10-Q 1 c95020e10vq.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 March 27, 2005 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) Two Westbrook Corporate Center, Suite 500, Westchester, Illinois 60154 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (708) 492-7000 -------------------------------------------------------------------------------- (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 [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS Number of shares outstanding of each of the issuer's classes of common stock, as of April 29, 2005: Class Outstanding ------------------------------ ----------------- Common Stock, $0.001 Par Value 11,862,344 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 ......................................... 11 Overview ........................................................... 11 Acquisitions and New Operations .................................... 11 Results of Operations .............................................. 12 Financial Condition and Liquidity .................................. 12 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 .................................................. 16 Item 1. Legal Proceedings .................................................. 16 Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities ................................................. 17 Item 3. Defaults upon Senior Securities .................................... 17 Item 4. Submission of Matters to a Vote of Security Holders ................ 17 Item 5. Other Information .................................................. 17 Item 6. Exhibits and Reports on Form 8-K ................................... 18 SIGNATURES .................................................................. 19
2 INSURANCE AUTO AUCTIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands except earnings per share amounts)
THREE MONTHS ENDED ---------------------- MARCH 27, MARCH 28, 2005 2004 --------- --------- (UNAUDITED) Revenues: Vehicle sales $ 9,843 $ 7,127 Fee income 61,100 50,064 ------- ------- 70,943 57,191 Cost of sales: Vehicle cost 8,465 5,984 Branch cost 42,677 38,395 ------- ------- 51,142 44,379 ------- ------- Gross profit 19,801 12,812 Operating expenses: Selling, general and administrative 11,282 8,480 Gain on sale of property and equipment (32) (2) ------- ------- Earnings from operations 8,551 4,334 Other (income) expense: Interest expense 419 477 Other income (32) (10) ------- ------- Earnings before income taxes 8,164 3,867 Provision for income taxes 3,143 1,566 ------- ------- Net earnings $ 5,021 $ 2,301 ======= ======= Net earnings per share: Basic $ .43 $ .20 ======= ======= Diluted $ .41 $ .20 ======= ======= Weighted average shares outstanding: Basic 11,607 11,537 Effect of dilutive securities 686 132 ------- ------- Diluted 12,293 11,669 ======= =======
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)
MARCH 27, DECEMBER 26, 2005 2004 ----------- ------------ (UNAUDITED) ASSETS Current assets: Cash $ 21,834 $ 13,325 Accounts receivable, net 51,169 50,443 Inventories 15,539 14,498 Deferred income taxes 5,296 4,693 Other current assets 3,504 1,613 --------- --------- Total current assets 97,342 84,572 --------- --------- Property and equipment, net 74,716 74,684 Deferred income taxes 6,613 6,481 Intangible assets, net 1,604 1,747 Goodwill 137,494 137,494 Other assets 562 482 --------- --------- $ 318,331 $ 305,460 --------- --------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 40,970 $ 38,505 Accrued liabilities 12,565 13,513 Obligations under capital leases 807 1,094 Income taxes payable 4,013 1,067 Obligations under line of credit 9,000 6,000 Current installments of long-term debt 7,500 7,512 --------- --------- Total current liabilities 74,855 67,691 --------- --------- Deferred income taxes 21,479 20,729 Other liabilities 4,613 4,353 Obligations under capital leases 570 661 Long-term debt, excluding current installments 7,500 9,375 --------- --------- Total liabilities 109,017 102,809 --------- --------- 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; 12,760,498 shares issued and 11,622,661 outstanding as of March 27, 2005; and 12,709,758 shares issued and 11,569,156 outstanding as of December 26, 2004 12 12 Additional paid-in capital 152,636 151,793 Treasury stock, 906,562 shares at March 27, 2005 and 906,480 shares at December 26, 2004 (9,638) (9,637) Deferred compensation related to restricted stock (3,648) (4,343) Accumulated other comprehensive loss (81) (186) Retained earnings 70,033 65,012 --------- --------- Total shareholders' equity 209,314 202,651 --------- --------- $ 318,331 $ 305,460 ========= =========
See accompanying notes to condensed consolidated financial statements. 4 INSURANCE AUTO AUCTIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (dollars in thousands)
THREE MONTHS ENDED ----------------------- MARCH 27, MARCH 28, 2005 2004 --------- --------- (UNAUDITED) Cash flows from operating activities: Net earnings $ 5,021 $ 2,301 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 3,203 3,243 Gain on sale of fixed assets (32) (2) Deferred compensation related to restricted stock 695 57 Deferred income taxes 15 392 Tax benefit related to employee stock compensation 94 - Changes in assets and liabilities (excluding effects of acquired companies): (Increase) decrease in: Accounts receivable, net (726) (2,045) Inventories (1,041) (1,285) Other current assets (1,891) 353 Other assets (80) (117) Increase (decrease) in: Accounts payable 2,465 5,069 Accrued liabilities (583) (1,338) Income taxes 2,946 2,117 --------- --------- Net cash provided by operating activities 10,086 8,745 --------- --------- Cash flows from investing activities: Capital expenditures (3,148) (5,417) Proceeds from disposal of property and equipment 88 180 --------- --------- Net cash used in investing activities (3,060) (5,237) --------- --------- Cash flows from financing activities: Proceeds from issuance of common stock 749 259 Proceeds from short-term borrowings 3,000 7,000 Principal payments on long-term debt (1,887) (1,886) Purchase of treasury stock (1) - Principal payments - capital leases (378) (712) --------- --------- Net cash provided by financing activities 1,483 4,661 --------- --------- Net increase in cash 8,509 8,169 Cash at beginning of period 13,325 15,486 --------- --------- Cash at end of period $ 21,834 $ 23,655 ========= ========= Supplemental disclosures of cash flow information: Cash paid or refunded during the period for: Interest $ 370 $ 656 ========= ========= Income taxes paid $ 154 $ 2 ========= ========= Income taxes refunded $ 2 $ 1,011 ========= =========
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 fiscal year ended December 26, 2004. Fiscal year 2004 consisted of 52 weeks and ended December 26, 2004. Fiscal year 2005 will consist of 52 weeks and will end on December 25, 2005. The Company operates in a single business segment - providing insurance companies and other vehicle suppliers cost-effective salvage processing solutions including selling total loss and recovered theft vehicles. Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ from those estimates. On February 22, 2005, the Company entered into a merger agreement ("Merger Agreement") pursuant to which the Company will be merged with an affiliate of Kelso & Company, L.P., a New York-based equity investment firm (the "Merger") that specializes in acquisition transactions ("Kelso"). Pursuant to the Merger Agreement, each outstanding share of Company common stock will be exchanged for the right to receive $28.25 in cash, without interest. The Company has circulated to its shareholders a Proxy Statement dated April 26, 2005 for a Special Meeting of Shareholders to be held on May 25, 2005, to consider and approve the Merger. Pending approval of the Merger Agreement by the shareholders and satisfaction of the other conditions included in the Merger Agreement, the Company expects the Merger to be completed shortly after the Special Meeting of Shareholders. Information contained in this Quarterly Report, especially forward looking information, should be read in light of the Merger. NEW ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R (SFAS 123R) "Share-Based Payment." SFAS 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. SFAS 123R establishes fair value as the measurement method in accounting for share-based payments to employees and eliminates the alternative use of the intrinsic value method of accounting under APB Opinion No. 25, "Accounting for Stock Issued to Employees." This statement is effective for public entities as of the beginning of the first annual reporting period that begins after June 15, 2005. The Company is currently evaluating the impact of adoption on our financial statements. 6 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 ----------------------- MARCH 27, MARCH 28, 2005 2004 --------- ---------- BASIC EARNINGS PER SHARE: Net earnings $ 5,021 $ 2,301 Average basic shares outstanding 11,607 11,537 Basic net earnings per share $ .43 $ .20 DILUTED EARNINGS PER SHARE: Net earnings $ 5,021 $ 2,301 Average basic shares outstanding 11,607 11,537 Effect of dilutive securities Stock options 647 65 Restricted stock 39 67 Average diluted shares outstanding 12,293 11,669 Diluted net earnings per share $ .41 $ .20
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 March 27, 2005 and December 26, 2004:
COST --------------------------------------------------------- MARCH 27, DECEMBER 26, ASSIGNED LIFE 2005 2004 ------------- --------------------- ------------- (dollars in millions) Goodwill Indefinite $ 137.5 $ 137.5 Covenants not to compete 3 to 5 years 4.2 4.2 ------- ------- $ 141.7 $ 141.7 ======= =======
ACCUMULATED AMORTIZATION --------------------------------------------------------- MARCH 27, DECEMBER 26, ASSIGNED LIFE 2005 2004 ------------- --------------------- ------------- (dollars in millions) Covenants not to compete 3 to 5 years $ (2.6) $ (2.5)
7 Amortization expense for the three months ended March 27, 2005 and March 28, 2004 was $0.1 million, respectively. This amount is included within selling, general and administrative expense on the Company's Condensed Consolidated Statements of Operations. Based upon existing intangibles, the projected annual amortization expense for each of the years 2005 and 2006 is $0.6 million, $0.4 million for 2007 and $0.2 million for 2008. The assets will be fully amortized by 2009. 5. FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES The Company is exposed to interest rate fluctuations on its floating rate credit facility, under which the Company has outstanding a $15.0 million term loan at March 27, 2005. 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 March 27, 2005, the interest rate swap agreement had a notional amount of $15.0 million, and provided that the Company pay a fixed rate of interest of 4.4% and receive a LIBOR-based floating rate on the notional amount. At March 27, 2005, the interest rate on the term loan was 5.4%. At March 27, 2005, the entire swap agreement qualified for hedge accounting and all changes in the fair value of the swap were recorded, net of tax, through other comprehensive income (see Note 6). The fair market value of the swap as of March 27, 2005 and March 28, 2004 was approximately $131,000 and $970,000, respectively. 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 ---------------------- MARCH 27, MARCH 28, 2005 2004 --------- --------- Net earnings $ 5,021 $ 2,301 Other comprehensive income Change in fair value of interest rate swap agreement 170 44 Income tax expense (65) (17) -------- -------- Comprehensive income $ 5,126 $ 2,328 ======== ========
The changes in fair value of the Company's interest rate swap agreement were due to changes in interest rates. 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 grant program. Under the Company's restricted stock grant program, shares of the Company's common stock 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 received pursuant to the program. Restrictions limit the sale or transfer of these shares over a four-year period. The sale and transfer restrictions on shares received under the program expire at a rate of 25% per year or earlier, based on the achievement of certain performance based goals. Upon issuance of shares of common 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 2004, 182,600 restricted shares were granted and in 2003, 66,500 restricted shares were granted. 8 Compensation expense for the three months ended March 27, 2005 was $0.7 million and $0.1 million for the three months ended March 28, 2004. Compensation expense was accelerated by $0.4 million in the three months ended March 27, 2005 due to the anticipated achievement of certain performance levels. In the first quarter of 2005, there were forfeitures of 1,200 restricted shares. There were no forfeitures of restricted shares in 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 ------------------------- MARCH 27, MARCH 28, 2005 2004 --------- --------- Net earnings as reported $5,021 $ 2,301 Add: Stock-based employee compensation expense included in reported net earnings, net of related tax effects 428 34 ------ ------- Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards, net of related tax effects (906) (619) ------ ------- Pro forma net earnings $4,543 $ 1,716 ====== ======= Earnings per share: Basic - as reported $ .43 $ .20 ====== ======= Basic - pro forma $ .39 $ .15 ====== ======= Diluted - as reported $ .41 $ .20 ====== ======= Diluted - pro forma $ .37 $ .15 ====== =======
8. COMMITMENTS AND CONTINGENCIES The Company leases its facilities and certain equipment under operating and capital leases. As of March 27, 2005, the Company had not entered into any capital leases in the current year. On February 4, 2003, the Company filed a lawsuit in the Superior Court of California, County of Sacramento, against, among others, Emery Air Freight Corporation ("Emery") and Tennessee Technical Services ("TN Tech"), the aircraft maintenance provider. The lawsuit seeks to recover damages caused by the crash of an Emery DC-8 aircraft onto the Company's Rancho Cordova, California facility on February 16, 2000. The aircraft was destroyed, and the three crew members aboard the aircraft were killed. The crash and the resulting release of jet fuel and fire destroyed a significant part of the Company's facility and contaminated it with ash, hydrocarbon, lead and other toxic materials. Emery refused to clean up the contamination, and the Company was required to do so. The Company suffered more than $3.0 million in inventory loss, clean-up and remediation costs, business interruption losses, legal and consulting fees, and other losses, costs, and expenses. The Company's property insurance carrier, Reliance, paid a large portion of its inventory losses. On April 12, 2005, the Company engaged in mediation with TN Tech. The mediation resulted in a settlement of the dispute whereby TN Tech agreed to pay $2.35 million to the Company for its unrecovered losses resulting from the crash. In exchange, the Company agreed to release TN Tech and Emery from all of its claims arising from the crash. The Company expects payment from the settlement mid-May 2005. The Company has not recorded any income related to the settlement with TN Tech. 9 9. TREASURY STOCK The Company records treasury stock purchases using the cost method of accounting. In the first quarter of 2005, the Company repurchased 82 shares of common stock at an average price of $21.75 per share to cover tax expense realized by some employees whose restricted stock vested. The Company did not repurchase any shares during the first quarter of 2004. 10. ACCOUNTS RECEIVABLE Accounts receivable consists of the following as of March 27, 2005 and December 26, 2004:
MARCH 27, 2005 DECEMBER 26, 2004 -------------- ----------------- (Unaudited) (dollars in thousands) Unbilled receivables $ 37,114 $ 35,555 Trade accounts receivable 13,898 14,596 Other receivables 861 1,086 -------- -------- 51,873 51,237 Less allowance for doubtful accounts (704) (794) -------- -------- $ 51,169 $ 50,443 ======== ========
Unbilled receivables represent amounts paid to third parties on behalf of insurance companies for which the Company will be reimbursed when the vehicle is sold. Trade accounts receivable includes fees and proceeds to be collected from both insurance companies and buyers. 11. PROPERTY AND EQUIPMENT Property and equipment consists of the following at March 27, 2005 and December 26, 2004:
MARCH 27, DECEMBER 26, 2005 2004 ----------- ------------ (Unaudited) (dollars in thousands) Land $ 7,662 $ 7,662 Buildings and improvements 13,878 13,722 Equipment 51,759 49,645 Leasehold improvements 50,184 49,485 -------- -------- 123,483 120,514 Less accumulated depreciation and amortization (48,767) (45,830) -------- -------- $ 74,716 $ 74,684 ======== ========
10 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" below and in the Company's Annual Report on Form 10-K for the fiscal year ended December 26, 2004. 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. provides insurance companies and other vehicle suppliers cost-effective salvage processing solutions principally on a consignment or purchase agreement method of sale. The consignment method includes both a percentage of sale and fixed fee 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 percentage of sale and fixed fee 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. On February 22, 2005, the Company entered into a merger agreement ("Merger Agreement") pursuant to which the Company will be merged with an affiliate of Kelso & Company, L.P., a New York-based equity investment firm (the "Merger") that specializes in acquisition transactions ("Kelso"). Pursuant to the Merger Agreement, each outstanding share of Company common stock will be exchanged for the right to receive $28.25 in cash, without interest. The Company has circulated to its shareholders a Proxy Statement dated April 26, 2005 for a Special Meeting of Shareholders to be held on May 25, 2005, to consider and approve the Merger. Pending approval of the Merger Agreement by the shareholders and satisfaction of the other conditions included in the Merger Agreement, the Company expects the Merger to be completed shortly after the Special Meeting of Shareholders. Information contained in this Quarterly Report, especially forward looking information, should be read in light of the Merger. 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. The following discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto and the Factors That May Effect Future Results appearing elsewhere in this Report. ACQUISITIONS AND NEW OPERATIONS Since its initial public offering in 1991, the Company has grown through a series of acquisitions and opening of new sites to include 78 sites as of April 30, 2005. 11 RESULTS OF OPERATIONS Three Months Ended March 27, 2005 Compared to the Three Months Ended March 28, 2004 Revenues were $70.9 million for the three months ended March 27, 2005, up from $57.2 million for the same three month period in 2004. Fee income in the first quarter increased 22% to $61.1 million, versus $50.1 million in the first quarter of last year due to more favorable pricing and an increase in volumes sold. Cost of sales increased $6.7 million to $51.1 million for the three months ended March 27, 2005, versus $44.4 million for the same period last year. Vehicle cost of $8.5 million is up $2.5 million from the $6.0 million incurred in the first quarter of 2004. Branch cost of $42.7 million increased $4.3 million from $38.4 million for the same period last year. Branch cost includes tow, office and yard labor, occupancy, depreciation, and other costs inherent in operating the branch. The increase in costs in the first quarter of 2005 compared to the same period last year is attributable to increased volumes, higher fuel and insurance costs, and additional performance-based bonus accruals. Gross profit increased 55% to $19.8 million for the three months ended March 27, 2005, from $12.8 million for the comparable period in 2004, primarily resulting from the increase in volumes and favorable pricing. Selling, general and administrative expense of $11.3 million increased $2.8 million, or 33%, from the $8.5 million of expense incurred during the first quarter of last year. The increase is due to one-time merger-related costs of $1.2 million, additional performance based bonus accruals, acceleration of restricted stock vesting and costs related to compliance with the Sarbanes-Oxley Act of 2002. Interest expense decreased to $0.4 million for the three months ended March 27, 2005, from $0.5 million for the comparable period in 2004, which is the result of the reduction in the underlying debt. The Company's effective income tax rate was 38.5% and 40.5% in 2005 and 2004, respectively. FINANCIAL CONDITION AND LIQUIDITY At March 27, 2005, the Company had current assets of $97.3 million, including $21.8 million in cash, current liabilities of $74.9 million and working capital of $22.4 million, which represents a $5.5 million increase from December 26, 2004. At March 27, 2005, the Company's long-term debt, including current installments, consisted of $15.0 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 interest rate based upon LIBOR. The aggregate principal balance of the loan is required to be paid in sixteen consecutive equal quarterly installments which commenced 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 March 27, 2005, the Company was in compliance with its credit agreement covenants. Other long-term liabilities include the fair market value 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 March 27, 2005 for the post-retirement benefits liability was approximately $2.4 million. Capital expenditures were $3.1 million for the three months ended March 27, 2005. 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 information technology system. 12 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. As of March 27, 2005, the Company had purchased 906,562 shares pursuant to this authorization at an average price of $10.63 per share. 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. There have been no changes in the critical accounting policies since the fiscal year end ended December 26, 2004. For further information regarding these policies, please refer to the Company's Form 10-K for the fiscal year ended December 26, 2004. 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 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 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 any indication of future performance. Furthermore, 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 national and 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. 13 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 2004, vehicles supplied by the Company's three largest suppliers accounted for approximately 37% of the Company's total unit sales. The largest suppliers, State Farm Insurance, Zurich Insurance, and GEICO, accounted for approximately 16%, 11%, and 10%, 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. Dependence on Information and Technology Systems. The Company's ability to provide cost-effective salvage vehicle processing solutions to the Company's customers depends in part on the Company's ability to effectively utilize technology to provide value-added services to the Company's customers. The Company has implemented a new web-based operating system, which allows the Company to offer hybrid internet/live auctions and to provide vehicle tracking systems and real-time status reports for the Company's insurance company customers' benefit. The Company's ability to provide the foregoing services depends on the Company's capacity to store, retrieve and process data, manage significant databases and expand and periodically upgrade our information processing capabilities. As the Company continues to grow, the Company will need to continue to make investments in new and enhanced information and technology systems. Interruption or loss of the Company's information processing capabilities or adverse consequences from implementing new or enhanced systems could have a material adverse effect on the Company's operating results and financial condition. As the Company's information system providers revise and upgrade their hardware, software and equipment technology, the Company may encounter difficulties in integrating these new technologies into the Company's business. Although the Company has experienced no significant breaches of the Company's network security by unauthorized persons, the Company's systems may be subject to infiltration by unauthorized persons. If the Company's systems or facilities were infiltrated and damaged by unauthorized persons, there could be a significant interruption to the Company's ability to provide many of the Company's electronic and web-based services to the Company's customers. If that were to occur, it could have a material adverse effect on the Company's operating results and financial condition. 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 acquisition 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. Furthermore, 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. In the future, 14 the Company will also be required to continue to improve its financial and management controls, reporting systems and procedures on a timely basis and to expand, train and manage its employee work force. The failure to improve these systems on a timely basis and to successfully expand, train and manage the Company's work force could have a material adverse effect on the Company's operating results and financial condition. 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, however, 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 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. Sarbanes-Oxley Act Compliance. Sarbanes-Oxley Act Compliance. During the Company's third fiscal quarter 2004, the Company retained the services of Jefferson Wells International to assist the Company in complying with the requirements of Section 404 (c) of the Sarbanes Oxley Act of 2002 ("Section 404 (c)"). Pursuant to Section 404 (c), the Company's management must (i) establish and maintain adequate internal control over its financial reporting; (ii) identify the framework used by management to evaluate the effectiveness of those controls; (iii) assess and attest to the effectiveness of those controls; and (iv) provide an attestation by the Company's independent auditors as to management's assessment of its internal controls over financial reporting. In order to comply with Section 404(c), the Company has to date incurred significant costs and anticipates further financial expenditures and dedication of managerial resources in its compliance efforts. Though the Company has complied with the requirements of Section 404 (c) and attested to the effectiveness of its internal controls over financial reporting in its amended annual report on Form 10-K for the fiscal year ended December 26, 2004, it cannot be certain that it will be able to continue to comply with the requirements of Section 404 (c) and provide an attestation as to the effectiveness of its internal control over financial reporting in its future periodic reports, within the prescribed time. The failure of the Company to comply with Section 404(c) and complete its assessment of its internal controls in the prescribed time and obtain from its independent auditors an attestation to management's assessment of the effectiveness of its internal controls over financial reporting could have a material adverse affect on the Company's business or stock price depending on the reasons for the failure. 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 $15.0 million term loan at March 27, 2005. 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 March 27, 2005, the interest rate swap agreement had a notional amount of $15.0 million, and provided that the Company pay a fixed rate of interest of 4.4% and receive a LIBOR-based floating rate on the notional amount. At March 27, 2005, the interest rate on the term loan was 5.4% 15 and the entire swap agreement qualified for hedge accounting. The Company believes that its exposure to adverse changes in interest rates is not significant. ITEM 4. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES Based on the evaluation required by Rule 13a-15(b) under the Securities Exchange Act of 1934, the principal executive officer and principal financial officer of the Company have concluded that the Company's disclosure controls and procedures (as defined in Rules 13a-15(e)), as of the end of the period covered by the report, are effective to ensure that the information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time period specified in SEC rules and forms. The disclosure controls and procedures are designed to provide reasonable assurance of achieving the desired control objectives and the principal executive officer and principal financial officer of the Company have concluded that the Company's disclosure controls and procedures are effective. DESIGN AND EVALUATION OF INTERNAL CONTROLS OVER FINANCIAL REPORTING. Management, including the principal executive officer and principal financial officer of the Company, have designed internal control over financial reporting, or caused such internal control over financial reporting to be designed under their supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING During the first quarter of 2005, we made changes to our controls and procedures as part of our ongoing monitoring and improvement of our controls. However, none of these changes has materially affected, or are reasonably likely to materially affect, our internal control 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 26, 2004, 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. Rancho Cordova Plane Crash On February 4, 2003, the Company filed a lawsuit in the Superior Court of California, County of Sacramento, against, among others, Emery Air Freight Corporation ("Emery") and Tennessee Technical Services ("TN Tech"), the aircraft maintenance provider. The lawsuit seeks to recover damages caused by the crash of an Emery DC-8 aircraft onto the Company's Rancho Cordova, California facility on February 16, 2000. The aircraft was destroyed, and the three crew members aboard the aircraft were killed. The crash and the resulting release of jet fuel and fire destroyed a significant part of the Company's facility and contaminated it with ash, hydrocarbon, lead and other toxic materials. Emery refused to clean up the contamination, and the Company was required to do so. The Company suffered more than $3.0 million in inventory loss, clean-up and remediation costs, business interruption losses, legal and consulting fees, and other losses, costs, and expenses. The Company's property insurance carrier, Reliance, paid a large portion of its inventory losses. On April 12, 2005, the Company engaged in mediation with TN Tech. The mediation resulted in a settlement of the dispute whereby TN Tech agreed to pay $2.35 million to the Company for its unrecovered losses resulting from the crash. In exchange, the Company agreed 16 to release TN Tech and Emery from all of its claims arising from the crash. The Company expects payment from the settlement mid-May 2005. 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 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. As of March 27, 2005, the Company had purchased 906,562 shares of common stock pursuant to Board authorization at an average price of $10.63 per share. The maximum number of shares that may yet be purchased under the plan is 1,343,438. The Company records treasury stock purchases using the cost method of accounting. The following table reflects all purchases of equity securities by the Company during each month of the first quarter of 2005. ISSUER PURCHASES OF EQUITY SECURITIES
(c) TOTAL NUMBER OF (a) TOTAL SHARES PURCHASED AS (d) MAXIMUM NUMBER OF NUMBER OF (b) AVERAGE PART OF PUBLICLY SHARES THAT MAY YET BE SHARES PRICE PAID ANNOUNCED PLANS OR PURCHASED UNDER THE PERIOD PURCHASED PER SHARE PROGRAMS (1) PLANS OR PROGRAMS ------------------ --------- ----------- ------------------- ---------------------- FIRST QUARTER 2005 January 34 $ 21.75 906,514 1,343,486 February 0 $ 0 0 1,343,486 March 48 $ 21.75 906,562 1,343,438 --- --------- ------- --------- Total 2005 82 $ 21.75 906,562 1,343,438
(1) 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 Company's repurchase plan expires upon the repurchase of all authorized shares. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. Inapplicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Inapplicable ITEM 5. OTHER INFORMATION. Inapplicable. 17 ITEM 6. EXHIBITS AND REPORT ON FORM 8-K. (a) EXHIBITS. 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. 32.1* Certification by the CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2* Certification by the CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith (b) REPORTS ON FORM 8-K. The Company filed a current report on Form 8-K, dated April 28, 2005, which contained a press release announcing the Company's financial results for the quarter ended March 27, 2005. 18 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: May 6, 2005 By: /s/ Scott P. Pettit -------------------------------------- Name: Scott P.Pettit Title: Senior Vice President and Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer) 19 EXHIBIT INDEX EXHIBIT NO. 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. 32.1 Certification by the CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification by the CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.