As of December 31, 2004, we operated in the following leased locations throughout the United States:
- -------------- (1) Effective January 1, 2005, the Human Capital Practice was merged into the Executive Benefits Practice. (2) Two subtenants occupy one of the three Human Capital Practice locations.
The following historical information should be read in conjunction with information included elsewhere herein, including the consolidated financial statements and notes thereto and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." The results of operations presented below are not necessarily indicative of the results of operations that may be achieved in the future.
(2) In 2003, we received $1.5 million from the favorable settlement of a lawsuit and we incurred operating expense of $7.5 million in connection with the reorganization of the Human Capital Practice. In 2001, we incurred an operating expense of $2.1 million in connection with the write-down of assets acquired from Insurance Alliances Group.
(4) Includes the results of operations subsequent to the date of acquisition of the following: o Rich Florin/Solutions, Inc. (f.d.b.a. Executive Alliance) as of March 12, 2001 o Partners First as of March 23, 2001 o Management Science Associates, Inc. as of July 24, 2001 o Lyons Compensation & Benefits, LLC as of August 31, 2001 o Coates Kenney as of December 26, 2001
A significant portion of our growth has been acquisition related. Business-owned life insurance programs have tax advantages associated with the products that are attractive to our clients. A portion of our product offerings are interest rate sensitive. Changes in tax and legislative laws can have an affect on our business, as seen over the last several years with our Executive Benefits Practice. We have been expanding our compensation consulting practices to diversify our product offerings. The largest component of our general and administrative expenses is salary and other employee related costs.
In recent years, the Internal Revenue Service ("IRS") has undertaken a major enforcement initiative to disallow the interest deductions on certain leveraged business-owned life insurance programs sold during or prior to 1995. The IRS has, with one exception, prevailed on the cases it has litigated to date related to this initiative and recently made a temporary (now expired) public settlement offer to address ongoing cases. While we stopped selling leveraged business-owned life insurance programs after 1995 and we do not expect any material adverse impact on our revenue from this enforcement initiative, it is impossible to determine the impact of this initiative on a client's decision to continue or surrender an existing leveraged business-owned life insurance program.
There have been several recent legislative proposals to change the federal tax laws with respect to business-owned life insurance. On September 17, 2003, the Senate Finance Committee approved legislation proposed by Sen. Jeff Bingaman (D-NM) that would tax the death benefits taxpayers receive from certain policies on the lives of former employees. Following an intensive lobbying effort by the insurance industry, the Finance Committee on February 2, 2004, reconsidered the business-owned life insurance provision it had previously approved and, in its place, approved legislation that generally would tax the death benefits taxpayers receive from policies on the lives of employees or former employees only in cases where the insured person had not consented to being covered or in the case of a former employee, or where the insured was not among the company's highly-compensated employees at the time of policy issuance. This same provision was reintroduced on January 31, 2005, by Senate Finance Committee Chairman Charles Grassley (R-IA) and Senator Max Baucus (D-MT) as part of the National Employee Savings and Trust Equity Guarantee Act (S. 219). We believe that this most recent proposal, if enacted, would not have a material adverse effect on our revenue from the sale of business-owned life insurance policies. However, if Congress were to adopt legislation broadly limiting the tax-free payment of death benefits on such policies or otherwise adversely affecting the tax treatment of the policies, future revenue from sale of business-owned life insurance policies could materially decline.
On October 22, 2004, President Bush signed into law H.R. 4520, the "American Jobs Creation Act of 2004," which included provisions affecting deferred compensation arrangements for taxable and tax-exempt employers. The legislation created new Section 409A of the Internal Revenue Code which will apply to voluntary deferred compensation arrangements, supplemental executive retirement plans, stock appreciation rights ("SARs") and certain other arrangements which have the effect of deferring compensation. Section 409A will generally apply to compensation deferrals made after December 31, 2004. Among other things, Section 409A will modify the times at which distributions are permitted from nonqualified deferred compensation arrangements and
There have been several recent proposals in various states (e.g., Georgia, Texas, Illinois, and Washington) to change the insurable interest and other state laws governing the ability of an employer to purchase or hold life insurance on the lives of employees. In 2003, California enacted legislation prohibiting the purchase of business-owned life insurance on the lives of employees not exempt from wage and hour laws (a group of employees not typically insured under the arrangements we market). Significant segments of the life insurance industry are engaged in an ongoing, intensive effort to prevent the enactment of state law changes that would have an adverse impact on business-owned life insurance. If one or more states were to adopt proposals broadly limiting the ability of employers to purchase or hold life insurance on the lives of employees, the market for these policies would be reduced and a number of existing policies could be surrendered or exchanged, with a resulting reduction in our revenues from these arrangements.
As a result of the surrender of a number of insurance policies by a single customer of ours in December 2004, we will cease receiving commissions and related payments in respect of such surrendered insurance policies. We estimate that the amount of such commissions and related payments is approximately $1 million per year, which is less than one percent of our renewal commission revenues in 2004. The amount of commissions and related payments included in the 2002 Securitization will be directed solely to the payment of principal and interest on the notes and related administration fees and expenses associated with the 2002 Securitization until such time as the Reserve Account established as part of the 2002 Securitization is replenished.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the 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. The Securities and Exchange Commission ("SEC") has defined a company's most critical accounting policies as those that are most important to the portrayal of its financial condition and the results of operations, and which require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Although we believe that our estimates and assumptions are reasonable, they are based upon information available when they are made. Actual results may differ significantly from these estimates under different assumptions and conditions.
o commissions paid by insurance companies issuing the policies underlying our benefit programs;
Our commission revenue is normally recurring, is typically paid annually and usually extends for a period of twenty years or more after the sale. Commissions are paid by insurance companies and vary by policy and by program and typically represent a percentage of the premium or the cash surrender value of the insurance policies underlying the program.
First Year Commission Revenue and Related Fees. First year commission revenue and related fees are derived from two principal sources: (a) the commission we earn when the client first purchases the policies, which revenue is recognized at the time the application is substantially completed, the client is contractually committed to purchase the insurance policies and the premiums are paid (which is the effective date of the insurance policy) by the client to the insurance company or, in certain instances, when cash is received; and (b) fees for the services related to the enrollment and initial administration of the benefit programs and underlying policies.
o have latitude in establishing the price the customer will pay;
o are viewed by the client as the administrator of the program once the product is sold.
Our intangible assets include the excess of the costs of acquired businesses over the fair values of the tangible net assets associated with an acquisition. Intangible assets also consist of the net present value of future cash flows from policies inforce at the acquisition date, non-compete agreements with the former owners, other identifiable intangibles, and goodwill. Non-compete agreements are amortized over the period of the agreements and other identifiable intangibles are amortized over their useful lives.
We are required to assess potential impairments of long-lived assets in accordance with Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting for Impairment of Long-Lived Assets, if events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. In assessing the recoverability of goodwill in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, and the net present value of future cash flows from policies inforce, we must make assumptions regarding estimated future cash flows, mortality, lapse, and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, we may be required to record impairment charges.
Revenue. Total revenues for the year ended December 31, 2004 were $315.6 million, a decrease of 3.2% from revenues of $325.9 million for the year ended December 31, 2003. First year revenues for the year ended December 31, 2004 were $97.5 million compared to $113.3 million for the year ended December 31, 2003. First year revenue of the Banking Practice was $19.5 million less for the year ended December 31, 2004 when compared to the year ended December 31, 2003 due to clients' efforts in mid 2003 to lock in interest rates prior to anticipated interest rate reductions in late 2003. Revenue for the years ended December 31, 2004 and 2003 included approximately $11.3 million and $10.3 million, respectively, related to supplemental compensation arrangements with insurance carriers. Renewal revenue for the year ended December 31, 2004, was $157.5 compared to $159.1 million for the year ended December 31, 2003. The decrease in renewal revenue is primarily the result of over funding of certain corporate plans. Consulting fees as a percentage of total revenue increased to 17.3% for the year ended December 31, 2004 compared to 14.5% in the year ended December 31, 2003. For the year ended December 31, 2004, executive compensation consulting services experienced an increase in demand over the prior year due to increased focus on corporate governance and executive compensation.
Amortization. Amortization expense decreased approximately $3.4 million to $18.2 million for the year ended December 31, 2004, from $21.6 million for the year ended December 31, 2003. For the three months ended September 30, 2003, there were costs of approximately $550 thousand relating to an adjustment to the purchase accounting for the LongMiller acquisition. The remaining decline is based on the timing of scheduled amortization of our inforce revenue streams purchased in acquisitions.
Other operating expenses. The year ended December 31, 2003 results included a $1.5 million favorable settlement of litigation that reduced operating expenses.
Net income. Net income for the year ended December 31, 2004 was $18.2 million, or $0.97 per diluted common share, versus net income of $12.7 million, or $0.68 per diluted share, for the same period last year.
Commission and fee expense. Commission and fee expense was $88.6 million, or 27.2% of total revenue, for the year ended December 31, 2003, versus $90.3 million, or 32.4% of total revenue, for the year ended December 31, 2002. The reduction in commission expense as a percentage of revenue reflects an increase in the percentage of revenue generated from employee consultants. Additionally, a higher percentage of 2003 revenue was renewal revenues (48.8%) as compared to 2002 (41.3%). Generally, renewal revenues have a lower commission rate than first year revenues. We do not pay commission, or any other related expenses, on the revenue associated with the supplemental compensation arrangements.
General and administrative expense. General and administrative expense for the year ended December 31, 2003 was $158.9 million, or 48.8% of total revenue, compared to $140.3 million, or 50.4% of total revenue, for the year ended December 31, 2002. General and administrative expenses increased for the year ended December 31, 2003 from the prior year as a result of a full year of expense from the 2002 acquisitions, such as LongMiller and Federal Policy Group, and the May 2002 hiring of former Arthur Andersen Human Capital Practice partners and employees, included for the entire year of 2003. General and administrative expense for the year ended December 31, 2003 included approximately $2.6 million in charges, primarily related to severance costs and lease terminations in our Executive Benefits Practice and Healthcare Group, and approximately $1.3 million relating to the corporate re-branding effort as a result of our name change. General and administrative expenses increase as we add more employees as opposed to independent producers.
Amortization. Amortization expense for the year ended December 31, 2003 was $21.6 million compared to $9.2 million in the prior year period. We acquired approximately $400 million of inforce revenue with our November 2002 acquisition of LongMiller. The acquisition of LongMiller added approximately $14.0 million of amortization expense in 2003 as a result of a full year of amortization of the net present value of inforce revenue and non-compete agreements. The 2002 results included one month of amortization related to this intangible asset.
Human Capital Practice reorganization. In the fourth quarter of 2003, we reorganized our executive compensation consulting practices. As part of the reorganization, some of the operations and employees of the Human Capital Practice were transferred to the Pearl Meyer & Partners practice. In addition, several partners and staff members were terminated which resulted in exiting certain activities of the Human Capital Practice and creating unused leased office space in numerous cities. We recorded a charge of $7.5 million in the fourth quarter of 2003 relating to the reorganization, of which $7.1 million remained on the consolidated balance sheet as of December 31, 2003. No similar costs were recorded in 2002.
Income taxes. Income taxes for the year ended December 31, 2003 were $8.1 million, an effective tax rate of 38.9%, compared to $12.4 million, an effective tax rate of 41.0%, for the year ended December 31, 2002. The effective tax rate for the year ended December 31, 2003 reflects $283 thousand of net state tax refunds relating to prior years. The 2003 decrease in the effective tax rate is primarily related to the true up of the estimated 2002 state tax liability.
Net income. Net income, for the year ended December 31, 2003 was $12.7 million, or $0.68 per diluted common share, versus net income of $17.3 million after an impairment charge of $523 thousand, net of taxes, from the adoption of SFAS No. 142, or $0.99 per diluted share, for the same period in the prior year. The diluted weighted average number of shares outstanding increased to 18.7 million shares for the year ended December 31, 2003 from 17.5 million shares for the year ended December 31, 2002.
In the fourth quarter of 2003, we reorganized our executive compensation consulting practices. As part of the reorganization, some of the operations and employees of the Human Capital Practice were transferred to the Pearl Meyer & Partners Practice. In addition, four partners and six staff members were terminated which resulted in exiting certain activities of the practice and creating unused leased office space in numerous cities. We recorded a charge of $7.5 million in the fourth quarter of 2003 relating to the reorganization of which $3.3 million remains on the consolidated balance sheet as of December 31, 2004.
As a result of the restructuring, we leveraged the Pearl Meyer & Partners brand name for executive compensation consulting, eliminated confusion in the marketplace regarding our practices and their markets, and significantly lowered the cost structure for the remaining Human Capital Practice. The remaining business of the Human Capital Practice in 2004 consisted of actuarial/retirement plan and investment advisory services. Effective January 1, 2005, the Human Capital Practice was merged into the Executive Benefits Practice.
During the third quarter of 2003, we completed agreements with two of our core insurance carriers, which will generate additional revenue on our existing blocks of business with these carriers. The length of one of the contracts is five and one half years and the other contract is one year. The contracts automatically renew each year unless notice is given by one of the parties. The agreements resulted in revenue of $4.1 million and $3.5 million for the years ended December 31, 2004 and 2003, respectively, and provide for additional payments upon certain conditions and measurement dates. The future payment amounts are based on the cash value (or fair value) of our existing inforce business with these carriers at specified dates of measurement. Future payment amounts would be negatively impacted by potential future surrenders of the inforce business or non-renewal of the agreements and positively impacted by asset growth of these contracts.
Total revenue for the year ended December 31, 2004 was $72.9 million compared to $70.0 million for the year ended December 31, 2003. First year revenue for the year ended December 31, 2004, was $26.2 million compared to $21.5 million for the year ended December 31, 2003. First year 2004 revenue for the year ended December 31, 2004 included $8.6 million for one large case. Renewal revenue for the year ended December 31, 2004, was $46.5 million compared to $48.2 million for the year ended December 31, 2003. The increase in first year revenues was partially offset by decreases in renewal revenues relating to the loss of three large clients ($2.3 million) and over funding of certain corporate plans. Commission expense as a percentage of total revenue declined to 38.8% for the year ended December 31, 2004, from 41.8% for the year ended December 31, 2003, due to the mix of sales by employee consultants who are paid a lower commission and the mix between first year versus renewal revenue. General and administrative expense for the year ended December 31, 2004, was lower than the year ended December 31, 2003, due mainly to lower headcount (234 for 2004 and 250 for 2003) and facility costs despite a charge of approximately $1.1 million for legal costs associated with the MacDonald settlement in June of 2004.
As of October 1, 2003, we transferred part of the operations of the Human Capital Practice to Pearl Meyer & Partners. As a result, all years presented have been reclassified to reflect this transfer. Executive compensation consulting services have seen an increase in demand over 2003, as companies and compensation committees increase their focus on executive compensation.
Total consulting revenue increased 23.2% to $33.1 million for the year ended December 31, 2004, compared to $26.9 million for the year ended December 31, 2003. The practice continues to experience more sales activity as a result of additional engagements in its areas of expertise of corporate governance and executive compensation due, in part, to increased public scrutiny of these areas. General and administrative expense was $27.7 million for the year ended December 31, 2004, compared to $25.8 million for the year ended December 31, 2003 reflecting higher headcount (97 in 2004 and 83 in 2003).
Total consulting revenue increased 20.3% to $26.9 million for the year ended December 31, 2003, compared to $22.3 million for the year ended December 31, 2002. The practice continues to experience more sales activity as a result of additional engagements in its areas of expertise of corporate governance and executive compensation due, in part, to increased public scrutiny of these areas. General and administrative expense was $23.3 million for the year ended December 31, 2003, compared to $20.9 million for the year ended December 31, 2002 reflecting higher headcount (83 in 2003 and 37 in 2002).
In the fourth quarter of 2003, we reorganized our executive compensation consulting practices. As part of the reorganization, some of the operations and employees of the Human Capital Practice (including the Rewards and Performance Group) were transferred to the Pearl Meyer & Partners practice. As a result, all periods presented have been reclassified to reflect this transfer. The Human Capital Practice exited certain revenue producing activities in connection with the fourth quarter 2003 reorganization. We recorded a charge of approximately $7.5 million in the fourth quarter 2003 relating to the reorganization of which $3.3 million remains on the consolidated balance sheet as of December 31, 2004.
Revenues and operating expenses were lower in 2002 than in 2003 due to HCP only operating for 6 1/2 months in 2002 versus 12 months in 2003.
Effective January 1, 2005, the Human Capital Practice was merged into the Executive Benefits Practice.
Our cash flow from operating activities for the twelve months ended December 31, 2004, 2003, and 2002 were as follows:
The non-cash expenses mentioned above include depreciation of equipment and leasehold improvements, amortization of intangibles, charges for performance-based stock options issued to non-employee producers, and deferred tax expense. In the first quarter of 2004, we wrote off approximately $1.5 million of costs associated with a securitization financing that we are no longer pursuing. Cash provided by changes in operating assets and liabilities included a reduction of accounts receivable ($3.1 million), primarily as a result of improved collection efforts, and an increase in non-current liabilities primarily as a result of increased contributions and earnings in our deferred compensation plans ($3.6 million).
The following tables represent the estimated gross renewal revenue associated with the business-owned life insurance policies owned by our clients as of December 31, 2004. The projected gross revenues are not adjusted for mortality, lapse, or other factors that may impair realization, have not been discounted to reflect their net present value, and do not reflect the commission expense we must pay to consultants when we recognize the related revenue. We cannot assure you that commissions under these policies will be received. These projected gross revenues are based on the beliefs and assumptions of management and are not necessarily indicative of the revenue that may actually be realized in the future.
The 10-year inforce revenues net of commission expense are $628.1 million as of December 31, 2004, as compared to $612.6 at December 31, 2003.
Securitized Gross Inforce Revenues. The following table represents the estimated gross renewal revenue associated with our securitized inforce bank-owned life insurance policies as of December 31, 2004. These revenue streams are restricted for the specific purpose of paying off our asset-backed notes which were issued in connection with the acquisition of LongMiller in November 2002.
BANKING PRACTICE ---------------- 2005..................... $ 45,388 2006..................... 47,407 2007..................... 50,170 2008..................... 52,892 2009..................... 54,846 2010..................... 56,983 2011..................... 58,579 2012..................... 60,908 2013..................... 63,591 2014..................... 66,146 -------- Total December 31, 2004 $556,910 ======== Total December 31, 2003 $572,020 ========
During the year ended December 31, 2004, $9.2 million of our cash was used for contingent consideration payments to prior owners of businesses we acquired and $4.8 million of our cash was used for purchases of equipment.
A substantial portion of the purchase price used to fund acquisitions has historically been paid in cash. This is primarily due to our desire to avoid diluting our existing stockholders. We expect acquisitions to continue and be financed primarily from available credit lines and possible additional equity. However, we can offer no assurances such will be the case.
As of December 31, 2004, there was restricted cash of approximately $12.0 million, a decrease of $6.9 million from December 31, 2003, which will be used to pay down the asset-backed notes issued to finance the acquisition of LongMiller. This cash is not available for general corporate purposes, but is solely to service securitization indebtedness incurred to finance the acquisition of LongMiller.
In May 2004, we received proceeds of approximately $17.5 million from our participation in a pooled trust preferred transaction, in which we issued $18.0 million aggregate principal amount of long-term subordinated debt securities with a floating rate based on three month LIBOR plus a spread of 380 basis points (5.96% as of December 31, 2004). We used the net proceeds to pay down the term portion of our credit facility. The pooled trust preferred debt is payable in one payment due in 30 years with interest paid quarterly.
In November 2003, we amended and restated our December 28, 1999 Credit Agreement revising the amount available under the credit facility to $80.0 million for a three year period ending December 31, 2006. In December 2003, a new participant bank was added to the facility increasing the facility amount to $90 million. The credit facility amount was reduced dollar for dollar by $18.0 million of repayments in 2003 and 2004 on the term portion of the facility. We had $72.0 million available under our credit line at December 31, 2004. Our assets are pledged to the bank group as part of the credit facility
except for cash flows from commissions to be received upon the renewals of specified inforce policies acquired in connection with the acquisition of LongMiller. In September 2004, we amended our credit agreement to allow for potential stock repurchases and dividend payments. The remaining provisions of the agreement remained substantively the same.
We do not have any material off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenue or expenses, results of operations, liquidity, capital expenditures, or capital resources. Set forth below is a summary presentation of our contractual obligations as of December 31, 2004, which are expected to become due and payable during the periods specified.
Inflation has not had a material effect on our results of operations. Certain of our expenses, such as compensation, benefits, and capital equipment costs, are subject to normal inflationary pressures. However, the majority of our service and administrative agreements with clients, which generate fee income, have a cost of living adjustment tied to the consumer price index.