CMI leases a 70,000 square foot office building in Dublin, Ohio, which is used as its principal office facilities. The original lease for the building was for a term of 15 years and was scheduled to expire in 2012. In 2002, CMI exercised a renewal option and extended the lease for an additional five years, through 2017. The lease requires CMI to pay all operating expenses for the building. The lease also provides for two renewal options of five years each.
Primrose leases a 13,000 square foot facility in Acworth, Georgia as its corporate headquarters. The initial lease is for a term of five years and expires in 2008. The lease contains two renewal options of five years each. Primrose also leases an 8,000 square foot building, also located in Acworth, Georgia, for its Company-owned and operated educational childcare facility. The initial lease term is 10 years and expires in 2013. The lease contains two renewal options of 10 years each.
The Company leases office space in Greenwich, Connecticut for its corporate headquarters. The initial lease is for a
term of seven years four months and expires February 2011 and contains a renewal option for an additional five years. The Company shares the office space with Capital Partners, Inc. (“Capital Partners”), a controlling stockholder. Under the terms of a Management Advisory Services Agreement (the “MAS Agreement”), Capital Partners pays the rent, and the Company’s reimbursement for its portion of the rent is included in the management advisory services fee the Company pays to Capital Partners (see Item 13. Certain Relationships and Related Transactions in this Form 10-K for further details regarding the annual management advisory services fee paid to Capital Partners pursuant to the MAS Agreement).
The following discussion should be read in conjunction with the financial statements of the Company and the related notes thereto appearing in Item 8. “Financial Statements and Supplementary Data” in this Report on Form 10-K. Amounts are in thousands except share and per share amounts.
Security Capital operates as a holding company that actively participates in the management of our subsidiaries, but also gives each subsidiary a certain degree of operating autonomy, with its own chief executive officer and senior management. The Company itself is managed by Capital Partners, pursuant to the MAS Agreement. Capital Partners controls approximately 81% of the Company’s shares, held principally by CPI, and provides us with management services under the MAS Agreement. Mr. Brian Fitzgerald controls Capital Partners and serves as our Chairman of the Board of Directors, President and Chief Executive Officer.
As discussed in Item 1. “Business” above, we have purchased, sold or otherwise disposed of a number of businesses over the last few years. Our current operations consist of two reportable operating segments, Employer Cost Containment and Health Services, conducted through WC, CMI and its wholly owned subsidiaries, and Educational Services, conducted through Primrose. In recent years, we have sought to strengthen these two valuable businesses, while at the same time shedding unneeded or unprofitable businesses. In keeping with our management philosophy, the senior management of both WC (approximately 20%) and Primrose (approximately 1.5%) have equity participations in our businesses, as well as stock options in those subsidiaries.
While the exploration of strategic alternatives was ongoing, we continued to pursue our objectives of shedding unwanted businesses, strengthening the core WC and Primrose businesses that we viewed as our most valuable assets, and otherwise resolving various matters that needed to be addressed in order to maximize the value of the Company and achieve an appropriate liquidity event for public stockholders. Thus, in 2004, we successfully sold Pumpkin and resolved outstanding matters with respect to the bankruptcy of Possible Dreams. We redeemed, for $5,000, our outstanding Preferred Stock that we had issued in 1999 in connection with our acquisition of Primrose, in the process resolving an arbitration that had been brought by the holder of the Preferred Stock with respect to the redemption. We also were successful in an appeal to the Ohio Supreme Court regarding whether certain of our WC operations in Ohio constituted the unauthorized practice of law.
In addition to successfully addressing these challenges, we have continued to focus on building the strength of our core WC and Primrose businesses and delivering strong operating results for our stockholders. We have strengthened the management at WC after the Company, upon the recommendation of the Audit Committee, terminated two senior members of the CMI management team based upon the findings of the Investigation. We have improved our operating systems at WC and strengthened our controls at the subsidiary level. We have continued to generate strong operating results and cash flows at WC, in spite of the $3,000 that WC had to spend on the Supplemental Procedures and the Investigation, approximately $900 of which was included in expenses for the fourth quarter of 2004, with the remainder recorded in the first quarter of 2005. We have successfully negotiated our latest acquisition at WC - Caronia - which closed on March 31, 2005.
Internal Independent Investigation Into Potential Related-Party Transactions and Conflicts of Interest
The Investigation uncovered a third entity controlled by CMI Management that engaged in related-party transactions with the CMI Companies. CMI Management had previously divested its controlling interest in this entity. The Investigation also reconfirmed the findings of the Supplemental Procedures that there were no instances of fraud or financial impropriety that would indicate the Company’s historical financial statements were misstated. The Investigation did reveal, however, that in some instances, these related-party entities used the personnel, office space and equipment of the CMI Companies.
The Investigation was completed in March 2005. The total cost of the Supplemental Procedures and Investigation was approximately $3,000. Approximately $900 of these costs were recorded in the fourth quarter of 2004 and the remaining costs were recorded in the first quarter of 2005. Apart from these costs, we do not believe that the issues uncovered are material to our financial condition, results of operations or cash flows.
The impact of the restatement on our 2001 earnings has been reflected as a $95 increase to accumulated deficit as of December 31, 2001 in the accompanying consolidated statements of stockholders’ equity. We have also restated the applicable statement of operations information for the year ended December 31, 2001 and balance sheet information at December 31, 2002, 2001 and 2000 in Item 6. “Selected Financial Data” of this report. We have not amended our previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the restatement, and the financial statements and the related financial information contained in those reports should no longer be relied upon. Throughout this Annual Report on Form 10-K, including in this management’s discussion and analysis, all referenced amounts for prior periods and prior period comparisons reflect balances and amounts on a restated basis.
There are certain accounting policies that we believe are critical to our business and the understanding of our financial statements, either because of their magnitude to the financial statements or because they require management to make certain estimates and assumptions. These critical accounting policies are described below. For additional disclosures with respect to our significant accounting policies, see Note 4 to Consolidated Financial Statements in this Annual Report on Form 10-K.
The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates include an allowance for doubtful accounts, allowance for uncollectible assignment development costs, bankruptcy accruals, reserves for contingencies, the utilization of carry forward tax benefits, the determination of fair value and economic lives of intangible assets, the estimates and assumptions inherent in our goodwill impairment testing procedures and the allocation of
Revenues for the Employer Cost Containment and Health Services segment are derived from third-party administrative services, self-insured plan administrator services, consulting services, group rating services, and managed care administration services. Revenues from third-party administrative services, self-insured plan administrator services, consulting services and group rating services are recorded based on the terms and duration of the related contracts. Cash received in advance of the services being provided is initially deferred and recognized as revenue on a pro rata basis over the related contract period, which typically ranges between three and twelve months. Revenues from managed care administration services are recognized on a monthly basis based on the contracted administrative fee with the OBWC. Certain contracts also provide for an incentive or bonus award based on the attainment of certain criteria stipulated in the contracts. Revenues from incentive or bonus awards are recognized when they are earned and collectibility is reasonably assured.
We measure compensation cost for stock options issued to employees under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). Under APB 25, when the exercise price of the Company’s stock options equals the market value of the underlying stock on the date of the grant, no compensation expense is recognized. The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as amended by Statement of Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transitions and Disclosure, an amendment to FASB Statement No. 123 (“SFAS 148”).
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”). Under SFAS 123R, the cost of share-based payment awards should be recognized through earnings based on the fair value of the award on the grant date and the estimated number of awards expected to vest. SFAS 123R requires this cost to be recognized over the expected vesting period. The provisions of SFAS 123R will become effective for the Company beginning January 1, 2006. SFAS 123R allows public companies to select from two alternative transition methods when adopting SFAS 123R, the modified prospective application or the modified retrospective application. Under the modified prospective application, the provisions of SFAS 123R are applied to new awards and awards modified, repurchased or cancelled after the effective date. Under the modified retrospective application, the provisions of SFAS 123R may be applied to (i) all awards granted, modified or settled in cash in fiscal years in which SFAS 123 was effective (years beginning after December 15, 1994) or (ii) only interim periods in the year of adoption unless the effective date of SFAS 123R coincides with a company’s fiscal year. At this time, we have not determined the impact of SFAS 123R on our financial statements, nor have we decided which transition method to use.
Consolidated revenues for the year ended December 31, 2004 increased $38,508, or 41% to $132,940 compared to revenues of $94,432 for the year ended December 31, 2003. Consolidated revenues for the year ended December 31, 2003 increased $21,729, or 30% to $94,432 compared to revenues of $72,703 for the year ended December 31, 2002. Revenues by segment were as follows:
Revenues from the Employer Cost Containment and Health Services segment for the year ended December 31, 2003 increased $20,138, or 31% to $84,598 compared to $64,460 reported for 2002. This increase resulted from revenues from Octagon of $9,459 for the three months following its acquisition in October 2003, additional revenue of $3,714 due to a full year of revenue from Barron, which was acquired in October 2002, and additional revenue of $4,045 from new contracts entered into in late 2002 and early 2003.
Revenues from the Educational Services segment for the year ended December 31, 2004 increased $1,771, or 18% to $11,605 compared to $9,834 for the same period last year. Royalty revenues for 2004 increased $1,357, or 17% compared to 2003 due to higher same school revenue, a full year contribution from schools opened in 2003 and the opening of seven additional schools during 2004. At December 31, 2004, there were 125 schools opened compared to 118 schools at December 31, 2003. Assignment revenue increased $220 as there were 16 property sale closings with franchisees during 2004 compared to five in 2003, and Company-owned school revenues increased $293 due to increasing enrollment as the school becomes established. These increases were partially offset by lower franchise fees of $309 as seven new schools were opened during 2004 compared to 13 openings in 2003.
Consolidated selling, general and administrative expense (“SG&A”) for the year ended December 31, 2004 increased $34,676, or 44% to $114,315 compared to SG&A of $79,639 for 2003. Consolidated SG&A for the year ended December 31, 2003 increased $22,160, or 39% compared to SG&A of $57,479 for 2002. SG&A by segment was as follows:
SG&A expenses in the Employer Cost Containment and Health Services segment increased $20,108, or 39% to $71,709 for the year ended December 31, 2003, compared to $51,601 for 2002. The increase was primarily due to expenses of $8,073 for Octagon for three months during 2003, additional expenses of $3,712 directly associated with the Barron operation acquired in October 2002 and additional personnel expenses necessary to service the new contracts entered into in late 2002 and early 2003.
SG&A expenses in the Educational Services segment increased $713, or 14% to $5,980 for the year ended December 31, 2004 compared to $5,267 for 2003. This increase was primarily attributable to higher personnel costs due to increased headcount necessary to service the number of franchised schools and higher expenses in our Company-owned school as a result of increasing enrollment as the school matured.
SG&A expenses at our corporate headquarters increased $1,516, or 120% to $2,779 for the year ended December 31, 2004 compared to $1,263 for 2003. This increase was mainly due to an increase in audit fees, legal fees, and the costs of the Special Committee. Audit fees for corporate increased $850 due to an increase in the hourly billing rates of our accountants, additional work incurred for the lease accounting restatement, and other factors associated with the planning and execution of audit procedures. Legal fees were $383 higher than last year mainly due to services pertaining to the review of strategic alternatives, the redemption of the Preferred Stock, the sale of Pumpkin, the settlement of the Possible Dreams bankruptcy and public filing requirements resulting from the offers to purchase the Company, the Supplemental Procedures and the Investigation and the late filing of our quarterly and annual reports. The costs of the Special Committee in 2004 were $580 and include costs of an investment banking firm, independent legal counsel and fees paid to the Special Committee members.
SG&A expenses at our corporate headquarters increased $684, or 118% to $1,263 for the year ended December 31, 2003 compared to $579 in 2002. This increase was primarily due to bad debt and severance expenses of $503 relating to the Possible Dreams bankruptcy and higher legal costs of $114.
Consolidated interest expense increased $2,786, or 178% to $4,351 for the year ended December 31, 2004 from $1,565 for 2003. Consolidated interest expense decreased $2,068, or 57% in the year ended December 31, 2003 from $3,633 for 2002.
Borrowings under the WC Term Debt and WC Revolver (prior to their refinancing on March 31, 2005), the Primrose Revolver and the Credit Agreement are at variable rates (as described in “ - Liquidity and Capital Resources”). Borrowings under the $30,000 Note issued in January 2004 were at a stated fixed rate of 10.0% (effective interest rate of 10.8%, including financing costs).
Interest expense at the Educational Services segment decreased $161, or 54% to $139 for the year ended December 31, 2004 from $300 for 2003 due to the repayment of debt during 2004. Interest expense decreased $1,266, or 81% to $300 for the year ended December 31, 2003 from $1,566 for 2002. In April 2002, the segment’s debt was refinanced. As a result of the refinancing, additional interest expense of $860 was recorded to write off the remaining unamortized original issue discount and deferred financing costs associated with the debt. Also, in connection with the refinancing, the Chairman of Security Capital issued a personal guaranty for a portion of the debt and received a guarantee fee of $170, which was recognized as interest expense in 2002. The guaranty was terminated on December 31, 2002.
Other income, net for the years ended December 31, 2004, 2003 and 2002 was composed of the following:
Income tax expense was $5,245, $4,617 and $4,114 for the years ended December 31, 2004, 2003 and 2002, respectively, representing an overall effective tax rate on continuing operations of 47.1%, 42.1% and 40.4%, respectively. The increase in our effective tax rates in 2004 and 2003 was due to increased state taxes, mainly as a result of the acquisition of Octagon, which is located in California and subject to a high state tax rate, and state losses for which we receive no benefit.
During 2002, we completed the transitional test for impairment of goodwill using the two-step process prescribed by SFAS 142, and impairment was recognized in the former Seasonal Products segment. The impairment charge of $3,402 (net of tax benefit) was reflected as the cumulative effect of a change in accounting principle as of January 1, 2002.
For the year ended December 31, 2004, net cash flows from operations was $17,632. This represents an increase of $5,090, or 41% compared to 2003 net cash flows from operations of $12,542. This increase was primarily due to an increase in unearned revenue of $4,168. Unearned revenue at WC increased $2,897 in 2004 as a result of growth at Octagon and growth in the managed care operations. WC enters into certain service contracts with terms of as much as one year and receives advance payments for services to be provided. Similarly, unearned revenue at Primrose increased $1,271 as the number of prospective franchisees increased in 2004 compared to 2003. Upon the signing of a franchise agreement, prospective franchisees pay a franchise fee and a real estate services fee for services to be provided by Primrose to the prospective franchisee up until the school receives its certificate of occupancy.
Net cash flow from operations of $12,542 for the year ended December 31, 2003 decreased $2,972, or 19% from $15,514 for 2002. The decrease was due to lower operating income of $605, an increase in accounts receivable of $737, primarily due to Octagon, and an increase in other assets and assignment development costs totaling $879.
In connection with the Caronia acquisition, WC entered into a Second Amended and Restated Loan Agreement (the “Credit Agreement”). The Credit Agreement provides WC with a $40,500 five-year, fully-amortizing term loan (the “Term Loan”) and an $8,000 revolving credit facility (“Amended WC Revolver”), which replaces the WC Revolver (defined below). The Term Loan bears interest at LIBOR plus 2.5% or Prime, at the Company’s option, and borrowings
The Term Loan and Amended WC Revolver contain restrictive covenants that prohibit or limit certain actions, including specified levels of capital expenditures, investments and incurrence of additional debt, and require the maintenance of a minimum fixed charge ratio. Borrowings are secured by a pledge of substantially all assets at the subsidiary level, as well as a pledge of the Company’s ownership in the subsidiary. The Credit Agreement contains provisions that required WC to deliver audited financial statements for 2004 to the lender by the end of April and require WC to deliver monthly financial statements beginning April 2005. WC has obtained a waiver from the lender until June 30, 2005 to deliver audited financial statements for 2004 and until August 31, 2005 to begin delivering monthly financial statements. WC anticipates that it will provide the lender with its audited financial statements prior to June 30, 2005.
(1) The third and fourth quarter of 2004 includes expenses of the Special Committee of $312 and $215, respectively. The fourth quarter also includes expenses of $900 related to the Supplemental Procedures and the Investigation.
(2) Includes interest expense on the Note of $866, $987 and $570 for the first, second and third quarters of 2004, respectively.
(3) The third quarter of 2004 includes a charge of $4,020 relating to the estimated loss on the sale of Pumpkin and the fourth quarter of 2004 includes a gain of $1,516 on the Possible Dreams settlement.
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and
We have audited the accompanying consolidated balance sheets of Security Capital Corporation and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
As discussed in Note 2 to the consolidated financial statements, the Company has restated its financial statements for each of the three years in the period ended December 31, 2004 to correct its accounting for leases and leasehold improvements.
(Amounts in thousands, except share and per share amounts, unless otherwise noted)
P.D. Holdings, Inc. (“Possible Dreams”) was a 75%-owned subsidiary that formerly operated as a designer, importer and distributor of giftware and collectible figurines. In October 2003, Possible Dreams filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code, at which time we no longer had control over this subsidiary and, therefore, excluded the accounts of Possible Dreams from our consolidated financial statements. For the periods prior to the bankruptcy filing, Possible Dreams was reported as a discontinued operation. As discussed in Note 7, we settled all outstanding claims against the Company with the bankruptcy Trustee in November 2004.
We had two reportable operating segments at December 31, 2004. The Employer Cost Containment and Health Services segment consists of WC, and the Educational Services segment consists of Primrose. See Note 19 for further details regarding our reportable operating segments.
2. Restatement of Financial Statements for Accounting for Leases and Leasehold Improvements
In February 2005, the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain lease accounting issues and their application under Statement of Financial Accounting Standards No. 13, Accounting for Leases and other authoritative pronouncements (“SFAS 13”). In light of this letter, management initiated a review of our accounting for leases and leasehold improvements and determined that our then-current accounting practices for leases and leasehold improvements were incorrect in our Employer Cost Containment and Health Services segment and at our corporate headquarters. Accordingly, management conducted an in-depth review of the Company’s lease accounting to determine the magnitude of the potential error on the financial statements. Based on the results of our review, we determined that our previously issued financial statements at December 31, 2003 and for the years ended December 31, 2003 and 2002 should no longer be relied upon and should therefore be restated.
3. Internal Independent Investigation Into Potential Related-Party Transactions and Conflicts of Interest
In July 2004, the Company discovered that CompManagement, Inc. (“CMI”) and CompManagement Health Systems, Inc. (“CHS”, and collectively with CMI, the “CMI Companies”), wholly owned subsidiaries of WC, may have engaged in potential related-party transactions with an entity that was controlled by certain officers of the CMI Companies (“CMI Management”). Management of the Company (“SCC Management”) immediately notified the Company’s Audit Committee of these potential related-party transactions and resulting conflicts of interest and launched a review of the matter by making additional inquiries and performing supplemental procedures (the “Supplemental Procedures”). The Supplemental Procedures, which were conducted through October 2004, revealed that certain members of CMI Management owned, operated and controlled two entities that had certain unauthorized and undisclosed transactional, operational and financial relationships with the CMI Companies. The Supplemental Procedures also revealed that the unauthorized and undisclosed transactional, operational and financial relationships with the CMI Companies resulted in conflicts of interest, but no fraud or financial impropriety that would indicate the Company’s historical financial statements were misstated. CMI Management had either previously divested its controlling interest or, as a result of the Supplemental Procedures, divested its controlling interest in each of these entities.
The Investigation uncovered a third entity controlled by CMI Management that engaged in related-party transactions with the CMI Companies. CMI Management had previously divested its controlling interest in this entity. The Investigation also confirmed the findings of the Supplemental Procedures that there were no instances of fraud or financial impropriety that would indicate the Company’s historical financial statements were misstated. The Investigation did reveal, however, that, in some instances, these related-party entities used the personnel, office space and equipment of the CMI Companies.
The Investigation was completed in March 2005. The total cost of the Supplemental Procedures and Investigation was $3,000. Approximately $900 of these costs was recorded in the fourth quarter of 2004. The remaining costs were recorded in the first quarter of 2005. Apart from these costs, we do not believe that the issues uncovered are material to our financial condition, results of operations or cash flows.
assumptions inherent in our goodwill impairment testing procedures and the allocation of the purchase price of an acquisition to the fair value of tangible and intangible assets acquired and liabilities assumed.
Revenues for the Employer Cost Containment and Health Services segment are derived from third-party administrative services, self-insured plan administrator services, consulting services, group rating services and managed care administration services. Revenues from third-party administrative services, self-insured plan administrator services, consulting services and group rating services are recorded based on the terms and duration of the related contracts. Cash received in advance of services being provided is initially deferred and recognized as revenue on a pro rata basis over the related contract periods, which typically ranges between three and twelve months. Revenues from managed care administration services are recognized on a monthly basis based on the contracted administrative fee with the Ohio Bureau of Workers’ Compensation (“OBWC”). In addition, certain contracts provide for an incentive or bonus award based on certain criteria stipulated in the contracts. Revenues from incentive or bonus awards are recognized when they are earned and collectibility is reasonably assured.
Restricted cash includes amounts collected from franchisees for advertising and development costs. The agreements with franchisees allow Primrose to collect up to 2% of the franchisees’ monthly gross revenue for advertising and development costs. The amounts received are held in a restricted account and Primrose is obligated to spend the funds in accordance with terms of the franchisee agreements. A corresponding liability has been recorded in accrued expenses and other liabilities.
We determine fair value of the reporting unit using a discounted cash flow approach, which requires management to make assumptions and estimates of future cash flows of the reporting unit, the appropriate discount rate and a terminal value of the reporting unit. The discount rate used for each reporting unit is determined by assessing the appropriate risk level of the cash flows of the respective reporting units and adjusting the risk-free rate by a factor dependent upon this risk assessment. The terminal period cash flow of the respective reporting units is based upon assigning a multiple of earnings before income taxes, depreciation and amortization (“EBITDA”) consistent with companies of similar size and industry in which each of the units operates. With the exception of the impairment charge recorded in connection with the transitional test for goodwill impairment in 2002, no impairment charges have been recognized during the years ended December 31, 2004, 2003 and 2002.
We review long-lived assets, including identified intangible assets, for impairment in accordance with the provisions of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). SFAS 144 requires companies to test long-lived assets when events or circumstances lead management to believe that the carrying value of an asset may not be recoverable. Recoverability is assessed based on the carrying value of an asset and its fair value, which is generally determined by the sum of the estimated undiscounted cash flows expected to result from the use and eventual disposal of the asset in question. If the fair value is less than the asset’s carrying value, an impairment loss is recognized based on the excess of the carrying amount of the asset over its fair value. We have not recognized any impairment losses on long-lived assets, including identified intangible assets, during each of the three years ended December 31, 2004, 2003 and 2002.
Financial instruments include cash and cash equivalents, restricted cash, accounts receivable, assignment development costs, accounts payable, accrued expenses, unearned revenue and long-term debt. The carrying values of cash and cash equivalents, restricted cash, accounts receivable, assignment development costs, accounts payable, accrued expenses and unearned revenue approximates fair value due to the short-term nature of these items. Long-term debt bears interest at current market rates and, accordingly, its carrying values approximate fair value.
Advertising costs are expensed when incurred and were $172, $211 and $290 for the years ended December 31, 2004, 2003 and 2002, respectively.
The following table is presented in accordance with SFAS 148 and illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123.
The Black-Scholes option pricing model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option pricing models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion the existing models do not necessarily provide a reliable single measure of the fair value of the Company’s employee stock options.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”). Under SFAS 123R, share-based payment awards result in a cost that should be measured at fair value on the awards’ grant dates, based on the estimated number of awards expected to vest. SFAS 123R requires this cost to be recognized through earnings over that expected vesting period. The provisions of SFAS 123R will become effective for the Company beginning January 1, 2006. SFAS 123R allows public companies to select from two alternative transition methods when adopting SFAS 123R, the modified prospective application or the modified retrospective application. Under the modified prospective application, the provisions of SFAS 123R are applied to new awards and awards modified, repurchased, or cancelled after the effective date. Under the modified retrospective application, the provisions of SFAS 123R may be applied to (i) all awards granted, modified or settled in cash in fiscal years in which SFAS 123 was effective (years beginning after December 15, 1994) or (ii) only interim periods in the year of adoption unless the effective date of SFAS 123R coincides with a
company’s fiscal year. At this time, we have not determined the impact of SFAS 123R on our financial statements, nor have we decided which transition method to use.
Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, whereby deferred taxes are recognized based on the temporary differences between the financial reporting basis and the tax basis of the assets and liabilities, using presently enacted rates. A valuation allowance is recorded when it is more likely than not that the asset will not be realized.
During the first quarter of 2004, WC acquired 100% of the stock of KRAMMCO, Inc., an Ohio corporation, for $984 (including acquisition costs of $9). KRAMMCO, Inc. is a management company whose sole asset is a management contract with the North American Employer’s Council, Inc. (“NAEC”), an Ohio not-for-profit corporation. NAEC is an Ohio association that provides association members with, among other value-added services, an Ohio group rating sponsor. The entire purchase price was allocated to customer lists and is being amortized over seven years. Additionally, a deferred tax liability for the difference between the book basis and tax basis of the customer list of $406 was recognized with the offset recorded to goodwill.
During the second quarter of 2004, WC acquired 100% of the stock of Integrated Claims Strategies (“ICS”) for $800 plus acquisition costs of $17 and assumed $180 of net liabilities. ICS provides insurance claims processing and administration services in the Tampa, Florida area. The preliminary allocation of the purchase price is as follows:
The acquisition was accounted for as a purchase, and the purchase price of $30,000, plus $914 of acquisition costs, was allocated to the fair values of assets acquired and liabilities assumed at the date of acquisition. During 2004, we obtained additional information with respect to the fair value of certain assets acquired and liabilities assumed that resulted in changes to the preliminary purchase price allocation. None of the changes to the purchase price allocation was recorded through earnings. The final purchase price allocation is as follows:
The Company’s identified intangible assets include franchise agreements, customer lists, proprietary curriculum and trademarks. Franchise agreements represent the value allocated to the franchise agreements in effect at the time we acquired Primrose. This amount is being amortized on a straight-line basis over 21 years. Customer lists are being amortized on a straight-line basis over five to seven years. Proprietary curriculum is being amortized on a straight-line basis over 10 years,
Discontinued operations are composed of the results of operations of Pumpkin and Possible Dreams as follows:
On October 25, 2004, Pumpkin Ltd., our wholly owned subsidiary and the parent company of Pumpkin, consummated the sale of substantially all of the assets of Pumpkin to Rauch Industries, Inc. (“Rauch”) for $7,000, subject to a working capital adjustment. The working capital adjustment has been finalized resulting in the Company receiving an additional payment from Rauch of $1,741. The net loss from Pumpkin is composed of net income from operations of $1,182 and a net loss on the sale of $3,928.
At December 31, 2004 and 2003, debt consisted of the following:
WC Holdings Senior Term Loan (“WC Term Debt”) bears interest at Prime minus 0.5% or one-month LIBOR plus 1.75%, at our option. Principal and interest payments were payable monthly through 2008; however, in March 2005, the WC Term Debt was refinanced (see below for further details).
Scheduled maturities at December 31, 2004 of long-term debt for the next five years were as follows:
We have an interest rate swap agreement with a notional value of $8,500, which effectively converts $8,500 of variable rate debt to fixed rate debt. Under the terms of the swap, we pay a fixed rate of 5.85% and receive a variable rate based on one-month LIBOR. The swap has not been designated as a hedge for financial accounting purposes, therefore changes in its fair value are recorded through earnings. Changes in the fair value of the interest rate swap resulted in a gain of $401 and $245 for the years ended December 31, 2004 and 2003, respectively, and a loss of $378 for the year ended December 31, 2002. This interest rate swap agreement is with a major financial institution, which we expect to fully perform under the terms thereof. The interest rate swap expires in December 2005.
During the first quarter of 2004, we entered into an interest rate swap with a notional value of $10,000, which effectively converts $10,000 of variable rate debt to fixed rate debt. Under the terms of this swap agreement, we pay a fixed rate of 3.44% and receive a variable rate based on one-month LIBOR. This swap has been designated as a cash flow hedge for financial accounting purposes and, to the extent the swap provides an effective hedge, changes in the fair value of the swap are recorded in other comprehensive income, a component of stockholders’ equity. Ineffectiveness is recorded through earnings. There was no ineffectiveness recorded through earnings for the twelve months ended December 31, 2004. This interest rate swap agreement is with a major financial institution, which we expect to fully perform under the terms thereof. The interest rate swap expires in 2009.
A summary of stock option activity for the years ended December 31, 2004, 2003 and 2002 is as follows:
The weighted average fair value of stock options granted in 2004, 2003 and 2002 was $4.11, $3.20 and $4.32, respectively.
On February 23, 2005, 320,000 Class A Common Stock shares were issued as a result of an employee exercise of stock options. As a result of this exercise, the number of shares outstanding increased to 6,770,967.
The Company has a Management Advisory Service Agreement (the “MAS Agreement”) with Capital Partners, Inc. (“Capital Partners”), the controlling stockholder of the Company, whereby Capital Partners provides certain management advisory services related to investments, general administration (including payroll and rent), corporate development, strategic planning, stockholder relations, financial matters and general business policy. The MAS Agreement is approved by our Board of Directors and is effective for the calendar year. The MAS Agreement can be terminated by either Capital Partners or the Company upon at least 60 days’ prior written notice to the other. Fees paid to Capital Partners for management advisory services were $1,550, $1,400, and $1,273 in the years ended December 31, 2004, 2003 and 2002, respectively.
In addition, the Company has agreed to pay fees to Capital Partners for acquisition opportunities presented to the Company at usual and customary rates for investment banking fees for transactions of similar size and complexity. Capital Partners is under no obligation to present to the Company any or all acquisition candidates of which it becomes aware. Furthermore, the Company is under no obligation to utilize Capital Partners for investment banking services. The payment of an investment banking fee to Capital Partners is subject to full Board approval. In 2003, the Company paid a one-time investment banking fee of $150 to Capital Partners as compensation for the
Amounts due to Capital Partners were $16 and $293 at December 31, 2004 and 2003, respectively. Fees paid to Capital Partners are generally subordinate to the rights of the lenders to the Company.
In connection with a refinancing of debt at Primrose in April 2002, the Chairman of the Company issued a personal guarantee for $4,000, for which he received a guarantee fee of 8% per annum of the declining average quarterly balance of his guarantee. On December 31, 2002, this guarantee was terminated. Fees incurred by Primrose for this guarantee were $170 for the year ended December 31, 2002 and are included in interest expense in the Consolidated Statement of Income.
We lease office space and certain equipment under noncancelable operating lease agreements that expire at various dates through 2017. Certain leases include renewal provisions and require us to pay for certain operating and maintenance costs. Future minimum operating lease payments and minimum sublease rental income at December 31, 2004 for each of the following years are as follows:
Net rent expense for the years ended December 31, 2004, 2003 and 2002 was as follows:
CMI was party to a lawsuit brought by the Cleveland Bar Association that alleged that certain practices by CMI and its hearing representatives in Ohio constituted the unauthorized practice of law. CMI believes that its practices do not differ from any other Ohio workers’ compensation third-party administrator and do not constitute the practice of law. On May 15, 2004, the Board of Commissioners on the Unauthorized Practice of Law (the “UPL Board”) found that the activities of CMI and its hearing representatives did constitute the unauthorized practice of law; CMI appealed these findings to the Ohio State Supreme Court (the “Supreme Court”). On December 15, 2004, the Supreme Court ruled that the activities engaged in by CMI did not constitute the unauthorized practice of law. However, in its decision, the Supreme Court remanded the matter back to the UPL Board to consider whether those activities which were the subject of the original suit were in violation of a recently enacted Industrial Commission resolution. Oral arguments on this issue are scheduled for July 6, 2005. At this time, we are unable to evaluate the outcome of this matter.
order of consolidation, consolidating the three complaints into one class action. Plaintiffs have submitted their first request for the production of documents. Since the announcement of the Initial Capital Partners Offer, Mr. Fitzgerald and Capital Partners have increased their offer to $10.60 per share, and offers to acquire the entire Company for $11.00 and $13.00 per share have been submitted by others. In addition, on June 7, 2005, the Company announced that is has retained UBS Securities LLC to conduct a formal sale process for the Company, and that Mr. Fitzgerald and Capital Partners have declared their full support for that sale process and committed to sell the shares they control if appropriate value is achieved in the transaction (see Note 21). At this time, we are unable to evaluate the possible outcome of the class action.
Our employer cost containment and health services segment has two customers that individually account for more than 10% of consolidated revenue. One customer accounted for approximately 22%, 29%, and 39% of total consolidated revenue for 2004, 2003 and 2002, respectively. The other customer accounted for approximately 12% of consolidated revenues for 2004 (this contract was acquired in late 2003 and was not significant to 2003 consolidated revenues). This contract expires on June 30, 2005. We are currently negotiating the renewal of such contract, and while we expect to renew this contract, no assurances can be given. The loss of either of these contracts could have a material adverse effect on the financial condition, results of operations, and cash flows of our employer cost containment and health services segment and the Company.
On March 31, 2005, our indirect, majority owned subsidiary, Octagon, acquired 100% of the outstanding capital stock of Managed Care Holdings Corporation, and its wholly owned subsidiary, Caronia Corporation (collectively, “Caronia”), for $16,000 in cash. The purchase price is subject to adjustment based upon the working capital of Caronia as of the closing date. Such acquisition was consummated pursuant to the terms of a stock purchase agreement, dated March 17, 2005, between Octagon and Continental Casualty Company.
On March 31, 2005, in connection with the acquisition of Caronia, WC entered into a Second Amended and Restated Loan Agreement (the “Credit Agreement”). The Credit Agreement provided WC with a $40,500 five-year, fully-amortizing term loan (the “Term Loan”) and an $8,000 revolving credit facility (“Amended WC Revolver”). The Term Loan bears interest at LIBOR plus 2.5% or Prime, at the Company’s option. Borrowings under the Amended WC Revolver bear interest at LIBOR plus 2% or Prime minus 0.5%, at the Company’s option, and there is an annual commitment fee equal to 0.5% of the unused commitment. The Amended WC Revolver replaced the WC Revolver. Principal payments of $675 are due monthly beginning May 1, 2005 under the Term Loan. The proceeds of the Term Loan were used to fund the Caronia acquisition and repay amounts outstanding under the WC Term Debt.
In the parent company’s financial statements, the Company’s investment in subsidiaries is stated at cost plus equity in undistributed earnings of the subsidiaries. Certain prior year amounts have been reclassified to conform to current year presentation. See the Notes to the Consolidated Financial Statements for additional information.
The restatement resulted in a decrease in condensed net income of $94 for the year ended December 31, 2003. There was no impact on condensed net income for the year ended December 31, 2002.
The Company had issued 500,000 shares of Preferred Stock that had a stated redemption value of $10 per share. Such Preferred Stock was convertible into Class A Common Stock on a 1:1 basis. The Preferred Stock was redeemable at the option of the shareholder upon the attainment of certain financial targets, but no later than April 6, 2006. Differences between the carrying value of the Preferred Stock and the redemption value were accreted using the interest method over the remaining estimated period to redemption by charges to additional paid-in capital. On November 10, 2004, the Company redeemed all shares of Preferred Stock at a redemption price of $10 per share, or $5,000. The condensed statements of operations reflect accelerated preferred stock accretion of $1,275 to accrete the carrying value of the Preferred Stock to its redemption value.