Because we are a service organization, compensation and other personnel costs make up the largest component of total expenses - 70% in 2003. Property and equipment are comprised primarily of furniture, computer systems and office equipment. Therefore, Hub’s capital resources, including external borrowings, internally generated cash flow and issuance of common shares, are targeted primarily toward acquisitions.
As a result of these and other factors, we reported a 30% revenue increase to $286.4 million in 2003, while net earnings increased 24% to $36.5 million. Diluted earnings per share increased 8% to $1.14 from $1.06. The slower rate of growth in diluted earnings per share as compared to growth in revenue and net earnings reflected a larger number of average shares outstanding, resulting from both our U.S. IPO in June 2002 and the use of common shares in both acquisitions and compensation programs.
During 2003 we experienced an unusual timing issue at a single hub that provides lender-placed auto insurance coverage for financial institutions. Lender-placed coverage is primarily collision coverage on automobiles financed through a financial institution. This is a high-volume business that is generally very profitable for us. However, in the third quarter of 2003, two financial institutions adjusted their credit policies, leading to cancellation of several quarters’ worth of policies in a single quarter resulting in 2003 revenue being reduced by approximately $4.3 million. Excluding the impact of this product line, U.S. organic growth was 9% in 2003.
Selling, occupancy and administration expense increased 26% to $56.6 million in 2003. As a percentage of revenue, selling, occupancy and administration expense declined slightly to 19.8%, versus 20.4% in 2002.
In June 2003, we completed a private placement of $65 million in principal amount of unsecured senior notes. The senior notes were issued in two series. Series A represents $10 million of 5.71% senior notes with interest due semi-annually, and principal due of $3,333 annually, June 15, 2008 through June 15, 2010. Series B represents $55 million of 6.16% senior notes with interest due semi-annually, and principal due of $11,000 annually June 15, 2009 through June 15, 2013. The senior notes were sold on a private basis in the United States to institutional accredited investors. Net proceeds of the sale of the senior notes were used to pay down $50 million of our revolving U.S. Dollar LIBOR Loan with the balance held for general corporate purposes, which may include future acquisitions. We incurred approximately $0.7 million in fees and expenses related to the offering of these notes, which were capitalized and are being amortized to expense over the term of the notes. At December 31, 2003, $65 million was outstanding under the senior notes. We are in compliance with all financial covenants governing the senior notes.
In the ordinary course of business, we are subject to various claims and lawsuits consisting primarily of alleged errors and omissions in connection with the placement of insurance. In the opinion of our management, the ultimate resolution of all asserted and potential claims and lawsuits will not have a material adverse effect on our consolidated financial position or results of operations.
The amounts allocated to customer relationships were determined by discounting the expected future net cash flows from commissions with consideration given to remaining economic lives, renewals, and associated expenses. Non-competition covenants value were determined using an income approach with consideration given to economic benefits associated with having the covenants in place versus damages that would ensue absent the agreements; and in the case of trademarks, a cash flow royalty savings approach addressing the economic benefits of the trademarks to Hub was used. The balance of the excess purchase price is allocated to goodwill.
We have audited the accompanying consolidated balance sheets of Hub International Limited and its subsidiaries as of December 31, 2003 and 2002 and the related consolidated statements of earnings, retained earnings and cash flows for each of the years in the three year period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statement schedules based on our audits.
On May 30, 2002 the Company completed the sale of Old Lyme to Fairfax Inc, a related party, and recorded a non-taxable gain on the sale of $2.6 million. This gain increased 2002 annual basic earnings per share and diluted earnings per share by $0.11 and $0.09, respectively.
Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is recorded based on the useful economic lives of the related assets as follows: for computer equipment on a straight-line basis from 3 to 5 years or on a 30% declining balance method; for furniture, fixtures, and office equipment on a straight-line basis from 5 to 7 years or on a 20% declining balance method. Leasehold improvements are amortized on the straight-line method over the term of the related lease. Upon sale or retirement, the cost and related accumulated depreciation or amortization are removed from the accounts and any gain or loss is reflected in earnings. If the carrying value of property and equipment is identifiable as impaired, it is written down to its net recoverable amount.
The Company completed its impairment testing on the balance of goodwill and intangible assets as of January 1, 2004, 2003 and 2002. Based on the testing performed, no impairment losses were incurred.
The Company typically pays a portion of the consideration for an acquired brokerage in cash. Consideration for the remainder of the purchase price is normally in the form of the Company’s common shares based on the fair market value of the Company’s common shares as traded on the NYSE or TSX, and is defined and calculated pursuant to the acquisition agreement.
During 2001, the Company purchased all of the issued and outstanding shares of Kaye, Burnham and Flanagan, as well as the outstanding shares or net assets of 13 other brokerages, all of which were acquired using the purchase method of accounting. Accordingly, the results of operations and cash flows of the acquired companies have been included in the Company’s consolidated results from their respective acquisition dates.
Income taxes for 2003, 2002 and 2001, amounted to $18.9 million, $14.3 million and $5.3 million, respectively, resulting in an effective tax rate of 34%, 33% and 34% in 2003, 2002, and 2001, respectively.
The components of the future tax assets and liabilities at December 31, 2003 and 2002, were as follows:
The consolidated financial statements have been prepared in accordance with Canadian GAAP, which differs in certain respects from U.S. GAAP.
The table below presents the differences between Canadian and U.S. GAAP affecting net earnings and comprehensive income for the years ending December 31, 2003, 2002 and 2001.
Also under U.S. GAAP, the fair value of the put options at the date of issuance was also recorded as a debit and credit to shareholders’ equity, representing an unearned compensation expense, as the put options require the selling shareholders to remain employed by the Company in order to be able to exercise the put options. Compensation expense is being recognized using the straight-line method over the period from the issue date to the exercise date.
The Company is not aware of any new accounting pronouncements which will impact on its financial reporting.