The following income statement data for the years ended December 31, 2005, 2004 and 2003 and balance sheet data as of December 31, 2005 and 2004 are derived from our audited financial statements, which are included elsewhere in this report. The following income statement data for the years ended December 31, 2002 and 2001 and balance sheet data as of December 31, 2003, 2002 and 2001 are derived from our audited financial statements not included in this report. You should read this data together with our financial statements and related notes included elsewhere in this report and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
(2) Based on net income available to common stockholders (diluted) of $9,511, $6,500 and $3,964 for the years ended December 31, 2005, 2004 and 2003, respectively. Net income available to common stockholders (diluted) is equal to net income less dividends on non-convertible preferred stock of $194, $194 and $196 for the years ended December 31, 2005, 2004 and 2003, respectively.
Brooke Franchise Most of our revenues are from commissions paid to Brooke Franchise, our wholly owned franchise subsidiary, by insurance companies for the sale of insurance policies on a retail basis through exclusive franchisees. Brooke Franchise primarily relies on the recruitment of additional franchisees to increase retail insurance commission revenues. Brooke Franchise’s franchisees typically specialize in general insurance sales, auto insurance sales and business insurance sales. Brooke Franchise also consults with business sellers and lenders.
Our consolidated results of operations have been significantly impacted by our expansion of territory and personnel in recent years. The following table shows income and expenses (in thousands, except percentages and per share data) for the years ended December 31, 2005, 2004 and 2003, and the percentage change from year to year.
Expenses are also expected to continue to increase as a result of opening new franchise locations in 2006. The increase of commission expense in 2005 is primarily attributable to increases in insurance commissions received from insurance companies, because a share of insurance commissions is typically paid to franchisees. Payroll expenses, which include wages, salaries, payroll taxes and compensated absences expenses, and other operating expenses, which include advertising, rent, travel, lodging, office supplies and insurance expenses, increased primarily as a result of the expansion of our franchise operations, securitization related expenses, the opening of additional service/sales centers and the acquisition of Texas All Risk General Agency in 2003. Payroll expenses, as a percentage of total operating revenue, were approximately 20% in 2005, 20% in 2004, and 17% in 2003. Other operating expenses, as a percentage of total operating revenue, were approximately 18% in 2005, 16% in 2004, and 13% in 2003.
Amortization expense increased in 2004 primarily as a result of amortization of the servicing asset, which increased significantly as a result of Brooke Credit’s participation loan sales activities. Depreciation increased in 2004 primarily as a result of the renovation of our national office facility in Overland Park, Kansas in the third quarter of 2003.
The increase in other operating interest expenses in 2005 and 2004 is primarily attributable to interest paid on a bank line of credit. We typically use these lines of credit to fund our loans until we sell them through a securitization. We consider bond and debenture interest expense to be an operating expense because the proceeds from the sale of such bonds and debentures were used to partially fund our lending activities.
We consider interest expense, other than line of credit, bond and debenture interest expense, to be a non-operating expense. Interest expense increased significantly in 2005 and 2004 as a result of increased debt to commercial banks, which was incurred primarily to capitalize our operating subsidiaries, and increased notes payable balances resulting from deferred payments to sellers of businesses acquired by us.
Assets are expected to continue to increase in 2006 as a result of continued expansion and holding more loans prior to the sale of participation interests in such loans or securitizing such loans in order to increase interest income. The following table shows selected assets and liabilities (in thousands, except percentages) as of December 31, 2005, 2004 and 2003, and the percentage change from year to year.
Customer receivables, notes receivables and interest earned not collected on notes are the three items above that comprise our accounts and notes receivable, net, as shown on our consolidated balance sheet.
The terms of our securitizations require the over-collateralization of the pool of loan assets that back the securities sold to investors. We retain ownership of the resulting subordinate interest in the loan pool, and the corresponding securities asset increased in 2005 and 2004 as the result of our securitization activity.
Deferred charges increased in 2004 primarily as a result of origination fees and other such expenses associated with acquiring a bank line of credit.
Accounts payable, which includes franchise payables, producer payables, payroll payables and other accrued expenses, increased in 2004 primarily from the continued expansion of our franchise operations, which increased the accrual for estimated commission expense due franchisees.
Payable under participation agreements is the amount we owe to funding institutions which have purchased a participating interest in loans pursuant to transactions that do not meet the true sale test of SFAS 140 “Accounting for Transfers and Services of Financial Assets and Extinguishments of Liabilities.” Payable under participation agreements increased in 2005 and 2004 because we sold more loans pursuant to transactions that did not meet the true sale test.
Debt decreased in 2005 primarily as the result of a securitization of notes receivable in December 2005 and a corresponding decrease in notes receivable balances. Debt increased in 2004 primarily to fund increases in our notes receivables and securities.
The following tables provide information regarding our Notes Receivables, Notes Participations, Notes Payables and Bonds & Debentures Payables principal balances and the corresponding weighted interest rates as of the end of each quarter in 2005, 2004 and 2003 (excluding capitalized lease balances). Notes Receivables balances include the loans originated by Brooke Credit to our franchisees and others, even though the notes may no longer be on our balance sheet. Notes Participations are comprised of loan participation interests that we have sold to our funding institutions and securitization entities that we typically no longer carry on our balance sheet. Notes Payables balances are comprised of borrowings to fund the loans that we have made to our franchisees and others and include primarily notes issued to sellers of agencies we have purchased, borrowings under our lines of credit and bank borrowings. Bonds and debentures payable include bonds and debentures that we have issued to primarily fund our lending and commission advance activities.
the ratio of revenues from our existing business to expenses from our existing business; and,
The ratio of revenues from our existing business to expenses from our existing business helps us identify operating losses we currently would experience in the event that franchise locations are not added and the associated initial franchise fees are not recorded. We define “revenues from our existing business” as net franchise commissions, net interest income, net brokerage commissions and net brokerage underwriting profits. These are the revenues that come from our existing franchise locations, our existing loans outstanding and our existing wholesale brokerage operations and are not dependent on the addition of new franchise locations. We exclude initial franchise fees, seller consulting fees, gains on sales of businesses and gain on loan sales. Revenues from our existing business are generally considered by us to be those revenues that are reasonably likely to be recorded in the next year regardless of whether new franchise locations are added.
We define “expenses from our existing business” as the expenses that we believe we will continue to incur, even if we do not expand our franchise network. Expenses from our existing business include payroll, other operating expenses and depreciation and amortization and are reasonably likely to be incurred in the next year regardless of whether new franchise locations are added. A ratio of 100% would indicate that our existing business produces sufficient revenues to cover the expenses incurred in connection with our existing operations. Part of our operating strategy is to ultimately increase this ratio to 100%.
Each segment is assessed a shared services expense, which is an internal allocation of legal, accounting, information technology and facilities management expenses based on our estimate of usage. Separate audited financial statements are prepared for each segment. Segment income and expenses exclude consolidating entries and segment assets and liabilities include consolidating entries, except total assets listed in tables.
Commission Revenues Retail insurance commissions have increased primarily as a result of Brooke Franchise’s continued expansion of franchise operations. Brooke Franchise also received commissions from the sale of investment securities and revenues from the sale of funeral services that are not directly related to insurance sales. However, these revenues are not sufficient to be considered material and are, therefore, combined with insurance commission revenues.
Profit sharing commissions, or Brooke Franchise’s share of insurance company profits paid by insurance companies on policies written by franchisees, increased $1,952,000, or 63%, to $5,039,000 in 2005 and
Prior to the fourth quarter of 2003, our franchises were typically conversions of acquired businesses and the initial franchise fee for basic services was typically waived because we believed that our franchise operations and trade name were not sufficiently established for franchisees to pay initial franchise fees for our basic services. Prior to the fourth quarter of 2003, our initial franchise fees were attributed to inspection reports and other specific buyers assistance services. However, as our franchise network has grown, our basic franchise services have become more valuable to our franchisees and we have been able to charge for these services.
The value of our basic franchise services was demonstrated when we began selling startup, or de novo, franchises in the fourth quarter of 2003. These franchisees did not require any specific buyers assistance services, but did require basic franchise services such as use of a registered trade name, supplier access and a proven business model. Therefore, when we introduced our startup franchise program in the fourth quarter of 2003, we began allocating a portion of the initial franchise fees paid by conversion franchisees to basic services because startup franchisees willingly paid us initial franchise fees for basic services. Correspondingly, the amount of this allocation was based on the amount of initial franchise fees typically paid by a startup franchisee.
Prior to 2006, initial franchise fees for basic services were typically assessed once for each franchisee, even though some franchisees operated multiple locations. Beginning in 2006, an initial franchise fee for basic services will be assessed for each location. A total of 210, 156 and 65 new franchise locations were added in 2005, 2004 and 2003, respectively. Out of these total franchise locations, 106, 41, and 1 were startup franchise locations added in 2005, 2004 and 2003, respectively. In 2006, our strategy is to continue to decrease our dependence on acquiring and converting new franchise locations into our system, and to increase the number of startup locations relative to the number of new conversion franchise locations. Therefore, we expect initial franchise fees for basic services to increase at a faster rate than initial franchise fees for buyers assistance plan services.
The buyers assistance plan is designed to assist a franchisee in inspecting the agency assets to be acquired. The buyers assistance plan (BAP) includes an inspection report, an operations report, and a marketing report, all of which are to be delivered on or prior to closing. As such Brooke Franchise performs substantially all of the BAP services before an acquisition closes. However, a relatively small level of BAP services are performed during the four months after acquisition, including advertising and training assistance. For this reason, a relatively small portion of the initial franchise fees for buyers assistance are correspondingly deferred until the service is performed. Brooke Franchise records initial franchise fee revenues for buyers assistance plans using the percentage of completion accounting method. To reflect revenues not yet earned, we deferred $118,000, $410,000 and $771,000 of initial franchise fee revenues for buyers assistance plans as of December 31, 2005, 2004 and 2003, respectively.
Gains on Sale of Businesses-Company-Owned Stores. If we expect to own and operate businesses for more than one year, we consider these businesses to be company-owned stores and treat such transactions under purchase accounting principles, including booking intangible assets and recognizing the related amortization expense. By contrast, agencies purchased with the intent to resell them to our franchisees (usually within one year) are carried at cost as business inventory, without the booking of intangible assets. Gains on sale resulting from the sale of company-owned stores was $68,000 in 2005 and $4,270,000 in 2004. The significant decrease in 2005 resulted from the sale of auto insurance agencies in 2004 that Brooke Franchise originally intended to operate as company-owned stores.
Gains on Sale of Businesses-Inventoried Stores. As noted above, acquired businesses are typically sold on the same day as acquired for the same nominal price paid to the seller. However, this is not always the case and businesses are occasionally held in inventory. As such, gains and losses are recorded when an inventoried business is ultimately sold and carrying values of inventoried businesses are adjusted to estimated market value when market value is less than cost. As a result, gains on sale resulting from the sale of inventoried businesses resulted in a gain of $1,838,000 and $181,000 in 2005 and 2004, respectively, and a loss of $260,000 in 2003.
2005 primarily because initial franchise fees for buyers assistance plans totaled $728,000 in the fourth quarter of 2005 which is a decrease of $2,256,000 from the $2,984,000 in initial franchise fees for buyers assistance plans received in the fourth quarter of 2004. This decrease partially results from our strategy to decrease dependence on acquiring and converting new franchise locations into our system, and to increase the number of startup locations relative to the number of new conversion franchise locations. Income before taxes increased in 2004 because revenues grew faster than expenses, primarily as the result of significant increases in initial franchise fees and seller related revenues, which have relatively high profit margins.
The number of businesses twice-purchased into inventory within twenty-four months is an important indicator of Brooke Franchise’s success in recruiting qualified buyers. The number of businesses twice-purchased during 2005, 2004 and 2003 was 1, 3 and 0, respectively. Brooke Franchise is not aware of any systemic adverse profitability or cash flow trends being experienced by buyers of businesses from its inventory.
Developed Stores One business was owned and under development by Brooke Franchise at December 31, 2005. Revenues and expenses from developed stores for 2005 were not sufficient to be considered material.
Same Store Sales Revenue generation, primarily commissions from insurance sales, is an important factor in franchise financial performance and revenue generation is carefully analyzed by Brooke Franchise. Analysis of same store sales is separated between converted stores and startup stores because existing businesses typically
Franchise Balances Brooke Franchise categorizes the balances owed by franchisees as either statement balances or non-statement balances.
Statement Balances Brooke Franchise assists franchisees by financing cyclical fluctuations of revenues, receivables and payables with commission advances recorded on franchisees’ monthly statements and granting temporary extensions of due dates for franchise statement balances owed by franchisees to Brooke Franchise. However, after initial conversion into its franchise system, Brooke Franchise expects franchisees’ monthly statements to be repaid in full at least once every four months. We believe the most accurate analysis of franchise statement balances occurs immediately after settlement of franchisees’ monthly statements and before any additional entries are recorded to their account. Therefore, the following discussion of statement balances is as of the settlement date that follows the corresponding commission month. Franchise statement balances totaled $4,047,000 and $2,228,000, respectively, as of December 2005 and 2004. Of these total franchise statement balances, Brooke Franchise identified statement balances totaling $1,859,000 and $1,576,000, respectively, which it categorizes as “watch” statement balances because the balances had not been repaid in full at least once in the previous four months.
Non-statement Balances Separate from these franchise statement balances, Brooke Franchise also extends credit to franchisees for long-term producer development, including hiring and training new franchise employees, and for other reasons not related to monthly fluctuations of revenues. These non-statement balances are not reflected in the franchise statement balances referenced above and totaled $3,334,000 and $584,000, respectively, as of December 2005 and 2004. During 2005, non-statement balances increased at a faster rate than commissions primarily as a result of our strategy to increase the number of startup franchises and the increasing use of our producer development program by an increasing number of startup franchises.
Allowance for Doubtful Accounts The balance of Brooke Franchise’s Allowance for Doubtful Accounts was $716,000 and $575,000, respectively, on December 31, 2005 and 2004. The amount of the Allowance for Doubtful Accounts was determined based primarily on analysis of Brooke Franchise’s watch balances. Other factors used in determining the amount of the Allowance for Doubtful Accounts were write off experience and Brooke Franchise’s evaluation of the potential for future losses. Total write offs increased primarily because write off of statement balances increased as the result of increasing franchising activity. Total write offs also increased because write off of non-statement balances increased as the result of increasing producer development activity and from implementation of a system in the third quarter of 2005 to better monitor the quality of non-statement balances.
Financial information for the years ended December 31, 2005, 2004 and 2003, and the percentage change between periods, relating to Brooke Credit and our Lending Services Segment is as follows (in thousands, except percentages):
Interest Income Brooke Credit earns interest income during the period it holds loans on its balance sheet and from retained interest resulting from loans sold as participation interests and asset-backed securities. Interest income increased due to the larger volume of loans originated by Brooke Credit and the longer period of time that Brooke Credit held those loans on its balance sheet.
When the sale is classified as a secured borrowing, no gain on sale is recognized, and the note receivable and the corresponding participation loan remain on the balance sheet.
in 2005 is primarily the result of securitizing more loans in 2005 and the decrease in 2004 is primarily the result of securitizing fewer loans in 2004 and greater reductions in net gain income from marking to fair market value the increasing retained interest asset balances.
During the fourth quarter 2005 the discount rate assumption was changed from 8.50% to 11.00%. Several factors were considered when determining the discount rate. As a starting point for analyzing this assumption, the risk free rate was used to determine a base discount rate. This base discount rate was then adjusted for various risk characteristics associated with the sold loans.
In connection with the recognition of non-cash losses for the servicing liabilities of loan participation sales, the present value of future cash flows were recorded as servicing liabilities. Components of the servicing liability as of December 31, 2005 were as follows:
Other Operating Interest Expense The increase in other operating interest expenses in 2005 and 2004 is primarily attributable to interest paid on bank lines of credit. Brooke Credit uses these lines of credit to fund its loans until we sell them in a securitization.
Other Operating Expenses The 2005 increase in other operating expenses is primarily attributable to securitization related fees of $1,953,000 in 2005 and $394,000 in 2004. The increase in securitization related fees is directly related to the 2005 increase in loan securitization activity and the corresponding increase in gain on sale of notes receivable. Securitization related fees include legal fees, advisor fees, accounting fees, program fees, origination fees and other fees related to securitizations and the corresponding line of credit. These fees include the legal fees paid through a shared services agreement with the parent company.
Income Before Income Taxes Brooke Credit’s income before income taxes increased significantly in 2005 primarily because net interest income revenues increased $4,934,000 from more loan originations and gain on sale of notes receivables income increased $3,451,000 (after deduction of an increase in securitization related expenses of $1,559,000) from more loan securitizations.
No amounts of recourse loans and loans associated with securitizations were charged off for the year ended December 31, 2005 and none of these loans were delinquent 60 days or more as of December 31, 2005, primarily because loan payments generally are deducted from commissions received by Brooke Franchise prior to payment of commissions to the borrower and most other creditors. We believe that credit problems on recourse and securitized loans are more likely to be identified when Brooke Franchise collects franchisees’ monthly statement account balances than by monitoring Brooke Credit’s loan delinquencies.
The terms of Brooke Credit’s securitizations (and a collateral preservation measure) require that payments on the pool of loan assets that back the securities sold to investors be paid from commissions received by Brooke Franchise prior to payment of commissions to the borrower and to most other creditors. As a result, we believe that our primary credit exposure generally results from Brooke Franchise’s collection of monthly franchisees’ statement balances rather than from loan defaults to Brooke Credit. Although we believe that credit loss exposure is limited on securitized loans and loan participations sold with recourse, Brooke Credit has reduced its expected retained interest associated with these loans by approximately $2,764,000 for credit loss allowance as of December 31, 2005, which reduced the amount of gain on sale revenue recognized at the time of each loan sale and resulted in a reduction of the carrying value of the corresponding asset on Brooke Credit’s balance sheet. Other than these reductions in asset totals, Brooke Credit has not established a separate credit loss reserve.
Perhaps a greater risk to Brooke Credit is the indirect exposure to credit losses that may be incurred by participating lenders and loan pool investors. Even if Brooke Credit does not bear any risk of direct credit losses, if losses by participating lenders and loan pool investors reach unacceptable levels, then Brooke Credit may not be able to sell loans in the future. Our business model requires that our franchisees have access to credit, so the inability to sell loans would have a significant adverse effect on Brooke Credit.
Profit sharing commissions, or Brooke Brokerage’s share of insurance company profits paid by insurance companies on policies written by non-exclusive insurance agents, increased $261,000, or 86% to $964,000, in 2005 and $519,000, or 283% to $703,000, in 2004. Profit sharing commissions increased in 2005 and 2004 primarily because overall insurance company profits increased on policies written by Brooke Brokerage’s non-exclusive insurance agents. Profit sharing commissions represented approximately 15% and 11%, respectively, of Brooke Brokerage’s insurance commissions for the years ended December 31, 2005 and 2004.
Insurance agents are typically paid a share of commission income, excluding profit sharing commissions. Commission expense decreased in 2005 because, after adjusting for profit sharing commissions, insurance commissions decreased in 2005. Commission expense increased in 2004 because insurance commission income increased. Commission expense represented approximately 43%, 46% and 40% of Brooke Brokerage’s insurance commission revenue for 2005, 2004 and 2003, respectively.
Policy fee income decreased in 2005 partially as the result of selling the Texas All Risk General Agency unit in November 2005 and increased in 2004 primarily as the result of acquiring the Texas All Risk General Agency unit in November 2003. Policy fee income represented approximately 25%, 32% and 11% of Brooke Brokerage’s insurance commissions for 2005, 2004 and 2003, respectively.
Net commission refund expense, or the estimated amount of Brooke Brokerage’s share of wholesale commission refunds due to policyholders resulting from future policy cancellations decreased $248,000 in 2005 primarily as the result of selling Texas All Risk General Agency. On December 31, 2005 and 2004, Brooke Brokerage recorded corresponding total commission refund liabilities of $86,000 and $455,000, respectively.
Underwriting Revenues Brooke Brokerage discontinued its plans to reinsure selected hard-to-place and niche insurance policies placed by Brooke Brokerage with unaffiliated insurance companies to unaffiliated policyholders through The DB Group, Ltd, a captive insurance company subsidiary. As of December 31, 2005, no reinsured policies had been written through The DB Group, Ltd and no premium revenues were recorded by The DB Group, Ltd. In December 2005, Brooke Brokerage sold The DB Group, Ltd to Brooke Investments, Inc., a sister company, and the captive insurance company will be used in 2006 to insure a portion of Brooke Franchise’s professional liability exposure. The issuance of professional liability policies through The DB Group, Ltd to insure a portion of Brooke Franchise’s professional liability exposure is important to Brooke franchisees and the corresponding premiums are paid by Brooke franchisees.
Our cash and cash equivalents increased a total of $6,020,000 from December 31, 2003 to December 31, 2004. During 2004, net cash of $5,804,000 was provided by operating activities. A cash inflow of $11,610,000 resulted from deferred payments to sellers for business inventory. Cash of $33,834,000 was used to fund an increase in notes receivable and cash of $24,092,000 was provided by an increase in line of credit loans resulting in $9,742,000 in increased notes receivable balances that were not funded by line of credit balances. Net cash of $1,754,000 was used by investing activities. A cash inflow resulted from the sale of subsidiaries and business assets, primarily auto insurance agencies, as cash proceeds of $12,977,000 from the sale of these assets exceeded corresponding cash purchases of $8,215,000. A cash outflow of $4,882,000 resulted from our purchase of securities related to our loan securitizations in 2004. Net cash of $1,970,000 was provided by financing activities with $19,785,000 of cash provided by loan proceeds from long-term debt and $10,591,000 of cash used to make payments on long-term debt.
In 2005, Brooke Corporation made equity contributions to Brooke Credit Corporation in the amount of $15,000,000 and Brooke Franchise Corporation in the amount of $5,000,000. These equity contributions were funded primarily with a portion of the $31,021,000 in net proceeds received from a Brooke Corporation public equity offering in 2005. Brooke Corporation does not expect to make any additional equity contributions to Brooke Credit Corporation or Brooke Franchise Corporation in 2006. However, Brooke Corporation expects to make an equity contribution to Brooke Brokerage Corporation in 2006 in the amount of $10,000,000, if its regulatory application to become a savings and loan holding company through acquisition of a federal savings bank is approved. The equity contribution will be made from Brooke Corporation’s cash reserves.
The sources and needs for capital of the individual subsidiaries are more fully explained below.
Brooke Credit Our finance subsidiary’s lending activities have been funded primarily through loan participation sales, asset-backed securitizations and bank lines of credit. Brooke Credit’s operating activities generated cash of $15,048,000 in 2005 and used cash of $7,789,000 in 2004. The changes in operating cash resulted primarily from changes in Brooke Credit’s loan inventory. Brooke Credit expects its loan portfolio to
Brooke Credit-Loan Participations In recent years, Brooke Credit has relied less on loan participation sales as a source of loan funding. Nevertheless, sales of loan participation interests remains an essential source of funding. Loan participation balances increased $4,260,000 and $37,135,000, respectively, in 2005 and 2004. Brooke Credit expects to sell similar amounts of loan participations to its lender network in 2006.
Brooke Credit-Asset Securitizations In recent years, Brooke Credit has relied on securitizations to fund an increasing share of its loan portfolio. Asset-backed securities totaling $83,500,000 and $20,000,000, respectively, were issued in 2005 and 2004. Based on Brooke Credit’s experience in recent years, it believes that it can sell the asset-backed securities that it expects to issue in 2006. However, if the market for these securities is such that it cannot, then Brooke Credit believes that the funding shortfall can be partially offset with the sale of more loan participations through its lender network and with increased borrowing from its bank lines of credit.
Subject to the above uncertainties, we believe that our existing cash, cash equivalents and funds generated from operating, investing and financing activities will be sufficient to satisfy our normal financial needs. Additionally, subject to the above, we believe that funds generated from future operating, investing and financing activities will be sufficient to satisfy our future financing needs, including the required annual principal payments of our long-term debt and any future tax liabilities.
** Projected future purchase price payments due to the sellers of CJD & Associates, L.L.C. that is contingent on future revenues. For additional information, see footnote 17 to our consolidated financial statements.
Our established accounting policies are summarized in footnotes 1 and 2 to our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003. As part of our oversight responsibilities, we continually evaluate the propriety of our accounting methods as new events occur. We believe that our policies are applied in a manner that is intended to provide the user of our financial statements with a current, accurate and complete presentation of information in accordance with Generally Accepted Accounting Principles.
We believe that the following accounting policies are critical. These accounting policies are more fully explained in the referenced footnote 1 to our consolidated financial statements.
The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. The following discussions summarize how we identify critical accounting estimates, the historical accuracy of these estimates, sensitivity to changes in key assumptions, and the likelihood of changes in the future. The following discussions also indicate the uncertainties in applying these critical accounting estimates and the related variability that is likely to result in 2006.
An estimate of franchisees’ share of undistributed commissions is made based on historical rates of commission payout, management’s experience and the trends in actual and forecasted commission payout rates. Although commission payout rates will vary, particularly if use of service/sales centers increases significantly, we do not expect significant variances from year to year. We regularly analyze and, if necessary, immediately
Discount, Prepayment and Credit Loss Rates Used to Record Loan Participation Sales and Asset-Backed Securities Sales We regularly sell the loans that we originate to banks and finance companies. Accounting for the sale of loan participations and loan securitizations and the subsequent tests for impairment are summarized in footnote 2.
and credit losses for the various loan pools indicated that our assumptions were historically accurate. The effect of variances can be significant and the impact of changes in these estimates is more specifically described in footnote 2.
Amortization and Useful Lives We acquire insurance agencies and other businesses that we intend to hold for more than one year. We record these acquisitions as Amortizable Intangible Assets. Accounting for Amortizable Intangible Assets, and the subsequent tests for impairment are summarized in footnote 1(g). The rates of amortization of Amortizable Intangible Assets are based on our estimate of the useful lives of the renewal rights of customer and insurance contracts purchased. We estimate the useful lives of these assets based on: historical renewal rights information; management’s experience; industry standards; and trends in actual and forecasted commission payout rates. The rates of amortization are calculated on an accelerated method (150% declining balance) based on a 15-year life. As of December 31, 2005, we tested amortizable intangible assets for impairment and the resulting analysis indicated that our assumptions were historically accurate and that the useful lives of these assets exceeded the amortization rate. The amortizable intangible assets have a relative stable life and, unless unforeseen circumstances occur, the life is not expected to change in the future. Because of the relatively large remaining asset balance, changes in our estimates could significantly impact our results. We believe that these estimates will not change in 2006.
Income Tax Expense An estimate of income tax expense is based primarily on historical rates of actual income tax payments. The estimated effective income tax rate used in 2005 to calculate income tax expense was 35%. Although not expected, significant changes in our estimated tax rate could significantly impact our results. We believe this estimate will not change significantly in 2006.
participation interests in individual loans to banks and finance companies and the securitization of pools of insurance agency loans. These typically meet the requirements of true sales as outlined in SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” The sale of loan participations and loan securitizations has resulted in the removal of a significant amount of loans from our balance sheet. The loan sales enable us to:
Loan Sales and Securitizations When the sale of a loan is classified as a true sale, gains or losses are recognized, loans are removed from the balance sheet and residual assets, representing the present value of future cash flows from the interest and servicing spread are recorded. Future cash flows are reduced by the amount of estimated credit losses and notes receivable prepayments, based on management’s assumptions and estimates.
To the extent that the difference between the rate paid by Brooke Credit to participating lenders and investors and the rate received by Brooke Credit from borrowers exceeds the maximum percentage allocated to the servicing benefit, Brooke Credit recognizes a non-cash asset, called an “Interest Receivable Asset,” on its balance sheet. This amount is equal to our estimate of the present value of future cash flows resulting from this interest spread. With respect to sale of loan participations, our right to interest income is not subordinate to the purchaser’s interests and we share interest income with purchasers on a pro rata basis. Although not subordinate to the purchaser’s interests, our retained interest is subject to credit and prepayment risks on the transferred assets. On loan participations sold with recourse, our retained interest is subject to credit risk on the transferred assets.
We annually evaluate and measure the retained interest and servicing assets for potential impairment. Impairment testing involves comparing our current discounted value of future interest and servicing revenue with our carrying value for the retained interest and servicing assets. If our current discounted value is less than our carrying value, we recognize an impairment equal to the difference in value. No impairment was recognized in the fiscal years ended December 31, 2005, 2004 and 2003.
In addition, we conduct sensitivity analysis to evaluate the potential impact of a 10% to 20% change in the key economic assumptions used in valuing our retained interest and servicing assets. These key economic assumptions include prepayment speed, expected credit losses and discount rate. As of December 31, 2005, an increase in these key economic assumptions by 10% to 20% generally results in decreases of 2% to 7% in the value of the retained interest and servicing assets. More drastic changes to economic and market conditions than those we have modeled would likely lead to greater diminution in the value of the retained interest and servicing assets.
In the event of such material change in economic and market conditions, we would likely examine a range of strategic options, including evaluating our current capital structure; the availability of credit sources in addition to the loan participation and loan securitization markets; a possible reduction in the expansion of our franchise network; a possible curtailment in our lending operations; and an examination of our internal cost and operating structure. We would make no such change prior to thoroughly evaluating our alternatives and market conditions. While our management cannot predict market conditions or the reactions of participating lenders to changes in market conditions or our strategies, we are unaware of any trends or uncertainties that are reasonably likely to materially reduce our ability to sell loans and remove them from our balance sheet under current accounting rules, or any need to consider any such strategic options at this time.
otherwise would require bifurcation. Our residual interests in securitizations typically have interests in derivative instruments embedded within the securitization. We have not yet determined if these embedded derivatives meet the criteria for bifurcation as outlined in the exposure draft.
A significant change in the credit markets could also have an adverse impact on our operations. Our lending operations depend on our ability to sell either loan participation interests or securities backed by our insurance agency loans to banks and finance companies. Several factors will affect our ability to sell participation interests in our loans and to complete securitizations, including:
performance is dependent, in part, on the fluctuations in insurance pricing. Although the current insurance market generally may be characterized as “soft,” with a flattening or decreasing of premiums in most lines of insurance, it is likely that insurance pricing will decrease further in the future, subjecting us to lower commissions on the insurance placed by our franchisees.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.
* The par value of common stock was changed from $1 per share to $.01 per share in the second quarter of 2004. The Company effected a 6-for-1 stock split in 2003 and a 2-for-1 stock split in 2004. These entries are shown as if the transactions occurred in the second quarter of 2002 for comparative purposes. The reclassification does not affect total equity.
Although the Company has multiple subsidiaries, the Company’s business operations are typically performed by one of three operating subsidiaries: Brooke Franchise Corporation, Brooke Credit Corporation and Brooke Brokerage Corporation. Separate annual audited financial statements are prepared for each operating subsidiary and each operates independently from the other two operating subsidiaries, and from the Company, to perform its specific business purpose. The Company provides accounting, administrative and legal support to its three operating subsidiaries for which it receives administrative fees. Company revenues are typically limited to dividends and administrative fees from these operating subsidiaries.
Brooke Brokerage Corporation, a Kansas corporation, serves as the parent holding company of the subsidiaries involved in the brokerage segment. It is the direct owner of 100% of the ownership interests of CJD & Associates, L.L.C. Although Brooke Brokerage Corporation is categorized as an operating subsidiary, all of its operations are conducted through CJD & Associates, L.L.C., a licensed insurance agency that sells hard-to-place and niche insurance on a wholesale basis, under the trade name of Davidson-Babcock, and brokers loans for general insurance agencies, captive insurance agencies, funeral homes and other small businesses.
These subsidiaries include Brooke Life and Health, Inc., The American Heritage, Inc., The American Agency, Inc., Brooke Credit Funding LLC, and First Brooke Insurance and Financial Services, Inc.
Subsidiaries have also been established for regulatory, licensing, security or other purposes and they typically conduct limited operations and do not own any assets. These subsidiaries include Brooke Bancshares, Inc., Brooke Funeral Services Company, LLC, Brooke Canada Funding, Inc., and Brooke Agency Services Company of Nevada, LLC.
The following schedule entitled “Valuation and Qualifying Accounts” summarizes the Allowance for Doubtful Accounts activity for the years ended December 31, 2005, 2004 and 2003 (in thousands). Additions to the allowance for doubtful accounts are charged to expense.
The Company’s brokerage subsidiary has established allowances of $0 and $52,000 at December 31, 2005 and 2004, respectively, against amounts owed by agents or insureds. Reserves of $0 and $60,000 at December 31, 2005 and 2004, respectively, were established for loan loss coverage on financial guaranty policies issued by DB Indemnity, Ltd on loans originated by the Company’s finance subsidiary.
Commissions. Commission revenue on insurance policy premiums is generally recognized as of the effective date of the policies or, in certain cases, as of the effective date or billing date, whichever is later. Contingent and profit sharing commissions typically represent a share of insurance company profits on policies
In the event of cancellation or reduction in premiums, for policies billed by an insurance carrier, a percentage of the commission revenue is often returned to the insurance carrier and revenues are correspondingly reduced. The commission refunds are calculated by the insurance carriers and are typically deducted from amounts due to the Company from insurance carriers. The Company has estimated and accrued a liability for commission refunds of $802,000 and $976,000 at December 31, 2005 and 2004, respectively.
Gains on sale of notes receivable. Loan participation and loan securitizations represent the transfer of notes receivable, by sale, to “participating” lenders or special purpose entities. When transfers meet the criteria to be accounted for as a true sale, established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” the gain on sale of a note receivable is recognized when the note receivable is sold. When the Company sells notes receivable, it typically retains servicing rights and interest income. Gains or losses on sales of notes receivable depends, in part, on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interest and servicing assets based on their relative fair value at the date of transfer.
The initial franchise fees paid for BAP services cover several separate and distinct consulting tasks such as inspection report compilation, marketing profile and plan development, and operations analysis. Each consulting task is a separate accounting unit and revenues for each consulting task are recognized using the percentage of completion accounting method. Most of the BAP services (inspection reports, operations analysis and marketing plan development) are provided by the Company before franchise acquisition, resulting in the recognition of associated revenues when initial franchise fees are paid at closing. Although substantially all of the BAP services are performed prior to closing, the Company does not record any revenues from initial franchise fees until the actual payment of fees at closing. As a result, in 2005, approximately 91% of those initial franchise fees related to BAP assistance were immediately recognized as revenue. The remaining BAP initial franchise fees are typically credits held in reserve for initial advertising, training and signage expenses. These credits are released, and the revenue recognized, as the actual expenses are incurred. When calculating the percentage of completion for these remaining BAP consulting services, the Company analyzes the time and expense expended to date in providing these services and the amount of tangible benefits received to date by franchisees.
Total initial franchise fees for BAP services typically vary based on a percentage of the acquired business’s revenues because the time and expertise required of the Company to perform BAP services generally varies with acquisition size. However, the time and expertise required of the Company to provide basic services and the value to franchisees of those basic services, remains the same for all franchisees (even to startup or de novo franchisees), so the amount of total initial franchise fees allocated to basic services does not vary. Accordingly, total initial franchise fees are first allocated to initial franchise fees for basic services in the amount typically charged to startup franchisees and the remainder of the total initial franchise fees is allocated to BAP services.
Seller consulting fees. The Company completes its consulting obligation to business sellers at closing and is not required to perform any additional tasks for the seller. Therefore, revenues from seller consulting fees are recognized at closing because the Company has no continuing obligation.
Gains on sale of businesses. The Company sometimes negotiates below-market interest rates on the deferred portion of purchase prices paid to business sellers. These interest rate concessions reduce the Company’s carrying value and increase the Company’s gain when sold to franchisees. Although the Company has a continuing obligation to pay the deferred portion of the purchase price when due, it is not obligated to prepay the deferred portion of the purchase price or to otherwise diminish the benefit of the below-market interest rate. Therefore, revenues from gains on sale of businesses resulting from deferred payments to sellers are recognized at closing because the Company has no continuing obligation.
Included in other assets are the unamortized costs of renewal rights (rights to renewal commissions received from insurance policies) purchased by the Company and through subsidiaries (Brooke Life and Health, Inc., The American Agency, Inc. and CJD & Associates, L.L.C.) for businesses the Company plans to own and operate for more than one year. The balance is being amortized over a 15-year period using an accelerated 150% declining balance switching to straight-line method. The rates of amortization of Amortizable Intangible Assets are based on our estimation of the useful lives of the renewal rights of customer and insurance contracts purchased. Amortization was $478,000, $898,000 and $291,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
The acquisition of renewal rights purchased by the Company or by its subsidiaries for businesses the Company plans to own and operate for less than one year are not classified as Amortizable Intangible Assets (see footnote 1(i)). Recent acquisitions and divestitures of Amortizable Intangible Assets are discussed in footnote 12.
On July 1, 2002, the Company acquired 100% of the outstanding ownership interests of CJD & Associates, L.L.C. and $1,417,000 of the initial purchase price was allocated to renewal rights. The sellers may be entitled to an increase of the initial purchase price based on the amount of monthly net revenues received in future periods. In accordance with FAS 141, “Business Combination,” any such payments for an increased purchase price will be recorded as Amortizable Intangible Assets when made. Additional payments of the purchase price have been made in the amount of $1,702,000 since the initial purchase.
On August 1, 2002, the Company acquired insurance agency renewal rights operating under the trade name of Bornstein Financial Group for an initial purchase price of $200,000. On August 8, 2003, an additional payment of $100,000 was made and the final total purchase price increased to $300,000 and was recorded as an Amortizable Intangible Asset in accordance with FAS 141, “Business Combinations.” The Company operates this business asset under Brooke Life and Health, Inc.
On November 30, 2003, CJD & Associates, L.L.C. acquired 100% of the outstanding shares of Texas All Risk General Agency, Inc. and T.A.R. Holding Co., Inc. which collectively owned 100% of the outstanding shares of All Risk General Agency, Inc. $1,000,000 of the initial purchase price was allocated to Amortizable Intangible Assets. The sellers were entitled to an increase of the initial purchase price based on the amount of monthly net revenues received in future periods. In accordance with FAS 141, “Business Combinations,” any such payments for an increased purchase price will be recorded as Amortizable Intangible Assets when made.
In February 2003, the Company acquired the rights to the Web site Agencies4Sale.com for $25,000.
Net income tax expense is the tax calculated for the year based on the Company’s effective tax rate plus the change in deferred income taxes during the year. Deferred tax liabilities were recorded in 2005 and 2004 to recognize the future tax consequences of temporary differences between financial reporting amounts and the tax basis of existing assets and liabilities based on currently enacted tax laws and tax rates in effect for the years in which the differences are expected to reverse.
The Contract database asset consists of legal and professional fees associated with development of standardized documents relating to the creation of a new asset class for securitization and rating of insurance agency loan pools. The initial one time development cost of standardized documents for creating a new security asset class is non-recurring and securitization of subsequent insurance agency loan pools results in lower and routine transaction expenses. This asset is being amortized over a five-year period because the benefits of this new asset class are expected to last at least five years and because significant changes to the associated standardized documents will probably not be required for five years.
Deferred charges include loan fees paid in 2004 and 2005 to establish and increase a line of credit with DZ BANK AG Deutsche Zentral-Genossenschaftsbank. Associated costs totaled $996,000, of which $696,000 was paid in 2004 to establish the line of credit and $300,000 was paid in 2005 to increase the line of credit. These costs are amortized over a period ending at the maturity date of the line of credit. Net of amortization, the balance of all such prepaid expenses at December 31, 2005 and 2004 was $779,000 and $649,000, respectively.
Deferred charges also include the costs associated with a public offering of bonds and debentures. Selling expenses, auditor fees, legal costs and filing charges associated with the Company’s public offering of bonds and debentures totaled $615,000 and are amortized over a period ending at the bond and debenture maturities. Net of amortization, the balance of all such prepaid expenses at December 31, 2005 and 2004 was $0 and $190,000, respectively. The bonds and debentures were paid in full during 2005.
In the first quarter of 2003, the Company authorized the split of common stock at a ratio of 6-for-1 and, in the second quarter of 2004, the Company authorized the split of common stock at a ratio of 2-for-1.
In August 2005, the Company issued 2,875,000 shares of its common stock through a secondary offering. Priced at $11.50 per share, the gross proceeds of the offering were $33,063,000, with proceeds of $31,161,000 to the Company, before expenses and after underwriter commissions and discounts.
As part of its initial services to franchisees, the Company sometimes assists franchisees with the conversion of acquired businesses into its franchise system pursuant to a buyers assistance plan (BAP). Substantially all of the BAP services (inspection reports, operations analysis and marketing plan development) are typically provided by the Company before franchise acquisition. However, some BAP related services (advertising and training) are performed during the four months after acquisition and a portion of BAP fees are correspondingly deferred. Unearned BAP and other related fees were $118,000 and $410,000 at December 31, 2005 and 2004, respectively.
The net notes receivable included as part of the “Accounts and Notes Receivable, Net” asset category are available for sale and are carried at the lower of cost or market. Any changes in the net notes receivable balances are classified as an operating activity.
The Company expenses the costs of advertising as they are incurred. Total advertising expense for the years ended December 31, 2005, 2004 and 2003 was $6,674,000, $4,589,000 and $2,098,000, respectively.
The Company holds insurance commissions for the special purpose entities Brooke Acceptance Company LLC, Brooke Captive Credit Company 2003, LLC, Brooke Securitization Company 2004A, LLC, Brooke Capital Company, LLC, and Brooke Securitization Company V, LLC for the purpose of making future loan payments, and the use of these funds is restricted until the next monthly loan payment is made. The amount of commissions held at December 31, 2005 and 2004 was $547,000 and $410,000, respectively.
When the Company sells notes receivable in securitizations of insurance agency loans, it retains an interest-only strip receivable, a subordinated tranche and cash reserve accounts, all of which are retained interests in the loan securitizations. The amount of gain or loss recorded on the sale of notes receivable in securitizations depends in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the retained interests based on their relative fair value at the date of transfer. To initially obtain fair value of retained interest resulting from securitization of notes receivable, quoted market prices are used if available. However, quotes are generally not available for such retained interests, so the Company typically estimates fair value based on the present value of future expected cash flows using management’s best estimates of key assumptions, credit losses (0.50% annually), prepayment speed (10.00% annually) and discount rates (11.00%) commensurate with the risks involved.
Insurance losses to be incurred and loss expenses to be paid by DB Indemnity, Ltd are estimated and recorded when advised by the insured. Outstanding losses and loss expense adjustments represent the amounts needed to provide for the estimated ultimate cost of settling claims relating to insured events that have occurred before the balance sheet date. These amounts are based upon estimates of losses reported by the insureds plus an estimate for losses incurred but not reported.
The Company has granted stock options to employees of the Company pursuant to its 2001 Compensatory Stock Option Plan. The Company’s net income would have been reduced to $9,641,000, $6,493,000 and $3,952,000 for the years ended December 31, 2005, 2004 and 2003, respectively, with the Company’s income per fully diluted share being reduced to $0.86, $0.63 and $0.39 at December 31, 2005, 2004 and 2003, respectively, if the compensation cost for the stock options had been determined based on the fair value at the date of grant pursuant to the provisions of SFAS 123R, “Share-Based Payment.” The Company made the
The aggregate carrying values of interest-only-strip receivables were $1,412,000 and $2,484,000 at December 31, 2005 and 2004, respectively. Interest-only strip receivables represent the fair value of an asset resulting from the sale of notes receivable to a participating bank. The amount of unrealized loss on the interest-only strip receivable was $93,000 at December 31, 2005 and the amount of unrealized gain on the interest-only strip receivable was $289,000 at December 31, 2004. The interest-only strip receivables have varying dates of maturities ranging from the third quarter of 2011 to the second quarter of 2020.
When the Company sells notes receivable to a participating bank, it retains an interest-only strip receivable. The amount of gain or loss recorded on the sale of notes receivable to a participating bank depends in part on the previous carrying amount of the financial assets involved in the transfer, allocated between the assets sold and the interest-only strip receivable based on its relative fair value at the date of transfer. To obtain fair values, the Company estimates fair value based on the present value of future expected cash flows using management’s best estimates of the key assumptions (credit losses, prepayment speeds, and discount rates) commensurate with the risks involved. As mentioned in footnote 1(u), the Company changed the discount rate assumption, as a result, the Company recorded an unrealized loss, net of taxes of $371,000 on the interest-only strip receivable for the year ended December 31, 2005. For additional information on the key assumptions and risks involved see footnote 2.
At December 31, 2005 and 2004, accounts and notes receivable consist of the following:
* The Company has a corresponding liability for interest payable to participating lenders in the amounts of $480,000 and $285,000 at December 31, 2005 and 2004, respectively.
Brooke Credit Corporation has loaned money to the Company and to other subsidiaries of the Company. These notes receivable have been eliminated in consolidation to the extent the notes receivable have not been sold to an unaffiliated third party. The sale of all or a portion of the intracompany notes receivable to an unaffiliated third party results in a notes payable, as discussed in footnote 4.
Loan participations and loan securitizations represent the transfer of notes receivable, by sale, to “participating” lenders or special purpose entities. The Company receives consideration from the transfer of notes receivable, through retained interest and servicing assets. These transfers are accounted for by the criteria established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”
Of the notes receivable sold, at December 31, 2005 and 2004, $233,473,000 and $138,740,000, respectively, were accounted for as sales because the transfers meet the criteria established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Purchasers of these notes receivable obtained full control over the transferred assets (i.e. notes receivables) and obtained the right, free of conditions that constrain it from taking advantage of that right, to pledge or exchange the notes receivables. Furthermore, the agreements to transfer assets do not entitle or obligate the Company to repurchase or redeem the notes receivable before their maturity, except in the event of an uncured breach of warranty.
the transfer, allocated between the assets sold and the retained interest and servicing assets based on their relative fair value at the date of transfer.
In December 2005, the Company sold $64,111,000 of loans to qualifying special purpose entity Brooke Securitization Company V, LLC. The sale represents a loan securitization in which an interest receivable was retained. Of the loans sold, $51,500,000 of asset-backed securities were issued to accredited investors by Brooke Securitization Company V, LLC. Brooke Credit Corporation received servicing income of $6,000 from the primary servicer for the year ended December 31, 2005. The fair value of the difference between loans sold and securities issued to accredited investors and the fair value of interest receivables retained were recorded on the Company’s books as a security with a balance of $18,201,000 at December 31, 2005. This security is comprised of retained interest totaling $5,505,000 and retained equity in the special purpose entity totaling $12,696,000.
At December 31, 2005 and 2004, the Company had transferred assets with balances totaling $233,473,000 and $138,740,000, respectively, resulting in pre-tax gains for the years ended December 31, 2005, 2004 and 2003 of $7,435,000, $2,475,000 and $4,368,000, respectively.
Of the business and real estate loans at December 31, 2005 and 2004, $3,807,000 and $3,733,000, respectively, in loans were sold to various participating lenders with recourse to Brooke Credit Corporation. Such recourse is limited to the amount of actual principal and interest loss incurred and any such loss is not due for payment to the participating lender until such time as all collateral is liquidated, all actions against the borrower are completed and all liquidation proceeds applied. However, participating lenders may be entitled to periodic advances from Brooke Credit Corporation against liquidation proceeds in the amount of regular loan payments. At December 31, 2005, all such recourse loans: a) had no balances more than 60 days past due; b) had adequate collateral; and c) were not in default.
To obtain fair values of retained interests, quoted market prices are used, if available. However, quotes are generally not available for retained interests, so the Company typically estimates fair value based on the present value of future expected cash flows estimated using management’s best estimates of key assumptions, credit losses, prepayment speed and discount rates commensurate with the risks involved.
The value of the “Servicing Asset” is calculated by estimating the net present value of net servicing income (or expense) on loans sold using the discount rate and prepayment speeds noted in the table below. At December 31, 2005 and 2004, the value of the servicing asset recorded by the Company was $2,650,000 and
$2,909,000, respectively. Subsequent to the initial recording at fair value, the servicing asset is amortized in proportion to and over the period of estimated net servicing income.
The value of the “Servicing Liability” is calculated by estimating the net present value of net servicing expense on loans sold using the discount rate and prepayment speeds noted in the table below. At December 31, 2005 and 2004, the value of the servicing liability recorded by the Company was $34,000 and $39,000, respectively.
Impairment of retained interest and servicing assets is evaluated and measured annually. The impairment testing is performed by taking the current interest and servicing revenue stream and valuing the new revenue stream with the appropriate assumptions. The new revenue stream is based on the loan balances at the date the impairment test is completed which will include all prepayments on loans and any credit losses for those loans. The new discounted revenue stream is then compared to the carrying value on the Company’s books and if the new value is greater than the value on the books no impairment has occurred. If the new discounted revenue stream is less than the value on the books and an other than temporary impairment has occurred the Company would write the asset down to the new discounted revenue stream. No impairment was recognized in the years ended December 31, 2005, 2004 and 2003.
At December 31, 2005, key economic assumptions used in measuring the retained interests and servicing assets when loans were sold or securitized during the year were as follows (rates per annum):
Effect of Increases in Assumed Prepayment Speed on Retained Interest (Interest-Only Strip Receivable, including retained interest carried in Securities balance)
Effect of Increases in Assumed Credit Loss Rate on Retained Interest (Interest-Only Strip Receivable, including retained interest carried in Securities balance)
Effect of Increases in Assumed Discount Rate on Retained Interest (Interest-Only Strip Receivable, including retained interest carried in Securities balance)
The following is an illustration of disclosure of expected static pool credit losses to the Company for loan participations sold with recourse and loans sold in securitizations. “Static pool credit loss” is an analytical tool that matches credit losses with the corresponding loans so that loan growth does not distort or minimize actual loss rates. The Company discloses static pool loss rates by measuring credit losses for loans originated in each of the last three years.
* Loans 60 days or more past due are based on end of period total loans.
** Net credit losses are charge-offs and are based on total loans outstanding.
Seller notes payable are typically the deferred portion of purchase prices paid by the Company to acquire insurance agencies for resale by the Company to franchisees. Seller notes payable are secured by a collateral
The note payable to DZ BANK AG Deutsche Zentral-Genossenschaftsbank also requires the Company and Brooke Credit Corporation to maintain minimum stockholders’ equity. The covenants do not restrict management’s ability to pay dividends (if minimum stockholders’ equity is maintained) or restrict management’s ability to incur additional debt. The note is subject to up front fees which have been paid and are included in the deferred charges account. The note is also subject to recurring fees based on the use of the line of credit (monthly program fee and a non-use fee). The Company records the balance on this loan as a current obligation as the intent is to securitize the loans collateralized within twelve months. This line of credit matures August 2009, with the Company being able to advance and pay down the principal balance until maturity.
The other bank loans, notes payable and other long-term obligations do not contain covenants that: require the Company to maintain minimum financial ratios or net worth; restrict management’s ability to pay dividends; restrict management’s ability to buy or sell assets; restrict management’s ability to incur additional debt; or include any subjective acceleration clauses.
Interest incurred on bank loans, notes payable and other long-term obligations for the years ended December 31, 2005, 2004 and 2003 was $5,842,000, $3,267,000 and $1,241,000, respectively.
Short-term debt represents the DZ BANK AG Deutsche Zentral-Genossenschaftsbank line of credit, the line of credit due January 2006 listed in the preceding table and non-cash investing transactions utilized to purchase business assets.
At December 31, 2005 and 2004, the bonds and debentures payable consisted of:
Net income tax expense is the tax calculated for the year based on the Company’s effective tax rate plus the change in deferred income taxes during the year. The elements of income tax expense are as follows:
The Company maintains cash balances at several banks. At December 31, 2005, the Company had account balances of $7,558,000 that exceeded the insurance limit of the Federal Deposit Insurance Corporation.
The tables below reflects summarized financial information concerning the Company’s reportable segments for the years ended December 31, 2005, 2004 and 2003:
Robert D. Orr, CEO and Leland G. Orr, CFO own a controlling interest in Brooke Holdings, Inc. which owned 46.9% of the Company’s common stock at December 31, 2005.
Anita K. Lowry is the sister of Robert D. Orr and Leland G. Orr and the mother of Shawn T. Lowry and Michael S. Lowry and is married to Don Lowry. Don and Anita Lowry are shareholders of American Heritage Agency, Inc. of Hays, Kansas. At December 31, 2005, Brooke Credit Corporation had five loans outstanding to American Heritage Agency with total principal balances of $559,000, of which $472,000 was sold to unaffiliated lenders. Such loans were made on substantially the same terms and conditions as provided to other franchises and have scheduled maturities between January 15, 2006 and June 15, 2016. The Company’s exposure to loss equals the retained principal balances of $87,000.
the contingency period of November 2004 to October 2008. Any such purchase price increase was to be paid to the sellers monthly during the contingency period and, in accordance with paragraph 28 of FAS 141, “Business Combinations,” the payment was recorded as an asset when made. Additional payments of the purchase price were made in the amount of $1,352,000 after the initial purchase.
In August 2002, the Company acquired insurance agency assets operating under the trade-name of Bornstein Financial Group for an initial purchase price of $200,000. In August 2003, an additional payment of $100,000 was made and the purchase price increased to $300,000. The seller is not entitled to any additional increases in purchase price based on future revenues. In accordance with FAS 141, “Business Combinations,” this additional payment was recorded as Amortizable Intangible Asset as disclosed in footnote 1(g). The Company operates this business asset under Brooke Life and Health, Inc. Its primary business activities include the sale of annuities, long-term care and final expense insurance to senior citizens.
In July 2002, the Company acquired 100% of the outstanding ownership interest of CJD & Associates, L.L.C. for an initial purchase price of $2,025,000. A portion of the initial purchase price has been allocated to Amortizable Intangible Assets as disclosed in footnote 1(g). The sellers are entitled to an increase of the initial purchase price equal to 30% of CJD & Associates’ monthly net revenues during the contingency period of September 1, 2003 to September 1, 2007. Any such purchase price increase shall be paid to the sellers monthly during the contingency period and, in accordance with paragraph 28 of FAS 141, “Business Combinations,” the payment shall be recorded as an asset when made. Additional payments of the purchase price have been made in the amount of $1,702,000 since the initial purchase.
In December 2005, CJD & Associates, L.L.C. sold DB Indemnity, Ltd and The DB Group, Ltd to Brooke Investments, Inc., another subsidiary of the Company. The captives were sold for their book value, thus no gain on sale resulted. DB Indemnity, Ltd was sold for $2,152,000 and The DB Group, Ltd was sold for $1,070,000.
The fair value of the options granted for the years ended December 31, 2005 and 2004 is estimated on the date of grant using the binomial option pricing model. The weighted-average assumptions used and the estimated fair value are as follows:
161,400 options to purchase shares were exercisable at December 31, 2005. The following table summarizes information concerning outstanding and exercisable options at December 31, 2005.
There were no intangible assets with indefinite useful lives as of December 31, 2005, and December 31, 2004. The intangible assets with definite useful lives had a value of $6,092,000 and $7,880,000 at December 31, 2005, and December 31, 2004, respectively. Of these assets, $2,650,000 and $2,909,000, respectively, were recorded as a servicing asset on the balance sheet. The remaining assets were included in “Other Assets” on the balance sheet. Amortization expense was $1,612,000, $1,875,000 and $990,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
Amortization expense for amortizable intangible assets for the years ended December 31, 2006, 2007, 2008, 2009 and 2010 is estimated to be $1,451,000, $1,253,000, $989,000, $803,000 and $687,000, respectively.
Business inventory increased from December 31, 2004 to December 31, 2005. During the years ended December 31, 2005, 2004 and 2003, the statements of cash flows reflect the purchase of businesses into inventory provided by sellers totaling $14,318,000, $11,610,000 and $6,999,000, respectively, the write down to realizable value of inventory of $0, $130,000 and $266,000, respectively, and the change in inventory of $4,036,000, $655,000 and $36,000, respectively.
The DB Group, Ltd is required by its license to maintain statutory capital and surplus greater than a minimum amount determined as the greater of $1,000,000, a percentage of outstanding losses or a given fraction of net written premiums. At December 31, 2005, the Company was required to maintain a statutory capital and surplus of $1,000,000. Actual statutory capital and surplus was $1,063,000 and $1,035,000 at December 31, 2005, and 2004, respectively. Of the actual statutory capital $1,102,000 and $1,102,000 is fully paid up share capital and contributed surplus, and, accordingly, all of the retained earnings were available for payment of dividends to shareholders.
The DB Group, Ltd is also required to maintain a minimum liquidity ratio whereby the value of its relevant assets are not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and deposits, investment income accrued and insurance balances receivable. Certain categories of assets do not quality as relevant assets under the statute. The relevant liabilities are total general business insurance reserves and total other liabilities, less sundry liabilities.
The DB Group, Ltd was required to maintain relevant assets of at least $0 and $1,000 at December 31, 2005, and 2004, respectively. At December 31, 2005 and 2004, relevant assets were $1,063,000 and $1,036,000, respectively. The minimum liquidity ratio was, therefore, met.
On December 16, 2004, the FASB issued SFAS 123R, “Share-Based Payment.” SFAS No. 123R requires companies to expense the value of employee stock options and similar awards. The cost of the awards will be measured at the fair value on the awards’ grant date, based on the estimated number of awards that are expected to vest. Compensation cost for awards that vest would not be reversed if the awards expire without being exercised. When measuring fair value, companies can choose an option-pricing model like Black-Scholes or binominal models. The effective date for public companies is interim and annual periods beginning after June 15, 2005, and applies to all outstanding and unvested share based payment awards at a company’s adoption date. The adoption of SFAS 123R for estimated unvested options at the adoption date may have a material effect on our consolidated financial statements. The Company’s compensation committee is considering various alternatives in response to this new pronouncement. As a result, the impact to our consolidated financial statements for future share based payment awards has not been determined.
On January 23, 2006, the Company entered into a definitive agreement to acquire all of the capital stock of Generations Bank from Kansas City Life Insurance Company for $10.1 million in cash. Generations Bank is a federal savings bank currently located in Kansas City, Missouri. The closing of the stock transaction is subject to regulatory approvals, the existence as of the closing date of not less than $8.2 million in the bank’s GAAP book equity, and standard closing conditions. Closing is expected to occur during the third quarter of this year.
Operating results for the quarters ended 2005 and 2004 were as follows:
* For comparative purposes the earnings per share were adjusted to reflect the 2-for-1 stock split in the second quarter of 2004.