NFP’s corporate headquarters is located at 340 Madison Avenue, New York, NY, where NFP and certain of its firms currently occupy three floors representing 99,485 square feet of space. NFP’s subsidiaries NFPSI and NFPISI lease approximately 113,480 square feet of space in Austin, Texas. Additionally, the Company’s firms lease properties for use as offices throughout the United States.
In August 2007, NFP entered into a sublease agreement for its prior office space at 787 Seventh Avenue, New York, NY for the remaining term of that lease. In September 2007, NFP entered into a lease agreement for its current corporate headquarters. During November 2009, NFP entered into a sublease with RBC Madison Avenue LLC (“RBC”) for RBC’s sublease of one floor of NFP’s corporate headquarters. For a discussion of the financial impact of such sublease, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Year ended December 31, 2009 compared with the year ended December 31, 2008-Corporate and other expenses.”
You should read the selected consolidated financial data set forth below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the consolidated financial statements and the related notes included elsewhere in this report. The Company derived the following selected financial information (excluding Other Data) as of December 31, 2009 and 2008 and for each of the three years in the period ended December 31, 2009 from the Company’s audited consolidated financial statements and the related notes included elsewhere in this report. The Company derived the selected financial information (excluding Other Data) as of December 31, 2007, 2006 and 2005 from the Company’s audited consolidated financial statements and the related notes not included in this report.
(1) Excludes Amortization and Depreciation which are shown separately under corporate and other expenses.
(2) Excludes Management agreement buyout which is shown separately under corporate and other expenses.
a) Effective January 1, 2006, the Company adopted new guidance that related to accounting for share-based payments. The Company adopted the modified prospective transition method provided for under the new guidance and, accordingly, has not restated prior year amounts. Under the transition method, compensation expense for 2006 includes compensation expense for all share-based payment awards granted prior to, but not yet vested as of, January 1, 2003, based on the grant date fair value estimated in accordance with the new guidance. Stock-based compensation expense includes an estimate for forfeitures and is recognized over the expected term of the award on a straight-line basis. The Company evaluated the need to record a cumulative effect adjustment related to estimated forfeitures for unvested previously issued awards and the impact was not deemed to be material. NFP measured the fair value for stock options using the Black-Scholes valuation model.
As a result of adopting the new accounting guidance, NFP recorded, for firm employees, principals and firm activities, a charge to cost of services of $5.7 million for 2009, $5.8 million for 2008 and $5.2 million for 2007. NFP recorded $4.8 million for 2009, $6.8 million of such expense for 2008 and $7.7 million for 2007, in corporate and other expenses-general and administrative. Previously all stock-based compensation was included in general and administrative expense as a component of corporate and other expenses. Total stock-based compensation for 2009 was $10.5 million. Total stock-based compensation of $12.6 million in 2008, $12.9 million in 2007, $9.2 million in 2006 and $4.5 million in 2005 is included in corporate and other expenses-general and administrative to conform to the current period presentation.
c) As a measure of financial performance, NFP calculates the internal growth rate of the revenue of the Company’s firms. This calculation compares the change in revenue of a comparable group of firms for the same time period in successive years. NFP includes firms in this calculation at the beginning of the first fiscal quarter that begins one year after acquisition by NFP unless a firm has internally consolidated with another owned firm or has made a sub-acquisition that represents more than 25% of the base earnings of the acquiring firm, or a significant portion of the firm’s assets have been sold. With respect to two owned firms that internally consolidate, the combined firm is excluded from the calculation from the time of the internal consolidation until the first fiscal quarter that begins one year after acquisition by the Company of the most recently acquired firm participating in the internal consolidation. However, if both firms involved in an internal consolidation are included in the internal growth rate calculation at the time of the internal consolidation, the combined firm continues to be included in the calculation after the internal consolidation.
With respect to the sub-acquisitions described above, to the extent the sub-acquired firm does not separately report financial statements to NFP, the acquiring firm is excluded from the calculation from the time of the sub-acquisition until the first fiscal quarter beginning one year following the sub-acquisition. Sub-acquisitions that represent less than 25% of the base earnings of the acquiring firms are considered to be internal growth. For further information about sub-acquisitions, see “Business-Acquisitions-Sub-Acquisitions.” With respect to situations where a significant portion of a firm’s assets have been sold, the surviving entity is excluded from the internal growth rate calculation from the time of the sale until one year following the sale. With respect to dispositions, NFP includes these firms up to the time of disposition and excludes these firms for all periods after the disposition. The calculation is adjusted for intercompany transactions for all periods after December 31, 2005. Management believes that the intercompany adjustments made to the internal revenue growth rate for periods after December 31, 2005 does not significantly impact its comparability with prior year periods.
The Company’s firms earn revenue that consists primarily of commissions and fees earned from the sale of financial products and services to their clients. The Company’s firms also incur commissions and fees expense and operating expense in the course of earning revenue. NFP pays management fees to non-employee principals of its firms and/or certain entities they own based on the financial performance of each respective firm. The Company refers to revenue earned by the Company’s firms less the expenses of its firms, including management fees, as gross margin. The Company excludes amortization and depreciation from gross margin. These amounts are separately disclosed as part of Corporate and other expenses. Management uses gross margin as a measure of the performance of the firms that the Company has acquired. Gross margin declined from $175.2 million in 2005 to $169.6 million in 2009. During 2009, the Company experienced continued declines in revenue from its retail life and life settlements products and also experienced less severe declines in its benefits and financial advisory revenue which contributed to the decline in revenue and gross margin during the year. The decline in revenue offset positive trends in the other variable components of the company’s cost structure as the Company recorded lowered commission and fees expense and operating expenses in 2009 than in the prior year. These factors contributed to the decline in the Company’s gross margin in 2009 as compared to growth it had experienced in years prior to 2008.
The Company’s gross margin is offset by expenses that it incurred at the corporate level, including corporate and other expenses. Corporate and other expenses have increased from $79.0 million in 2005 to $731.4 million in 2009 primarily due to an impairment charge of $618.5 million during 2009. Corporate and other expenses include general and administrative expenses, which are the operating expenses of NFP’s corporate headquarters. General and administrative expenses have grown from $45.8 million in 2005 to $59.2 million in 2009. General and administrative expenses as a percent of revenue increased from 5.1% in 2005 to 6.2% in 2009.
While acquisitions remain a component of the Company’s business strategy over the long term, NFP suspended acquisition activity (with the exception of certain sub-acquisitions or other limited strategic transactions) in the latter part of 2008 in order to conserve cash. NFP continues to assess the market and economic environment. Under NFP’s typical acquisition structure, NFP acquires 100% of the equity of businesses that distribute financial services products on terms that are relatively standard across its acquisitions. To determine the acquisition price, NFP’s management first estimates the annual operating cash flow of the business to be acquired based on current levels of revenue and expense. For this purpose, management defines operating cash flow as cash revenue of the business less cash and non-cash expenses, other than amortization, depreciation and compensation to the business’ owners or individuals who subsequently become principals. Management refers to this estimated annual operating cash flow as “target earnings.” Typically, the acquisition price is a multiple (generally in a range of five to six times) of a portion of the target earnings, which management refers to as “base earnings.” Under certain circumstances, NFP has paid multiples in excess of six times based on the unique attributes of the transaction that in the Company’s view justify the higher value. Base earnings averaged 54% of target earnings for all firms owned at December 31, 2009. This percentage can vary based on the percentage of base earnings acquired, disposed, and/or restructured. In determining base earnings, management focuses on the recurring revenue of the business. Recurring revenue refers to revenue from sales previously made (such as renewal commissions on insurance products, commissions and administrative fees for ongoing benefits plans and mutual fund trail commissions) and fees for assets under management.
Additional purchase consideration may be paid to the former owners upon satisfying specified internal growth thresholds over the three-year period following the acquisition.
Although management believes that NFP will continue to have opportunities to complete acquisitions once market conditions stabilize, there can be no assurance that NFP will be successful in identifying and completing acquisitions: See “Risk Factors-The Company may not resume acquisitions or may be unsuccessful in acquiring suitable acquisition candidates, which could adversely affect the Company’s growth.” Any change in the Company’s financial condition or in the environment of the markets in which the Company operates could impact its ability to source and complete acquisitions.
Corporate and executive benefits commissions and fees. The Company’s firms earn commissions on the sale of insurance policies written for benefits programs. The commissions are paid each year as long as the client continues to use the product and maintains its broker of record relationship with the firm. The Company’s firms also earn fees for the development, implementation and administration of corporate and executive benefits programs. Asset-based fees are also earned for administrative services or consulting related to certain benefits plans. Some of the Company’s firms offer property and casualty insurance brokerage and advisory services. The Company believes that these services complement the corporate and executive benefits services provided to the Company’s clients. In connection with these services, the Company earns commissions and fees.
Some of the Company’s firms also earn additional compensation in the form of incentive and marketing support revenue from manufacturers of financial services products, based on the volume, persistency and profitability of business generated by the Company from these three sources. Incentive and marketing support revenue is recognized at the earlier of notification of a payment or when payment is received, unless historical data or other information exists which enables management to reasonably estimate the amount earned during the period. These forms of payment are earned both with respect to sales by the Company’s owned firms and sales by NFP’s affiliated third-party distributors.
NFPSI, NFP’s registered broker-dealer and investment adviser, also earns commissions and fees on the transactions it conducts. Most principals of the Company’s firms, as well as many of the Company’s affiliated third-party distributors, conduct securities or investment advisory business through NFPSI.
earned 29% of its revenue in the fourth quarter. A continued difficult economic environment may result in a change in this historical pattern for the year ended December 31, 2010, as was the case for the years ended December 31, 2009 and December 31, 2008.
Commissions and fees. Commissions and fees are typically paid to third-party producers, who are producers that are affiliated with the Company’s firms. Commission and fees are also paid to non-affiliated producers who utilize the services of one or more of the Company’s life brokerage entities, including the Company’s life settlements brokerage entities. Additionally, commissions and fees are paid to non-affiliated producers who provide referrals and specific product expertise to NFP’s firms. When business is generated solely by a principal, no commission expense is incurred because principals are only paid from a share of the cash flow of the acquired firm through management fees. However, when income is generated by a third-party producer, the producer is generally paid a portion of the commission income, which is reflected as commission expense of the acquired firm. Rather than collecting the full commission and remitting a portion to a third-party producer, a firm may include the third-party producer on the policy application submitted to a carrier. The carrier will, in these instances, directly pay each named producer their respective share of the commissions and fees earned. When this occurs the firm will record only the commissions and fees it receives directly as revenue and has no commission expense. As a result, the NFP firm will have lower revenue and commission expense and a higher gross margin percentage. Gross margin dollars will be the same. The transactions in which an NFP firm is listed as the sole producer and pays commissions to a third-party producer, versus transactions in which the carrier pays each producer directly, will cause NFP’s gross margin percentage to fluctuate without affecting gross margin dollars or earnings. In addition, NFPSI pays commissions to the Company’s affiliated third-party distributors who transact business through NFPSI.
Operating expenses. The Company’s firms incur operating expenses related to maintaining individual offices, including compensating producing and non-producing staff. Firm operating expenses also include the expenses of NFPSI and of NFPISI, two subsidiaries that serve the Company’s acquired firms and through which the Company’s acquired firms and its third-party distributors who are members of its marketing organizations access insurance and financial services products and manufacturers. The Company records share-based payments related to firm employees and firm activities to operating expenses as a component of cost of services.
For firms electing to continue to participate in the ongoing incentive plan, in addition to the incentive award, NFP pays an additional cash incentive equal to 50% of the incentive award elected to be received in NFP common stock. This election is made subsequent to the completion of the incentive period. For firms that began their incentive period prior to January 1, 2005, the principal could elect from 0% to 100% to be paid in NFP’s common stock. No accrual is made for these additional cash incentives until the incentive award is earned and the related election is made. However, for firms beginning their incentive period on or after January 1, 2005 (with the exception of Highland Capital Holding Corporation firms which completed this incentive period in 2008), the principal is required to take a minimum of 30% (maximum of 50%) of the incentive award in NFP common stock. The Company accrues on a current basis for these firms the additional cash incentive (50% of the stock portion of the award based upon the principal’s election) on the minimum percentage required to be received in company stock. Since December 2008, NFP has elected to pay all incentive awards under the ongoing incentive plan in cash.
The Company uses gross margin before management fees and gross margin before management fees as a percentage of total revenue to evaluate how the Company’s business is performing before giving consideration to a principal’s participation in their firm’s earnings. This measure is one for which the principal is compensated and reflects the principal’s performance and is a result of their direct operating authority and control. Management fees as a percentage of gross margin before management fees is a measure that management uses to evaluate how much of the Company’s margin and margin growth is being shared with principals. This management fee percentage is a variable, not a fixed, ratio. Management fees as a percentage of gross margin before management fees will fluctuate based upon the aggregate mix of earnings performance by individual firms. It is based on the percentage of the Company’s earnings that are capitalized at the time of acquisition, the performance relative to NFP’s cumulative preferred position in the earnings and the growth of the individual firms (for further discussion on the Acquisition Model and management fee structure, see “Business-Acquisitions-Acquisition Model”). Management fees may be higher during periods of strong growth due to the increase in incentive accruals. Higher firm earnings will generally be accompanied by higher incentive accruals. Where firm earnings decrease, management fees and management fee percentage may be lower as firms’ earnings fall below target and incentive accruals are either reduced or eliminated. In addition, because management fees earned are based on a firm’s cumulative performance through the year, to the extent that a firm’s performance improves through the year, whether by revenue growth or expense reductions, the management fee percentage may likewise increase through the year. For example, if a firm has base earnings and target earnings of $1.0 million and $2.0 million, respectively, and if the firm’s cumulative earnings are $0.7 million for the first nine months of the year, no management fee would be earned and the management fee percentage would be zero. In the remaining fourth quarter, if the firm was able to achieve cumulative earnings of $2.0 million, the management fee earned would be $1.0 million and the management fee percentage would be equal to approximately 80% for the quarter. Further, since NFP retains a cumulative preferred interest in base earnings, the relative percentage of management fees generally decreases as firm earnings decline. For firms that do not achieve base earnings, principals typically earn no management fee. Thus, a principal generally earns more management fees only when firm earnings grow and, conversely, principals earn less when firm earnings decline. This structure provides the Company with protection against earnings shortfalls through reduced management fee expense; in this manner the interests of the principals and shareholders remain aligned.
New Incentive Plans. For a discussion of new incentive plans, please see “Note 4-Commitments and Contingencies-New Incentive Plans.”
General and administrative. At the corporate level, the Company incurs general and administrative expense related to the acquisition of and administration of its firms. General and administrative expense includes both cash and stock-based compensation, occupancy, professional fees, travel and entertainment, technology, telecommunication, advertising and marketing, legal, internal audit and certain corporate compliance costs.
Depreciation. The Company incurs depreciation expense related to capital assets, such as investments in technology, office furniture and equipment, as well as amortization for its leasehold improvements. Depreciation expense related to the Company’s firms as well as NFP’s corporate office is recorded within this line item.
Impairment of goodwill and intangible assets. The Company evaluates its amortizing (long-lived assets) and non-amortizing intangible assets for impairment in accordance with GAAP.
In accordance with GAAP, long-lived assets, such as purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company generally performs its recoverability test on a quarterly basis for each of its acquired firms that has experienced a significant deterioration in its business indicated principally by either an inability to produce base earnings for a period of time or in the event of a restructure in base.
A two-step impairment test is performed on goodwill for reporting units that demonstrate indicators of impairment. In the first step, NFP compares the fair value of each reporting unit to the carrying value of the net assets assigned to that reporting unit. NFP determines the fair value of its reporting units by blending two valuation approaches: the income approach and a market value approach. In order to determine the relative fair value of each of the reporting units the income approach was conducted first. These relative values were then scaled to the estimated market value of NFP.
valuation of an intangible asset in a very short period of time. The timing and amount of realized losses reported in earnings could vary if management’s conclusions were different. Any resulting impairment loss could have a material adverse effect on the Company’s reported financial position and results of operations for any particular quarterly or annual period.
In 2009, the Company experienced continued declines in its retail life, life brokerage and life settlements products and also experienced less severe declines in its benefits and financial advisory revenue which contributed to the decline in revenue and margins during the year. The decline in revenue was partially offset by positive trends in the other variable components of the company’s cost structure as the Company recorded lowered commission and fees expense and operating expenses in 2009 than in 2008. In 2008, revenue declined 3.7% while revenue grew 11% in 2007. This growth was driven, in 2007, primarily by the Company’s acquisitions and in previous years through a combination of acquisitions and internal growth in the revenue of its acquired firms, augmented by the growth of NFPISI and NFPSI. In 2009 and 2008, the Company’s firms had an internal revenue growth rate decline of 16% and 9%, respectively. In 2007, the Company’s firms had an internal revenue growth rate of less than 1%.
As a measure of financial performance, NFP calculates the internal growth rate of the revenue of the Company’s firms. This calculation compares the change in revenue of a comparable group of firms for the same time period in successive years. NFP includes firms in this calculation at the beginning of the first fiscal quarter that begins one year after acquisition by the Company unless a firm has internally consolidated with another owned firm or has made a sub-acquisition that represents more than 25% of the base earnings of the acquiring firm, or a significant portion of the firm’s assets have been sold. With respect to two owned firms that internally
consolidate, the combined firm is excluded from the calculation from the time of the internal consolidation until the first fiscal quarter that begins one year after acquisition by NFP of the most recently acquired firm participating in the internal consolidation. However, if both firms involved in an internal consolidation are included in the internal growth rate calculation at the time of the internal consolidation, the combined firm continues to be included in the calculation after the internal consolidation. With respect to situations where a significant portion of a firm’s assets have been sold, the surviving entity is excluded from the internal growth rate calculation from the time of the sale until one year following the sale. With respect to the sub-acquisitions described above, to the extent the sub-acquired firm does not separately report financial statements to NFP, the acquiring firm is excluded from the calculation from the time of the sub-acquisition until the first fiscal quarter beginning one year following the sub-acquisition. Sub-acquisitions that represent less than 25% of the base earnings of the acquiring firms are considered to be internal growth. For further information about sub-acquisitions, see “Business-Acquisitions-Sub-Acquisitions.” With respect to dispositions, NFP includes these firms up to the time of disposition and excludes these firms for all periods after the disposition. The calculation is adjusted for intercompany transactions for all periods after December 31, 2005. Management believes that the intercompany adjustments made to the internal revenue growth rate for periods after December 31, 2005 does not significantly impact its comparability with prior year periods.
employees due to cost-cutting measures and rising unemployment, and financial planning and investment advisory revenue, as fees for assets under management declined with declining market values during 2009 as compared to the prior year. Although the capital markets have tentatively begun to recover, the recovery may not continue and the markets may continue to experience volatility. During the fourth quarter, the Company did experience an increase in financial planning and investment advisory revenue but experienced an overall decline for the year. The revenue decrease of $202.1 million was comprised of a decrease of $208.3 million from existing firms offset by a $6.2 million increase in revenue from new acquisitions and included a $24.3 million decline in revenue from firms disposed subsequent to the fourth quarter of 2008.
Commissions and fees. Commissions and fees expense decreased $99.0 million, or 27.3%, to $263.9 million in 2009 from $362.9 million in 2008. As a percentage of revenue, commissions and fees expense was 27.8% in the year ended December 31, 2009 as compared to 31.5% in the prior year period. The sharp decline in commissions and fees expense both in dollars and as a percentage of revenue was largely attributable to the decline in revenue, particularly in retail life products, life brokerage and life settlements, which typically have higher commission payouts. Approximately $99.2 million of the decrease in commissions and fees expense was from existing firms which was partially offset by a $0.2 million increase in commission and fees expense from new acquisitions. Included within the overall decline in commissions and fees expense was a decline of $8.9 million in expenses for firms disposed subsequent to the fourth quarter of 2008.
Operating expenses. Operating expenses decreased $40.4 million, or 9.9%, to $368.6 million in 2009 compared with $409.0 million in 2008. As a percentage of revenue, operating expenses increased to 38.9% in 2009 from 35.6% in 2008. The decline in operating expenses at existing firms was largely a result of cost reduction initiatives across the firms. Personnel and related costs continue to comprise more than 60% of firm operating expenses and account for nearly 35% of the operating expense decline during the year largely as a result of headcount reductions and reductions in commission payments among employee producers. The increase in operating expenses as a percentage of revenue was largely a result of the sharp decline in revenue concentrated in retail life, life brokerage and life settlements as well as declines in corporate and executive benefits, financial planning and investment advisory revenue. Approximately $42.5 million of the decrease in operating expenses was from existing firms which was partially offset by a $2.1 million increase in operating expenses from new acquisitions. Included within the overall decline of operating expenses was a decline of $11.4 million for firms disposed subsequent to the fourth quarter of 2008.
Gross margin. Gross margin decreased $38.3 million, or 18.4%, to $169.6 million in 2009 compared with $207.9 million in 2008. As a percentage of revenue, gross margin decreased to 17.9% in 2009 compared with 18.1% in 2008. The decline in gross margin as a percentage of revenue was a result of the revenue decline during the year combined with higher operating expenses and management fees as a percentage of revenue offset by lower commission and fees expense as a percentage of revenue.
Amortization. Amortization decreased $2.6 million, or 6.6%, to $36.6 million in 2009 compared with $39.2 million in 2008. Amortization expense decreased as a result of a 5.1% decrease in amortizing intangible assets resulting primarily from dispositions, impairments, and the suspension of new acquisitions. As a percentage of revenue, amortization was 3.9% in 2009 compared with 3.4% in 2008.
Depreciation. Depreciation expense increased $5.8 million, or 43.3%, to $19.2 million in 2009 compared with $13.4 million in 2008. Due to the sublet of one of the floors of the Company’s headquarters, the Company was required to accelerate depreciation expense on certain items related to the sublet. The increase in depreciation was primarily a result of the acceleration of the depreciation of $5.5 million on certain leasehold improvements, furniture and fixtures and office equipment. As a percentage of revenue, depreciation expense was 2.0% in 2009 and 1.2% in 2008. Depreciation expense attributable to firm operations totaled $7.9 million and $8.0 million in 2009 and 2008, respectively, which has not been included in Cost of services.
The following table provides a comparison of the Company’s revenue and expenses for the periods presented:
Commissions and fees. Commissions and fees decreased $43.9 million, or 3.7%, to $1,150.4 million in 2008 from $1,194.3 million in 2007. Commissions and fees generated from new acquisitions totaled $54.3 million for the year ended December 31, 2008 and was offset by a $98.2 million decline in revenue from existing firms. As the economic environment worsened in the second half of the year, revenue, particularly in life insurance products, declined from prior year levels. Revenue from benefits and executive benefits offset these declines slightly as they remain higher this year compared to the prior year.
management fees and the decrease in the incentive accrual year over year. Management fees included $1.9 million of stock-based compensation expense in the year ended December 31, 2008 compared with $0.9 million in the year ended December 31, 2007.
Amortization. Amortization increased $4.9 million, or 14.3%, to $39.2 million in 2008 compared with $34.3 million in 2007. Amortization expense increased as a result of an 11.5% increase in amortizing intangible assets resulting primarily from new acquisitions. As a percentage of revenue, amortization was 3.4% in 2008 compared with 2.9% in 2007.
Impairment of goodwill and intangible assets. Impairment of goodwill and intangible assets increased $33.4 million to $41.3 million in 2008 compared with $7.9 million in 2007. The impairments were related to 23 firms in 2008 and 4 firms in 2007 and resulted in a reduction of the carrying value of the identifiable assets and goodwill associated with these firms to their fair value. During the fourth quarter of 2008, the Company recognized an impairment charge of $31.0 million to its earnings resulting in a year to date impairment charge of $41.3 million. The increase in the fourth quarter impairment charge was a result of the completion of the Company’s most recent evaluation for impairment. As part of this evaluation, the Company adjusted its projected future cash flow estimates for certain of its firm subsidiaries in the context of their historical performance and the effect of the recent economic conditions on their future long term projections. In addition, to reflect the recent market conditions, the risk adjusted discount rate that was used as part of this analysis was increased. See also “-Critical Accounting Policies-Impairment of goodwill and other intangible assets” found elsewhere in this report. As a result of these changes in conditions and assumptions, the Company recognized an additional charge of $33.4 million in the year as compared to the prior year increasing from $7.9 million to $43.1 million.
Management agreement buyout. Effective June 30, 2007, NFP acquired an additional economic interest in one of its existing firms through the acquisition of a principal’s ownership interest in a management company. The management company was contracted by NFP to manage and operate one of its wholly-owned subsidiaries. The acquisition of the ownership interest has been treated as a settlement of an executory contract in a business combination between parties in a preexisting relationship as defined by GAAP. NFP paid cash, NFP common stock and other consideration totaling $13.0 million which has been reflected in the caption entitled “Management agreement buyout” in the Consolidated Statements of Operations.
Interest and other income. Interest and other income decreased $3.5 million or 36.1%, to $6.2 million in 2008 compared with $9.7 million in 2007. The decrease resulted from the Company’s proportional share in the loss of its startup joint venture of $2.0 million, lower interest earned on lower average available cash balances, offset by an increase in rental income from its former corporate headquarters.
Income tax expense. Income tax expense decreased $9.9 million, or 22.9%, to $33.3 million in 2008 compared with $43.2 million in 2007. The effective tax rate was 76.6% in 2008 which increases to 79.7% with the inclusion of interest and penalties totaling $1.3 million which were treated discretely. This compares with an effective tax rate of 47.0% in 2007. The effective tax rate rose in 2008 largely as the result of a decrease in pre-tax book income and an increase in impairments of intangible assets not deductible for tax purposes.
NFP’s credit facility is structured as a revolving credit facility and matures on August 22, 2011. NFP may elect to pay down its outstanding balance at any time before August 22, 2011 but repayment is not required before that date. NFP’s classification of this obligation as a current liability has been driven by NFP’s practice of drawing against the credit line during the year and subsequently repaying significant amounts of the borrowing. The debt is current in the sense of NFP’s practice of frequent draws and repayments; it is not current in that repayment is not required in the next twelve months.
During the second quarter of 2009, NFP executed the third amendment to its credit facility (the “Third Amendment”). As of December 31, 2009, the Company was in compliance with all of its debt covenants. However, if the Company’s earnings deteriorate, it is possible that NFP would fail to comply with the terms of its credit facility, such as the consolidated leverage ratio covenant, and therefore be in default under the credit facility. See “-Borrowings-Credit Facility” below. Upon the occurrence of such event of default, the majority of lenders under the credit facility could cause amounts currently outstanding to be declared immediately due and payable. Such an acceleration could trigger “cross acceleration provisions” under NFP’s indenture governing the notes; see “-Borrowings-Convertible Senior Notes” below. A summary of the changes in cash and cash equivalents is as follows (in thousands):
NFP has performed additional assessments to determine the impact of recent market developments, including a review of access to liquidity in the capital and credit markets. If the difficult economic conditions continue, leading to longer term disruptions in the capital and credit markets, the Company’s access to liquidity needed for its business could be adversely impacted. The inability to obtain adequate financing from debt or capital sources could force the Company to forgo certain opportunities. Any disruption in NFP’s access to capital could require the Company to take additional measures to conserve cash until alternative credit arrangements or other funding for business needs can be arranged. Measures the Company may take or has already taken include deferring capital expenditures, reducing or eliminating future share repurchases, dividend payments, acquisitions or other discretionary uses of cash. While acquisitions remain a component of the Company’s business strategy over the long term, NFP suspended acquisition activity (with the exception of certain sub-acquisitions or other limited strategic transactions) in the latter part of 2008 in order to conserve cash. NFP continues to assess the market and economic environment. On November 5, 2008, NFP’s Board of Directors directed management to suspend repurchasing additional shares under the current share repurchase authorization and also suspended NFP’s quarterly cash dividend.
During the twelve months ended December 31, 2009, cash provided by operating activities was approximately $123.8 million compared with cash provided during the prior year of $56.5 million. The improvement in operating cash for the year ended December 31, 2009 as compared with the prior year corresponding period was largely due to lower earned management fees paid to principals in early 2009 for their 2008 performance. Generally, the portion of earnings above target that are attributable to the principals are paid in the first quarter of the subsequent year. During the year ended December 31, 2009, cash was provided primarily from net income adjusted for non-cash charges, which totaled $109.7 million. Included within cash provided by operating activities was $5.5 million of cash received for key man life proceeds during the year and $1.9 million in proceeds from the settlement of an NFP-owned key man life insurance policy on a principal during the third quarter. Working capital was positively impacted by the net effect of collecting receivables outstanding at the beginning of the period and of new receivables established at the end of the period which totaled approximately $10.4 million. Cash used during the year ended December 31, 2009 was largely the result of a reduction in amounts due to principals and/or certain entities they own of $11.9 million, and other non-current liabilities of $6.1 million. Included within the increase in accrued liabilities was a decrease of $1.8 million related to the ongoing incentive plan, an increase of $9.0 million related to the PIP and an increase of $9.3 million relating to contingent consideration amounts accrued as of December 31, 2009 as compared to December 31, 2008. During the year ended December 31, 2008, cash was provided primarily from net income adjusted for non-cash charges, which totaled $115.8 million, plus the net effect of collecting receivables outstanding at the beginning of the period and new receivables established at the end of the period which totaled $14.0 million. Cash used during the year ended December 31, 2008 was largely the result of a reduction in amounts due to principals and/or certain entities they own of $33.1 million, accrued liabilities of $17.7 million and accounts payable of $5.3 million. The large decrease in accrued liabilities was primarily the result of a decrease in the ongoing incentive plan accrual of $23.2 million. Included in and reducing cash used in operating activities during the year ended December 31, 2008 was $14.4 million paid in connection with the acquisition of a group benefits intermediary and subsequent merger with an existing wholly-owned subsidiary of the Company which has been treated as a prepaid management fee. A portion of this payment has been amortized with the remaining balance included in Other current assets and Other non-current assets. During 2007, cash provided by operating activities was $108.4 million resulting primarily from net income and non-cash charges, an increase in accrued and other liabilities, offset by a decrease in accounts and income taxes payable, and an increase in commissions, fees and premiums receivable, net, and cash, cash equivalents and securities purchased under resale agreements in premium trust accounts.
During the year ended December 31, 2009, cash used in investing activities was $4.1 million, which was primarily due to $10.0 million in cash reserved at NFPSI pursuant to a limited guarantee and security agreement. The Company paid $7.1 million for purchases of property and equipment, approximately $3.1 million as payments for acquired firms, net of cash acquired and contingent consideration and reserved the $10.0 million in cash at NFPSI. These uses were offset by $16.1 million from proceeds received from the disposal of subsidiaries.
For the year ended December 31, 2009, the Company paid $4.3 million in cash in connection with contingent consideration. During the year ended December 31, 2008 the Company used $76.4 million for payments for acquired firms and contingent consideration. Included within the $76.4 million for acquired firms and contingent consideration was $27.3 million NFP paid in cash in connection with contingent consideration. During the year ended December 31, 2008 cash used in investing activities was $87.0 million principally for the acquisition of firms and property and equipment. In 2008, capital expenditures included approximately $20.2 million due to construction and other costs related to the relocation of the corporate headquarters and the concurrent consolidation of space with seven firms. During 2008 and 2007, the Company used $76.4 million and $206.4 million, respectively, in payments for acquired firms, net of cash acquired, and contingent consideration. Included within the $206.4 million for acquired firms in contingent consideration in 2007, was $26.7 million NFP paid in cash in connection with contingent consideration. During 2008 and 2007, payments for acquired firms represented the largest use of cash in investing activities.
During the year ended December 31, 2009, cash used in financing activities was approximately $112.4 million, while cash used by financing activities was $35.0 million in 2008 and cash provided by financing activities was $125.3 in 2007. The Company uses its credit facility primarily to fund general corporate purposes. During the year ended December 31, 2009, NFP did not borrow any amounts under its credit facility but repaid $108.0 million of its outstanding credit facility balance. During the year ended December 31, 2008, net borrowings under the Company’s line of credit were $22.0 million. Cash dividends paid in the year ended December 31, 2008 were $33.1 million. During the year ended December 31, 2008, pursuant to NFP’s share repurchase authorization, NFP repurchased 994,500 shares of NFP common stock for $24.6 million. During 2007, NFP issued convertible senior notes resulting in proceeds to NFP, net of associated costs, of $222.4 million. NFP utilized $106.6 million to repurchase 2.3 million shares of its common stock from Apollo in a privately negotiated transaction. NFP also sold warrants for aggregate proceeds of $34.0 million and purchased a convertible note hedge for $55.9 million for a net cost to NFP of $21.9 million. NFP also received $9.2 million in cash proceeds payable to NFP from the exercise of principal and employee stock options. This $9.2 million included $4.7 million (including tax benefit) from the exercise of 349,455 shares in connection with a secondary public offering in January 2007.
NFP’s Credit Agreement among NFP and the financial institutions party thereto is structured as a revolving credit facility and matures on August 22, 2011. The maximum amount of revolving borrowings available under the credit facility as of August 22, 2006 was $212.5 million. NFP has amended its credit facility, most recently in the second quarter of 2009, as discussed in more detail below. The Second Amendment provided, among other terms, for the reduction in maximum revolving borrowings to $200.0 million at December 31, 2009.
On January 16, 2007, NFP entered into an amendment (the “First Amendment”) to the Credit Agreement. The First Amendment, among other things, modified certain covenants to which NFP was subject under the Credit Agreement, and made other changes in contemplation of the issuance by NFP of the 0.75% convertible senior notes due February 1, 2012 (discussed separately below). Under the First Amendment, NFP was able incur up to $250.0 million in aggregate principal amount outstanding in unsecured indebtedness and unsecured subordinated indebtedness subject to certain conditions; previously, NFP could incur $75.0 million of unsecured subordinated debt. The First Amendment also provided that cumulative Restricted Payments (as defined in the First Amendment), which include but are not limited to dividends and share repurchases, may not exceed the sum of (i) 50% of consolidated net income for the then completed fiscal quarters of the Company commencing with the fiscal quarter ending March 31, 2006 and (ii) $150.0 million.
On December 9, 2008, NFP entered into the Second Amendment (the “Second Amendment”) to the Credit Agreement. Under the terms of the Second Amendment, the maximum Consolidated Leverage Ratio was amended to be 3.0 to 1.0 on the last day of the rolling four-quarter period ending December 31, 2008, 3.5 to 1.0 on the last day of the rolling four-quarter period ending March 31, 2009, 3.25 to 1.0 on the last day of the rolling four-quarter period ending June 30, 2009, 3.0 to 1.0 on the last day of the rolling four-quarter period ending September 30, 2009 and 2.5 to 1.0 on the last day of the rolling four-quarter period ending December 31, 2009 and each rolling four-quarter period thereafter. Prior to the Second Amendment, the maximum Consolidated Leverage Ratio was 2.5 to 1. The Second Amendment also provided for the reduction in maximum revolving borrowings to $225.0 million on June 30, 2009 and $200.0 million on December 31, 2009. All capitalized terms used in this “Second Amendment” section are as defined in the Credit Agreement.
effect to such payment, (A) the Consolidated Leverage Ratio shall not be more than 2.5 to 1.0, on a pro forma basis, (B) the Consolidated Fixed Charge Coverage Ratio shall not be less than 2.0 to 1.0, on a pro forma basis and (C) Minimum Liquidity shall not be less than $50.0 million.
Under the terms of the Second Amendment, the Applicable Margin for Eurodollar Loans, the Applicable Margin for ABR Loans and the Letter of Credit Fee Rate increased by between 1.75% and 2.25%. The Commitment Fee increased by between 0.25% and 0.35%. The definition of Applicable Rate was amended to reflect the percentages set forth below:
On May 6, 2009, NFP entered into the Third Amendment to its Credit Agreement. Under the terms of the Third Amendment, the definition of EBITDA has been amended to expressly provide that the non-cash impairment of goodwill and intangible assets associated with the Company’s evaluation of intangible assets for the first quarter of 2009 in accordance with GAAP will be disregarded in the calculation of EBITDA.
As of December 31, 2009, the Company was in compliance with all of its debt covenants. However, if the Company’s earnings deteriorate, it is possible that NFP would fail to comply with the terms of its credit facility, such as the consolidated leverage ratio covenant, and therefore be in default under the credit facility. Upon the occurrence of such event of default, the majority of lenders under the credit facility could cause amounts currently outstanding to be declared immediately due and payable. Such an acceleration could trigger “cross acceleration provisions” under NFP’s indenture governing the notes; see “-Convertible Senior Notes” below.
In January 2007, NFP issued $230.0 million (including over-allotment) aggregate principal amount of 0.75% convertible senior notes due February 1, 2012 (as used in this section, the “notes”). The notes are senior unsecured obligations and rank equally with NFP’s existing or future senior debt and senior to any subordinated debt. The notes will be structurally subordinated to all existing or future liabilities of NFP’s subsidiaries and will be effectively subordinated to existing or future secured indebtedness to the extent of the value of the collateral. The notes were used to pay the net cost of the convertible note hedge and warrant transactions, repurchase 2.3 million shares of NFP’s common stock from Apollo and to repay a portion of outstanding amounts of principal and interest under NFP’s credit facility (as discussed herein).
Holders may convert their notes at their option on any day prior to the close of business on the scheduled trading day immediately preceding December 1, 2011 only under the following circumstances: (1) during the five business-day period after any five consecutive trading-day period (the “measurement period”) in which the price per note for each day of that measurement period was less than 98% of the product of the last reported sale price of NFP’s common stock and the conversion rate on each such day; (2) during any calendar quarter (and only during such quarter) after the calendar quarter ending March 31, 2007, if the last reported sale price of NFP’s common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 130% of the applicable conversion price in effect on the last trading day of the immediately preceding calendar quarter; or (3) upon the occurrence of specified corporate events. The notes will be convertible, regardless of the foregoing circumstances, at any time from, and including, December 1, 2011 through the second scheduled trading day immediately preceding the maturity date. Default under the credit facility resulting in its acceleration would, subject to a 30-day grace period, trigger a default under the supplemental indenture governing the notes, in which case the trustee under the notes or the holders of not less than 25% in principal amount of the notes could accelerate the payment of the notes.
Concurrent with the issuance of the notes, NFP entered into a convertible note hedge and warrant transactions with an affiliate of one of the underwriters for the notes. The transactions are expected to reduce the potential dilution to NFP’s common stock upon future conversions of the notes. Under the convertible note hedge NFP purchased 230,000 call options for an aggregate premium of $55.9 million. Each call option entitles NFP to repurchase an equivalent number of shares issued upon conversion of the notes at the same strike price (initially $55.62 per share), generally subject to the same adjustments. The call options expire on the maturity date of the notes. NFP also sold warrants for an aggregate premium of $34.0 million. The warrants expire ratably over a period of 40 scheduled trading days between May 1, 2012 and June 26, 2012, on which dates, if not previously exercised, the warrants will be treated as automatically exercised if they are in the money. The warrants provide for net-share settlement. The net cost of the convertible note hedge and warrants to the Company is $21.9 million. Debt issuance costs associated with the notes of approximately $7.6 million are recorded in other current and non-current assets and will be amortized over the term of the notes.
On January 1, 2009, the Company adopted new guidance related to the accounting for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement). The new guidance applies to NFP’s convertible senior notes (see “Note 9-Borrowings”). The new guidance requires NFP to separate the convertible senior notes into two separate components: a non-convertible note and a conversion option. As a result, NFP is required to recognize interest expense on its convertible senior notes at their non-convertible debt borrowing rate (6.62%) rather than at their stated face rate (0.75%). With the change in accounting principle required by the new guidance, NFP is required to amortize to interest expense the excess of the principal amount of the liability component of its notes over the carrying amount using the interest method, and the non-cash portion of interest expense relating to the discount on the notes is now recognized as a charge to earnings. The new guidance does not have any impact on cash payments or obligations due under the terms of the notes. As required, effective January 1, 2009, NFP’s comparative financial statements of prior years have been adjusted to apply its provisions retrospectively. For more detail on the effects of the change in accounting principle, see “Note 2-Summary of Significant Accounting Policies-Recently adopted accounting standards.”
The Company encourages succession planning in the management of its firms. See “Business-Operations-Succession Planning.” NFP has financed several purchases of interests in entities owned by principals or applicable management agreements to facilitate succession. This financing is secured by management fees and, in other cases, is secured by other assets.
NFP typically advances management fees monthly to principals and/or certain entities they own for up to nine months while monitoring the performance of the firms to determine if the actual earnings are on track to meet or exceed target earnings. If earnings are not equal to or greater than pro rata target earnings, NFP ceases to pay or reduces the management fee advance. If an over advance of a management fee exists, the principal and/or such entities are expected to repay the advance within 30 days of the end of the calendar year. If a principal and/or such entities cannot repay the over advance, NFP has allowed principals and/or such entities to repay the advance over time. In these cases, NFP generally requires the principals and/or such entities to provide it with an interest-bearing note in an amount equal to the over advance, generally secured by the principals’ and/or such entities’ shares of NFP’s common stock and in some cases, is secured by other assets.
In addition to the foregoing lawsuits and claims, during 2004, several of the Company’s firms received subpoenas and other informational requests from governmental authorities, including the New York Attorney General’s Office, seeking information regarding compensation arrangements, any evidence of bid rigging and related matters. The Company has cooperated and will continue to cooperate fully with all governmental agencies.
At December 31, 2009, future minimum rentals for operating leases (which may be subject to escalation clauses) primarily consisted of real estate leases that had initial or uncancelable lease terms in excess of one year and were payable as follows:
At December 31, 2009, the Company remains secondarily liable on two assigned leases. The maximum potential of undiscounted future payments is $0.3 million as of December 31, 2009. Lease option dates vary with some extending to 2011.
Contingent consideration payable for acquisitions consummated in 2006 would generally be payable by the end of 2009. NFP currently anticipates using contingent consideration arrangements in future acquisitions, which would result in an increase in the maximum contingent consideration amount in 2010 and thereafter.
Since the Company’s formation and through December 31, 2009, it has completed 266 acquisition transactions, including 46 sub-acquisitions. All of these transactions have been accounted for using the purchase method, and their related net assets and results of operations were included in NFP’s consolidated financial statements commencing on their respective acquisition dates. Certain of the acquisitions have provisions for additional contingent consideration based upon the financial results achieved over a multi-year period. This additional consideration is reflected as an increase in goodwill when results are achieved and the outcome of the contingency is determinable beyond a reasonable doubt.
For the years ended December 31, 2009, 2008, and 2007, the Company recorded impairment losses of $27.0 million, $6.3 million, and $2.3 million respectively, related to management contract and book of business, which is reflected in the consolidated statements of operations.
For the years ended December 31, 2009, 2008, and 2007, the Company recorded impairment losses of $591.5 million, $35.0 million, and $5.5 million, respectively, related to goodwill and trade name, which is reflected in the consolidated statements of operations. See “Note 16-Goodwill and Other Intangible Assets-Impairment of goodwill and intangible assets.”
commissions have been earned. The Company carries an allowance for policy cancellations, which approximated $1.2 million at each of December 31, 2009, 2008 and 2007, that is periodically evaluated and adjusted as necessary. Miscellaneous commission adjustments are generally recorded as they occur. Contingent commissions are recorded as revenue when received which, in many cases, is the Company’s first notification of amounts earned. Contingent commissions are commissions paid by insurance underwriters and are based on the estimated profit and/or overall volume of business placed with the underwriter. The data necessary for the calculation of contingent commissions cannot be reasonably estimated prior to receipt of the commission.
NFP is authorized under its 2009 Stock Incentive Plan to grant awards of stock options, stock appreciation rights, restricted stock, restricted stock units, performance units, performance-based awards or other stock-based awards that may be granted to officers, employees, principals, independent contractors and non-employee directors of the Company and/or an entity in which the Company owns a substantial ownership interest (such as a subsidiary of the Company). Any shares covered by outstanding options or other equity awards that are forfeited, cancelled or expire after April 15, 2009 without the delivery of shares under NFP’s Amended and Restated 1998 Stock Incentive Plan, Amended and Restated 2000 Stock Incentive Plan, Amended and Restated 2000 Stock Incentive Plan for Principals and Managers, Amended and Restated 2002 Stock Incentive Plan or Amended and Restated 2002 Stock Incentive Plan for Principals and Managers, may also be issued under the 2009 Stock Incentive Plan.
Effective January 1, 2007, NFP established a qualified Employee Stock Purchase Plan (“ESPP”). The ESPP is designed to encourage the purchase of common stock by NFP’s employees, further aligning interests of employees and stockholders and providing incentive for current employees. Up to 3,500,000 shares of common stock are currently available for issuance under the ESPP. The ESPP enables all regular and part-time employees who have worked for NFP for at least one year to purchase shares of NFP common stock through payroll deductions of any whole dollar amount of a participant’s eligible compensation per pay period, up to an annual maximum of $10,000. The employees’ purchase price is 85% of the lesser of the closing market price of the common stock on the first or the last day of the quarterly offering period. The Company recognizes compensation expense related to the compensatory nature of the discount given to employees who participate in the ESPP, which totaled $0.6 million, $0.5 million and $0.4 million for the year ended December 31, 2009, 2008 and 2007, respectively.
Effective January 1, 2007, the Company adopted new guidance, which clarified the accounting for uncertain tax positions by prescribing a minimum recognition threshold that a tax position is required to meet before being recognized in the financial statements.
the convertible note hedge, including the related tax benefit, and the proceeds from the sale of the warrants as adjustments to additional paid-in capital. As such, the face value of the notes of $230.0 million was previously shown as a liability on the consolidated statement of financial condition and the discount was recognized as an adjustment to additional paid-in capital of $55.9 million. In addition, interest expense was previously recognized through earnings based only on the stated rate of the notes.
The notes are now presented on the consolidated statement of financial condition at their net carrying amount, or the face value of the notes less their unamortized discount. The new guidance does not have any impact on cash payments or obligations due under the terms of the notes. As required, effective January 1, 2009 NFP’s comparative financial statements of prior years have been adjusted to apply its provisions retrospectively.