's ability to integrate and expand its facilities will depend on its ability to identify and obtain additional sources of capital. Volatility of Stock Price. The market price of the Company's common stock has been and will continue to be subject to significant fluctuations in response to various factors and events, including variations in the Company's operating results, the timing and size of acquisitions and facility openings, the loss of vehicle suppliers or buyers, the announcement of new vehicle supply agreements by the Company or its competitors, changes in regulations governing the Company's operations or its vehicle suppliers, environmental problems or litigation. Any failure to meet expectations of securities analysts or the market in general could adversely affect the market price of the Company's common stock. Environmental Regulation. The Company's operations are subject to federal, state and local environmental laws and regulations. In the salvage vehicle auction industry, large numbers of wrecked vehicles are stored at auction facilities for short periods of time. Minor spills of gasoline, motor oils and other fluids may occur from time to time at the Company's facilities and may result in soil, surface water or groundwater contamination. Petroleum products and other hazardous materials are contained in aboveground or underground storage tanks located at certain of the Company's facilities. Waste materials, such as waste solvents or used oils, are generated at some of the Company's facilities and are disposed of as non-hazardous or hazardous wastes. The Company believes that it is in compliance in all material respects with applicable environmental regulations and does not anticipate any material capital expenditure for environmental compliance or remediation. To date, the Company has not incurred significant expenditures for preventive or remedial action with respect to contamination or the use of hazardous materials. Environmental laws and regulations could become more stringent over time and the Company may be subject to significant compliance costs in the future. Future contamination at any one or more of the Company's facilities, or the potential contamination by previous users of certain acquired facilities, create the risk, however, that the Company could 14 incur significant expenditures for preventive or remedial action, as well as potential liability arising as a consequence of hazardous material contamination, which could have a material adverse effect on the Company's operating results and financial condition. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company is exposed to interest rate fluctuations on its floating rate credit facility, under which the Company has outstanding a $20.7 million term loan. In 2002, the Company entered into an interest rate swap to mitigate its exposure to interest rate fluctuations, and does not, as a matter of policy, enter into hedging contracts for trading or speculative purposes. At June 27, 2004, the interest rate swap agreement had a notional amount of $20.7 million under which the Company paid a fixed rate of interest of 5.6% and received a LIBOR-based floating rate. At June 27, 2004, the entire swap agreement qualified for hedge accounting. The Company believes that the exposure of its consolidated financial position, results of operations and cash flows to adverse changes in interest rates is not significant. ITEM 4. CONTROLS AND PROCEDURES a. Evaluation of Disclosure Controls and Procedures The Company completed an evaluation as of the end of the period covered by this report under the supervision and with the participation of management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective to provide them reasonable assurances that the information required to be disclosed in the reports the Company files or submits under the Securities and Exchange Act of 1934 is recorded, processed, summarized and reported within the time period specified in Securities and Exchange Commission rules and forms. Any control system, no matter how well designed and operated, can provide only reasonable (not absolute) assurance that its objectives will be met. Furthermore, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. b. Changes in Internal Controls Subsequent to the Company's evaluation, there were no significant changes in the internal controls or in other factors that could significantly affect internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses. While there were no significant changes to the internal controls, the Company completed the implementation of a new enterprise-wide application to manage the salvage and auction process in the fourth quarter of 2003. The Company continues to modify this application, which may affect its internal controls over financial reporting. PART II. OTHER INFORMATION. ITEM 1. LEGAL PROCEEDINGS. In addition to the legal proceedings described in its Annual Report for the year ended December 28, 2003, the Company is from time to time subject to claims and suits arising in the ordinary course of business. Although the ultimate disposition of such proceedings is not presently determinable, management does not believe that the ultimate resolution of these matters will have a material adverse effect on the Company's financial condition, results of operations or cash flows. The Company maintains comprehensive general liability insurance that it believes to be adequate for the continued operation of its business. ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES. The Company has never declared or paid any cash dividends on its common stock and does not anticipate paying any cash dividends in the foreseeable future. The Company intends to retain any future earnings to finance the growth and development of its business. In addition, the Company's financing 15 agreement limits the Company's ability to pay cash dividends to no more than 25% of the Company's consolidated net income earned over a specified period. The Company's Board of Directors authorized the purchase of 1,500,000 shares of the Company's common stock in September 2000 and an additional 750,000 shares in April 2003, for a combined authorization of 2,250,000 shares. Purchases may be made from time to time in the open market or in privately negotiated transactions, subject to the requirements of applicable laws, and will be financed with existing cash and cash equivalents, and cash from operations. The repurchase plan expires upon the repurchase of all authorized shares. As of June 27, 2004, the Company had purchased 807,209 shares pursuant to this authorization at an average price of $9.93 per share. The maximum number of shares that may yet be purchased under the plan is 1,442,791. The Company did not repurchase any shares during the second quarter 2004. The Company records treasury stock purchases using the cost method of accounting. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. Inapplicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. At the Annual Meeting of Shareholders of the Company held June 16, 2004, the shareholders (i) elected seven directors to serve on the Company's Board of Directors, (ii) approved the adoption of an amendment to the Company's Employee Stock Purchase Plan to increase the number of shares of common stock reserved for issuance thereunder by 100,000 shares, and (iii) ratified the Company's appointment of KPMG LLP to serve as the Company's independent auditors for the fiscal year ending December 26, 2004. Shareholders holding 10,849,756 shares of common stock, representing 93% of the total number of shares outstanding and entitled to vote at the meeting, were present in person or by proxy at the meeting. The vote for nominated directors was as follows:
Director Votes FOR Votes Withheld -------- ---------- -------------- Thomas C. O'Brien 10,719,824 129,932 Peter H. Kamin 10,549,093 300,663 Todd F. Bourell 10,714,842 134,914 Maurice A. Cocca 10,554,235 295,521 Philip B. Livingston 10,554,335 295,421 Melvin R. Martin 10,638,164 211,592 John K. Wilcox 10,719,984 129,772
The vote to approve the amendment to the Company's Employee Stock Purchase Plan was as follows: For: 8,621,607; Against: 133,862; Abstain: 3,783; and not voted: 2,090,504. The vote for ratifying the appointment of KPMG LLP as the Company's independent auditors for the fiscal year ending December 26, 2004 was as follows: For: 10,829,392; Against: 18,800; and Abstain: 1,564. 16 ITEM 5. OTHER INFORMATION. Inapplicable. ITEM 6. EXHIBITS AND REPORT ON FORM 8-K. (a) EXHIBITS. 10.1* Employment Agreement dated July 23, 2004 by and between the Company and John Kett. 31.1* Certification by the CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2* Certification by the CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32** Certification by the CEO and CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith ** Furnished herewith. (b) REPORTS ON FORM 8-K. The Company filed a current report on Form 8-K, dated July 23, 2004, which contained a press release announcing the Company's financial results for the quarter ended June 27, 2004. 17 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INSURANCE AUTO AUCTIONS, INC. Date: August 10, 2004 By: /s/ Scott P. Pettit --------------- ------------------------------- Name: Scott P. Pettit Title: Senior Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer) 18 EXHIBIT INDEX EXHIBIT NO. ----------- 10.1 Employment Agreement dated July 23, 2004 by and between the Company and John Kett. 31.1 Certification by the CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification by the CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certification by the CEO and CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 19