Our corporate headquarters are located in New York City, where we lease approximately 35,200 square feet of space. Our subsidiaries NFPSI and NFPISI lease approximately 38,600 square feet of space in Austin, Texas. In addition, our firms lease properties for use as offices throughout the United States. We believe that our existing properties are adequate for the current operating requirements of our business and that additional space will be available as needed.
We adopted SFAS No. 144 on January 1, 2002. In accordance with SFAS No. 144, long-lived assets, such as property and equipment and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. We recognized an impairment loss on identifiable intangible assets subject to amortization of $1.0 million in 2002, $4.2 million in 2003 and $2.4 million in 2004. Prior to the adoption of SFAS No. 144, we accounted for long-lived assets in accordance with SFAS No. 121. For the years ended December 31, 2000 and 2001, we recorded an impairment loss on intangibles subject to amortization of $1.4 million and $2.3 million, respectively.
(c) Reflects our obligations under put options relating to shares of our common stock and is not included in total stockholders’ equity.
(d) As a measure of financial performance, we calculate the internal growth rate of the revenue of our firms. This calculation compares the change in revenue of a comparable group of firms for the same time period in successive years. We include firms in this calculation at the beginning of the first fiscal quarter that begins one year after acquisition by us unless a firm has merged with another owned firm or has made a sub-acquisition that represents more than 25% of the base earnings of the acquiring firm. With respect to two owned firms that merge, the combined firm is excluded from the calculation from the time of the merger until the first fiscal quarter that begins one year after acquisition by us of the most recently acquired firm
participating in the merger. However, if both firms involved in a merger are included in the internal growth rate calculation at the time of the merger, the combined firm continues to be included in the calculation after the merger. With respect to the sub-acquisitions described above, to the extent the sub- acquired firm does not separately report financial statements to NFP, the acquiring firm is excluded from the calculation from the time of the sub-acquisition until the first fiscal quarter beginning one year following the sub-acquisition. Sub-acquisitions that represent less than 25% of the base earnings of the acquiring firms are considered to be internal growth. For further information about sub-acquisitions, see “Business-Operations-Sub-Acquisitions.” With respect to dispositions, we include these firms up to the time of disposition and exclude these firms for all periods after the disposition. The calculation described above is not adjusted for intercompany transactions that result in the same item of revenue being recorded by two firms.
Our firms earn revenue that consists primarily of commissions and fees earned from the sale of financial products and services to their clients and incur commission and fee expense and operating expense in the course of earning revenue. We pay management fees to non-employee principals of our firms based on the financial performance of each respective firm. We refer to revenue earned by our firms minus the expenses of our firms, including management fees, as gross margin. Management uses gross margin as a measure of the performance of the firms that we have acquired. Through acquisitions and internal growth, gross margin has grown from $19.8 million, or 19.8% of revenues, in 1999 to $140.4 million, or 22.0% of revenues, in 2004.
Our gross margin is offset by expenses that we incur at the corporate level, including corporate and other expenses. Corporate and other expenses have grown from $36.5 million in 1999 to $67.7 million in 2004. Corporate and other expenses include general and administrative expenses, which are the operating expenses of our corporate headquarters. General and administrative expenses have grown from $24.9 million in 1999 to $35.4 million in 2004. General and administrative expenses as a percent of revenue declined from 24.9% in 1999 to 5.5% in 2004.
(a) Consists principally of the assumption of debt and capitalized acquisition costs.
NFPSI, our registered broker-dealer and investment adviser, also earns commissions and fees on the transactions effected through it. Most principals of our firms, as well as many of our affiliated third-party distributors, conduct securities or investment advisory business through NFPSI. Our affiliated third-party distributors generated commission revenue through NFPSI of $34.3 million, $45.0 million and $64.7 million in the years 2002, 2003 and 2004, respectively. Incidental to the corporate and executive benefits services provided to their customers, some of our firms offer property and casualty insurance brokerage and advisory services. We earn commissions and fees in connection with these services.
Operating expenses. Our firms incur operating expenses related to maintaining individual offices, including compensating non-producing staff. Firm operating expenses also include the expenses of NFPSI and of NFPISI, another subsidiary that serves our acquired firms and through which our acquired firms and our affiliated third-party distributors access insurance and financial services products and manufacturers.
The ratio of management fees to gross margin before management fees is dependent on the percentage of total earnings of our firms capitalized by us, the performance of our firms relative to base earnings and target earnings, the growth of our firms in the periods after their first three years following acquisition, and the earnings of NFPISI and NFPSI, from which no management fees are paid. Because of our cumulative preferred position,
General and administrative. At the corporate level, we incur general and administrative expense related to the acquisition of and administration of our firms. General and administrative expense includes compensation, occupancy, professional fees, travel and entertainment, technology, telecommunication, advertising and marketing costs. Stock-based compensation expense is disclosed separately.
In addition to these incentive programs, we have incurred stock-based compensation expense for awards (stock options and restricted stock) granted to employees and directors. Stock options granted to employees through December 31, 2002 were accounted for under the intrinsic-value-based method of accounting in accordance with Accounting Principles Board, or APB, Opinion No. 25. On January 1, 2003, we adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” and have adopted the “prospective” method of transition. Under this method, the cost of awards granted to employees after January 1, 2003 are included in the determination of net income.
Amortization. We incur amortization expense related to the amortization of intangible assets.
a firm in a direct way and the cultural incompatibility of an acquired firm’s management team with us. In such situations, we may take impairment charges in accordance with SFAS No. 142 and SFAS No. 144 and reduce the carrying cost of acquired identifiable intangible assets (including book of business, management contract and tradename) and goodwill to their respective fair values. Management reviews and evaluates the financial and operating results of our acquired firms on a firm-by-firm basis throughout the year to assess the recoverability of goodwill and other intangible assets associated with these firms. In assessing the recoverability of goodwill and other intangible assets, we use historical trends and we make projections regarding the estimated future cash flows and other factors to determine the recoverably of the respective assets. If a firm’s goodwill and other intangible assets do not meet the recoverability test, the firm’s carrying value will be compared to its estimated fair value. The fair value is based upon the amount at which the acquired firm could be bought or sold in a current transaction between NFP and the principals and/or the present value of the assets’ future cash flows. The intangible assets associated with a particular firm may be impaired when the firm has experienced a significant deterioration in its business indicated by an inability to produce at the level of base earnings for a period of four consecutive quarters and when the firm does not appear likely to improve its operating results or cash flows in the foreseeable future. Management believes that this is an appropriate time period to evaluate firm performance given the seasonal nature of many firms’ activities.
Through acquisitions and internal growth, we have achieved revenue growth of 30%, 33% and 38% in the years ended December 31, 2002, 2003 and 2004, respectively. This growth was driven by our acquisitions, internal growth in the revenues of our acquired firms and the growth of NFPISI and NFPSI. In 2002, 2003 and 2004, our firms had an internal revenue growth rate of 5%, 14% and 16%, respectively.
As a measure of financial performance, we calculate the internal growth rate of the revenue of our firms. This calculation compares the change in revenue of a comparable group of firms for the same time period in successive years. We include firms in this calculation at the beginning of the first fiscal quarter that begins one year after acquisition by us unless a firm has merged with another owned firm or has made a sub-acquisition that represents more than 25% of the base earnings of the acquiring firm. With respect to two owned firms that merge, the combined firm is excluded from the calculation from the time of the merger until the first fiscal quarter that begins one year after acquisition by us of the most recently acquired firm participating in the merger. However, if both firms involved in a merger are included in the internal growth rate calculation at the time of the merger, the combined firm continues to be included in the calculation after the merger. With respect to the sub-acquisitions described above, to the extent the sub-acquired firm does not separately report financial statements to NFP, the acquiring firm is excluded from the calculation from the time of the sub-acquisition until the first fiscal quarter beginning one year following the sub-acquisition. Sub-acquisitions that represent less than 25% of the base earnings of the acquiring firms are considered to be internal growth. For further information about sub-acquisitions, see “Business-Operations-Sub-Acquisitions.” With respect to dispositions, we include these firms up to the time of disposition and exclude these firms for all periods after the disposition. The calculation described above is not adjusted for intercompany transactions that result in the same item of revenue being recorded by two firms.
Stock-based compensation. Stock-based compensation expense increased $1.2 million to $1.4 million in 2004 compared with $0.2 million in 2003. The increase is primarily due to new awards granted during 2004. The 2003 amount of $0.2 million includes a reduced accrual for accrued stock-based compensation expense
Interest and other expense. Interest and other expense decreased $0.8 million, or 22.2%, to $2.8 million in 2004 compared with $3.6 million in 2003. The decrease was due to lower average borrowings under our bank line of credit offset, in part, by a $1.1 million write-off of leasehold improvements and furniture and fixtures related to the Company relocating its headquarters.
Amortization. Amortization increased $3.2 million, or 24.1%, to $16.5 million in 2003 compared with $13.3 million in 2002. Amortization expense increased as a result of a 13% increase in net intangible assets resulting primarily from acquisitions consummated in 2003. As a percentage of revenue, amortization was 3.6% in 2003 compared with 3.8% in 2002.
Interest and other expense. Interest and other expense increased $0.1 million, or 2.9%, to $3.6 million in 2003 compared with $3.5 million in 2002. The increase was due to higher average borrowings under our bank line of credit offset, in part, by lower interest rates.
Income tax expense. Income tax expense increased $10.2 million, or 77.9%, to $23.3 million in 2003 compared with $13.1 million in 2002. The increase is a direct result of an 89.5% increase in pretax income for the year ended December 31, 2003 of $46.8 million compared with $24.7 million for the year ended December 31, 2002, offset by a decrease in our effective tax rate to 49.8% from 53.1%. The effective tax rate differs from the provision calculated at the federal statutory rate primarily because of certain expenses that are not deductible for tax purposes, as well as the effects of state and local taxes. The effective tax rate declined in 2003 as a direct result of the proportional increase in pretax income relative to nondeductible expenses. In addition, in 2003, we recorded an accrual of $1.3 million compared to an accrual of $2.1 million in 2002, representing the difference between the final aggregate state and local taxes and those previously estimated and accrued.
We have a $90.0 million credit facility with a group of banks. Borrowings under the credit facility bear interest, at our discretion, at (1) the greatest of (a) the prime rate, (b) the three-month certificate of deposit rate plus 1% or (c) the federal funds effective rate plus ½ of 1%; or (2) the Eurodollar rate for one, two, three or six-month periods plus 2%. The rates under (1) above float with changes in the indicated rates and under (2) are fixed for the indicated Eurodollar rate period. Interest is computed on the daily outstanding balance. The weighted average interest rate under the credit facility at December 31, 2004 and 2003, was 5.3% and 3.3%, respectively. The credit facility is structured as a revolving credit facility and is due on September 14, 2005, unless we elect to convert the credit facility to a term loan, in which case it will amortize over one year, with a principal payment due on March 14, 2006 and a final maturity on September 14, 2006. At December 31, 2004 and 2003, we did not have an outstanding balance under the credit facility. Our obligations under our credit facility are collateralized by all of our assets.
On November 20, 2003, our Board of Directors declared its first quarterly cash dividend of $0.10 per share of common stock, or $3.1 million, which was paid to shareholders on January 7, 2004. Our dividend policy is determined by the Board of Directors. Dividends are declared after the Board of Directors considers our current available cash and cash equivalents and cash flow projections, which include earnings projections and anticipated cash payments for such items as funding operations, new acquisitions and capital spending. There can be no assurance that dividends will be paid in the future. Based on the most recent quarterly dividend declared of $0.12 per share of common stock, the total annual cash requirement for dividend payments would be approximately $16.4 million.
In a few cases, we have disposed of firms. We have also agreed, in a few cases, to reduce the levels of base earnings and target earnings in exchange for a payment from the principals of a firm. In these situations, we typically take back a note for a portion of the cost of the disposition or the restructuring to the principal.
In addition, we, along with over twenty other unrelated insurance brokers and insurers, are defendants in four putative class actions filed by alleged policyholders. Two of these actions were filed in the United States District Court for the Northern District of Illinois, one was filed in the United States District Court for the Northern District of California and one was filed in the United States District Court for the District of New Jersey. These actions assert, on behalf of a class of persons who purchased insurance through the broker defendants, claims arising from the conduct alleged in the New York Attorney General’s civil complaint against Marsh Inc. and Marsh & McLennan Companies, Inc. We dispute the allegations in these actions and intend to defend the actions vigorously. Additional complaints may be filed against us in various courts alleging claims arising from the conduct alleged in the New York Attorney General’s complaint. Our ultimate liability, if any, in the pending and possible future suits is uncertain and subject to contingencies that are not yet known.
We cannot predict at this time the outcome of the internal review or the effect that any current or future regulatory activity will have on our business. It is possible that we will become subject to further governmental inquiries and subpoenas and have lawsuits filed against us. Our ultimate liability, if any, in connection with these matters and any possible future such matters is uncertain and subject to contingencies that are not yet known.
Effective January 1, 2001, a second acquisition bonus program was implemented (“second bonus program”), which replaced the first bonus program for eligible acquisitions closed on or after January 1, 2001. The new program is for the same founding officers and directors that were eligible for the first bonus program as well as certain outside consultants. These individuals are eligible to receive payments of: (i) 6% of base earnings of an acquisition at the close of a transaction, paid in cash and (ii) 2% of the base earnings on an annual basis for each of the first three years following the close of the transaction, subject to the acquired firm’s achieving target earnings in each year, or cumulatively as of each anniversary of the acquisition, also paid in cash. The amount expensed under the new program totaled $0.3 million for the year ended December 31, 2002. For the years ended December 31, 2003 and 2004, amounts previously accrued were reduced by $(0.1) million, and $(0.4) million, respectively.
Principals and certain employees of our acquired firms are eligible to participate in two option incentive programs. Under our original option incentive program, principals and certain employees of 27 firms (certain acquisitions that closed during the period from January 1, 1999 to October 1, 1999) were eligible to receive option grants with a $10.00 strike price based on each such firm’s growth in earnings over a three-year measurement period which ended in the fourth quarter of 2002. The second option program is open to principals and certain employees of 40 firms (certain acquisitions that closed during the period from April 1, 1999 to October 31, 2000). Under this program, principals and certain employees of these firms are eligible to receive option grants at the fair market value of our common stock at the time the options are granted based on their firm’s growth in earnings over a three-year measurement period. This program expired in 2003. For the year ended December 31, 2002, stock-based expense under both of these programs totaled $9.7 million, and for the year ended December 31, 2003, previous accruals were reduced by $(2.1) million. The reduction of this accrual offset stock-based expense of $1.8 million recorded in connection with the option incentive programs.
The minimum contingent payments which could be payable as purchase consideration and employee compensation in each year is zero. The maximum contingent payment which could be payable as purchase consideration and employee compensation based on commitments outstanding as of December 31, 2004 consists of the following:
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This statement establishes standards for the way companies report information about operating segments in financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. In accordance with the provisions of SFAS No. 131, we have determined that we operate in a single segment entirely within the United States of America.
Since our formation we have completed over 166 acquisitions. All of these acquisitions have been accounted for using the purchase method, and their related net assets and results of operations were included in our consolidated financial statements commencing on their respective acquisition dates. Certain of the acquisitions have provisions for contingent additional consideration based upon the financial results achieved over a multi-year period. This additional consideration is reflected as an increase in goodwill when results are achieved and the outcome of the contingency is determinable beyond a reasonable doubt.
We allocate the excess of purchase price over net assets acquired to book of business, management contracts, trade name and goodwill. We amortize intangibles related to book of business over a 10-year period and a 25-year period for management contracts. Prior to December 31, 2001, goodwill and tradename in connection with acquisitions before July 1, 2001 was amortized over a 25-year period. In accordance with SFAS 142 all amortization of goodwill ceased on January 1, 2002.
On January 1, 2002, we adopted SFAS No. 142, which addresses the financial accounting and reporting standards for the acquisition of intangible assets outside of a business combination and for goodwill and other intangible assets subsequent to their acquisition. This accounting standard requires that goodwill be separately disclosed from other intangible assets in the consolidated statement of financial condition, and no longer be amortized but tested for impairment on a periodic basis. Intangible assets deemed to have indefinite lives are no longer amortized but are subject to impairment tests at least annually. Other intangible assets will continue to be amortized over their useful lives. The transitional impairment test indicated there was no goodwill impairment as of January 1, 2002. The impact of adoption of SFAS No. 142 resulted in $154 million of goodwill and tradename no longer being amortized. In accordance with SFAS No. 142, we recognized an impairment loss on goodwill and identifiable intangible assets not subject to amortization of $0.8 million, $5.7 million, and $2.4 million for the years ended December 31, 2002, 2003 and 2004 respectively.
premium is paid, and (3) the insured party is contractually committed to the purchase of the insurance policy. We carry a reserve for policy cancellations, which is periodically evaluated and adjusted as necessary. Miscellaneous commission adjustments are recorded as they occur. Contingent commissions are recorded as revenue when received which, in many cases, is our first notification of amounts earned. Contingent commissions are commissions paid by insurance underwriters and are based on the estimated profit and/or overall volume of business placed with the underwriter. The data necessary for the calculation of contingent commissions cannot be reasonably obtained prior to receipt of the commission. Our firms also receive commissions for their settlement of life insurance. These commissions are generally based on a percentage of the settlement proceeds received by their clients, and recognized as revenue when the policy is transferred and the rescission period has ended.
Our firms earn additional compensation in the form of incentive and marketing support revenue from manufacturers of financial services products, based on the volume, persistency and profitability of business they generate. Incentive and marketing support revenue is recognized when earned, which is typically when payment is received.
We are authorized under the 1998, 2000 and 2002 Stock Incentive Plans, and the 2000 and 2002 Stock Incentive Plans for Principals and Managers, to grant stock options, stock appreciation rights, restricted stock, and performance units to officers, employees, principals of our acquired firms and/or certain entities principals own, independent contractors, consultants, non-employee directors and certain advisory board members. Awards granted under the 1998, 2000 and 2002 Stock Incentive Plans generally vest 20% per year over a 5-year period. Awards granted under the 2000 and 2002 Stock Incentive Plans for Principals and Managers generally vest immediately upon grant.
Awards to non-employees, including principals, are accounted for under SFAS No. 123. Fair value is determined using the Black-Scholes option-pricing method.
and tax bases of our assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Valuation allowances are established when necessary to reduce the deferred tax assets to the amounts expected to be realized.