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 remaining renewal options of five years each.
CMI leases 35,000 square feet of office space in Oakland, California for its Octagon headquarters. The initial lease term is for five and one-half years and is scheduled to expire in June 2010. The lease provides for a renewal option for an additional five years.
CMI has 40 other leases for office space of between 1,000 and 15,000 square feet that serve as regional offices and service centers. These leases have initial terms between two and six years and expire between 2006 and 2011.
The Company leases 4,800 square feet of office space in Greenwich, Connecticut for its corporate headquarters. The lease is for an initial term of seven years four months, expiring in February 2011, and contains a renewal option for an additional five years. The Company shares the office space with Capital Partners. While the lease of the office space is in the name of the Company, Capital Partners pays the monthly rent and other costs of the lease, including utilities and taxes. The Company’s reimbursement for its portion of the rent is included in the advisory services fee the Company pays to Capital Partners. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8. “Financial Statements and Supplementary Data.”
At December 31, 2005, we had two reportable operating segments, Employer Cost Containment and Health Services, conducted through WC, CMI and CMI’s 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 and Primrose have equity participations in our businesses (approximately 15.6% and 1.5%, respectively), as well as stock options in those subsidiaries, giving us an 83.7% and 91.5% fully diluted ownership interest in WC and Primrose, respectively.
While one of the goals of the Company has always been to maximize stockholder value, beginning in January 2004 and proceeding through the filing of this Annual Report, management and the Board of Directors have also sought to provide an opportunity for liquidity to our public stockholders. We recognized that, with the costs of being a public company increasing, and less than 20% of our shares in public hands, it made sense for us to consider alternatives to remaining a publicly traded company. In that vein, in January 2004, the Board of Directors formed a Special Committee to explore strategic alternatives that would fulfill our goals of maximizing value to all our stockholders, providing liquidity to our public stockholders, and exploring alternatives to being a publicly traded company.
Additionally, in response to an SEC letter issued to the American Institute of Certified Public Accountants in February 2005, management conducted an internal review of our accounting practices with respect to leases and leasehold improvements, concluding that various adjustments were required, and that previously issued financial statements should be restated (the “Restatement”). For more information regarding the Investigation and the Restatement, see our Annual Report on Form 10-K for the year ended December 31, 2004 (the “2004 Form 10-K”).
Throughout the Investigation, the Restatement and the added demands placed on management from the lengthy year-end audit procedures, we continued to strengthen the core WC and Primrose businesses and resolve 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. As a result of the findings of the Investigation, the employment of two senior members of the CMI management team was terminated and new management was put in place. The operating systems at WC were improved and controls were strengthened at the subsidiary level.
In March 2005, CMI, through one of its operating subsidiaries, acquired Caronia, a leading provider of third-party professional medical liability claims administration and risk management services to hospitals and healthcare systems, physician and paraprofessional groups, nursing homes, rehabilitation centers and clinics. As a result of this acquisition, management believes that CMI is now one of the largest independent providers of professional medical liability claims services in the United States.
On February 10, 2006, the Company signed a definitive agreement for the sale of Primrose to an affiliate of American Capital Strategies, Ltd. for an aggregate purchase price of $85 million. After adjustment for transaction costs and certain items specified in the agreement, the net purchase price is anticipated to be approximately $82.8 million. The Company expects to net, after taxes, approximately $58.2 million for its 91.5% fully diluted share of Primrose, or approximately $8.44 per diluted share. The sale is subject to customary closing conditions and is anticipated to close by March 31, 2006.
administrator services, self-insured plan administrator services, consulting services, group rating services, and managed care administration services. Revenues are recorded based on the terms and duration of the related contracts. Revenues from managed care administration services with the OBWC are recognized on a monthly basis based on the contracted administrative fee. 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. 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 12 months.
On a consolidated basis, the allowance for doubtful accounts and for potentially uncollectible recoverable costs was 4.8%, 6.9% and 5.7% of gross receivables at December 31, 2005, 2004 and 2003, respectively. A one percentage point increase in the allowance for doubtful accounts and for potentially uncollectible recoverable costs would have increased operating expenses by $244, $211 and $174 for the years ended December 31, 2005, 2004 and 2003, respectively.
Acquisitions are accounted for under the “purchase method,” whereby acquired tangible and intangible assets and assumed liabilities are recorded at fair value. The determination of fair value of tangible and intangible assets and their respective useful lives requires management to make certain estimates, judgments and assumptions. We determine fair value based on a variety of different methods, including, but not limited to, reference to quoted market prices, discounted cash flow
Effective July 1, 2005, we adopted the fair value method of accounting for stock-based compensation under Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”). Prior to July 1, 2005, we applied the intrinsic value method in measuring stock-based compensation under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and disclosed in the footnotes to our financial statements the pro forma effect on net income and earnings per share assuming we had applied the fair value method of accounting for stock-based awards.
The options expire 10 years from the date of grant. Increasing the estimate of the expected life from seven years to 10 years would have increased the fair value of the option award from $4.09 per share to $4.98 per share, and resulted in additional share-based compensation expense of $57 being recognized over the requisite service period.
For the year ended December 31, 2005, revenues were $155,311 compared to $132,940 in 2004. We experienced double digit revenue growth over 2004 in both our Employer Cost Containment and Health Services segment and our Educational Services segment. The growth in the Employer Cost Containment and Health Services segment was fueled by
the March 2005 acquisition of Caronia, which accounted for slightly more than half of the revenue growth and customer growth. The growth in our Education Services segment was driven by the opening of 24 new franchise schools and increasing royalties from the existing franchise schools due to increasing enrollment and tuition.
The formal process to sell the Company announced in June 2005 is ongoing. As previously discussed, we have reached an agreement to sell Primrose for an aggregate purchase price of $85,000, and are currently considering offers for our interest in WC and the balance of the Company. We currently expect to enter into a definitive agreement during the second quarter of 2006 to sell WC and the balance of the Company.
Through December 31, 2005, costs of approximately $500 have been incurred in connection with the formal sale process. The majority of the costs related to the sale will be incurred upon the closing of the sale of Primrose and the completion of the sale of the Company. These costs would include, but are no limited to, investment banking fees, legal and accounting fees, stay pay bonuses and fees to Capital Partners for its role in the formal sale process. Some of the costs of the process, such as legal and accounting fees, are not contingent and will be paid even if the transactions do not close.
A more detailed discussion of our results of operations is provided in the sections below.
Consolidated revenues for the year ended December 31, 2005 increased $22,371, or 17% to $155,311 compared to revenues of $132,940 for the year ended December 31, 2004. 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.
Revenues from the Employer Cost Containment and Health Services segment for the year ended December 31, 2004 increased $36,737, or 43% to $121,335 compared to $84,598 for 2003. The increase was primarily driven by the acquisition of Octagon in October 2003. The operations of Octagon were included in our 2003 results only for the three months following the acquisition, whereas in 2004 the operations of Octagon were included for the entire year. The
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 2003. 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 and real estate services fees 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.
Selling, general and administrative expense (“SG&A”) by segment was as follows:
Consolidated SG&A for the year ended December 31, 2005 increased $17,930, or 16% to $132,245 compared to SG&A of $114,315 for 2004. Consolidated SG&A for the year ended December 31, 2004 increased $34,676, or 44% compared to SG&A of $79,639 for 2003.
SG&A expenses in the Educational Services segment increased $1,267, or 21% to $7,247 for the year ended December 31, 2005 compared to $5,980 for 2004. This increase was primarily attributable to higher compensation and benefits expense of approximately $900 due to increased personnel necessary to service the increased number of franchised schools and a special one-time cash payment of $240 to certain employees (see “Liquidity and Capital Resources”).
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 franchise 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 decreased $292, or 10%, to $2,487 for the year ended December 31, 2005 compared to $2,779 for 2004. Contributing to this decrease was a significant decline in accounting and auditing expenses of approximately $800 due to the extended procedures performed for the 2004 audit resulting from the Investigation and the Restatement and other factors associated with the planning and execution of year-end audit procedures. For the 2005 period, we selected new independent public accountants, which also resulted in a decrease in fees for our 2005 quarterly reviews compared to the 2004 quarterly reviews. The fees and costs of the Special Committee also decreased approximately $300 in 2005 as their activities were significantly diminished when the Board determined to pursue a formal sale process for the Company. Partially offsetting these decreases were higher legal fees of approximately $430 due to the Investigation, the late filing of our 2004 Form 10-K and our 2005 Form 10-Qs, communications with the AMEX and SEC, the Caronia acquisition, and the formal sale process. We do not have an in-house legal staff and, accordingly, rely on outside legal counsel for all our legal services. In 2005, we also recorded approximately $320 of expenses relating to professional services incurred in connection with the formal sale process and share-based compensation expense relating to the adoption of SFAS 123R.
Consolidated D&A increased by $1,204, or 32% to $4,984 for the year ended December 31, 2005 compared to $3,780 for 2004. Consolidated D&A increased by $1,329, or 54% to $3,780 for the year ended December 31, 2004 compared to $2,451 for 2003.
Consolidated interest expense decreased $1,744 or 40% to $2,607 for the year ended December 31, 2005 from $4,351 for 2004. This decrease was due to a decrease in our average outstanding borrowings of approximately $9,300 in 2005 compared to 2004 and a decrease in our effective interest rate to 7.8% in 2005 compared to 10.2% in 2004. The decrease in the average outstanding borrowings and effective interest rate in 2005 was due mainly to the repayment of the Note, which bore interest at a fixed rate of 10%, in September 2004.
Consolidated interest expense increased $2,786, or 178% to $4,351 for the year ended December 31, 2004 from $1,565 for 2003. The increase in 2004 compared to 2003 was due to the issuance of the Note in January 2004 and the full year effect of the additional debt from the acquisition of Octagon in October 2003. Due to the issuance of the Note, the effective interest rate in 2004 increased to 10.2% from 6.3% in 2003.
Interest expense at the Employer Cost Containment and Health Services segment increased $796, or 44% to $2,585 for the year ended December 31, 2005 from $1,789 for 2004 primarily due to additional debt resulting from the acquisition of Caronia and slightly higher interest rates. For the year ended December 31, 2004, interest expense increased $524, or 41% to $1,789 compared to $1,265 for 2003 due to an increase in outstanding debt resulting from the Octagon acquisition.
Discontinued operations included the results of Pumpkin and Possible Dreams. In October 2004, we consummated the sale of substantially all of the assets of Pumpkin, and in November 2004, we entered into an agreement with the bankruptcy trustee for Possible Dreams to resolve all outstanding claims against the Company. The loss from discontinued operations in 2004 included a net loss on the sale of Pumpkin of $3,928 and a net gain from the settlement of the Possible Dreams bankruptcy of $1,516.
At December 31, 2005, we had available unrestricted cash and cash equivalents of $12,340. This was only a slight decrease from the available unrestricted cash and cash equivalents of $12,488 at December 31, 2004. At December 31, 2005, WC had an available $8,000 revolving line of credit (the “WC Revolver”) and Primrose had an available $1,000 revolving line of credit (the “Primrose Revolver”). Available borrowings under the WC Revolver were reduced by the aggregate amount of outstanding letters of credit ($1,250 at December 31, 2005). There were no outstanding borrowings under the WC Revolver or the Primrose Revolver, and accordingly, at December 31, 2005, WC had the ability to borrow an additional $6,750 and Primrose had the ability to borrow an additional $1,000. Management believes that cash flows from operations along with the available borrowing capacity under the WC Revolver and the Primrose Revolver will be sufficient to fund our operations and service our debt for the next 12 to 24 months.
by the SEC regarding the reporting of cash flows from discontinued operations. We had previously disclosed cash flows from operating, investing and financing activities of discontinued operations on a combined basis. To comply with Statement of Financial Accounting Standards No. 95, Statement of Cash Flows, we have revised our consolidated statements of cash flows for 2004 and 2003 to report separately the cash flows from operating, investing and financing activities of discontinued operations.
Net cash flow from operations for 2005 was $11,816 compared to $17,339 in 2004. The decrease was principally the result of payments of accounts payable and accrued liabilities, primarily due to an increase in estimated Federal income tax payments and significant payments made during the first quarter of 2005 for accounting and auditing services. Also, cash flow in 2004 benefited from the timing of cash receipts from advance billings on certain customer contracts and cash receipts from prospective franchisees (see increase in unearned revenue discussion below).
In 2004, net cash of $13,475 was used in financing activities to repay debt of $39,960, which included the repayment of the $30,000 Note, redeem all issued and outstanding shares of Preferred Stock for $5,000 and settle the outstanding claims against the Company in the Possible Dreams bankruptcy for $442. Cash of $29,289 was received from the issuance of the Note (net of financing costs) and cash of $2,638 was provided by financing activities of discontinued operations. In 2003, net cash of $11,854 was provided by financing activities primarily due to the issuance of debt to fund the Octagon acquisition partially offset by repayments of existing debt.
The WC Term Loan, the WC Revolver and the Primrose Revolver each contains 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 also contains provisions that require WC to provide monthly financial statements and audited annual financial statements to the lender. Management believes that the Company is currently in compliance with all of these requirements.
On March 6, 2006, we entered into the Agreement with the Former Executives. Under the terms of the Agreement, the Former Executives received a cash payment of $562 shortly after signing the Agreement and will receive additional cash payments on the first and second anniversary dates of the signing of the Agreement aggregating $373. In addition, the Former Executives are eligible to receive additional cash payments aggregating$846 upon a change in control of the Company or WC.
The table below shows payments due under contractual obligations at December 31, 2005 for the periods indicated:
reflected in the above table for 2006 only. The Amended Advisory Services Agreement is an annual agreement that automatically renews on December 31 under the existing terms unless either party gives at least 60 days’ prior written notice to the other. The Company is under no obligation to continue being a party to such an agreement beyond 2006. Accordingly, obligations for periods after 2006 are not reflected in the above table.
The payments due under the Agreement do not include the $846 of additional payments that would become payable under the Agreement upon a change of control of the Company or WC.
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2005, 2004 and
(in thousands, except share and per share amounts, unless otherwise noted)
Security Capital Corporation (“Security Capital”, “Company”, “we”, “us” and “our”) operates as a holding company that actively participates in the management of its subsidiaries. At December 31, 2005, we operated two subsidiaries, WC Holdings, Inc. (“WC”) and Primrose Holdings, Inc. (“Primrose”). WC is a majority-owned subsidiary that provides cost containment services relative to direct and indirect costs of corporations and their employees primarily relating to industrial health and safety, industrial medical care and workers’ compensation insurance. As a result of certain transactions that occurred during 2005, our ownership interest in WC increased from 80% to 84.4% (see Note 11). WC’s activities are primarily centered in Ohio, California, Virginia, Maryland, Texas, Michigan, Florida, Washington, Minnesota and New York. Primrose is a 98.5%-owned subsidiary involved in the franchising of educational-based childcare services, with related activities in real estate consulting and site selection services. At December 31, 2005, Primrose schools were located in the Southeast, Southwest and Midwest. On February 10, 2006, the Company signed a definitive agreement for the sale of Primrose (see Note 17).
We had two reportable operating segments at December 31, 2005. The Employer Cost Containment and Health Services segment consists of WC, and the Educational Services segment consists of Primrose. See Note 4 for further details regarding our reportable operating segments.
In June 2005, we announced that the Company’s Board of Directors, upon the recommendation of a Special Committee of the Board formed in January 2004 to explore strategic alternatives to maximize stockholder value and provide an opportunity for liquidity to our public stockholders, determined to pursue a formal sale process to seek the highest price reasonably attainable for the Company. As a part of that process, the Company has solicited offers both for the entire Company and for our Primrose and WC businesses separately. At December 31, 2005, that process was ongoing. For developments subsequent to that date, see Note 17.
The accompanying consolidated financial statements include the accounts of Security Capital and its majority-owned subsidiaries and have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). All intercompany balances have been eliminated in consolidation. The consolidated statements include 100% of the assets and liabilities of the Company’s subsidiaries, and the ownership interests of the minority investors in the subsidiaries are recorded as minority interests.
The Company has revised its 2004 and 2003 consolidated statements of cash flows as a result of recent guidance provided by the Securities and Exchange Commission staff regarding the reporting of cash flows from discontinued operations. We had previously disclosed cash flows from operating, investing and financing activities of discontinued operations on a combined basis. To comply with Statement of Financial Accounting Standards No. 95, Statement of Cash Flows, we have revised our consolidated statements of cash flows for 2004 and 2003 to report separately the cash flows from operating, investing and financing activities of discontinued operations.
Certain prior year amounts have been reclassified to conform to the 2005 presentation.
Revenues for the Employer Cost Containment and Health Services segment are derived from third-party administrator services, self-insured plan administrator services, consulting services, group rating services, and managed care administration services. Revenues are recorded based on the terms and duration of the related contracts. Revenues from managed care administration services with the Ohio Bureau of Workers’ Compensation (the “OBWC”) are recognized on a monthly basis based on the contracted administrative fee. 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. 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 12 months.
Restricted cash includes amounts collected from franchisees for advertising and marketing 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.
Our receivables are composed primarily of amounts due for contract services provided by WC and royalty payments due to Primrose from franchisees. Primrose also incurs third-party professional services costs on behalf of franchisees for assignment and real estate services. These costs are recorded as recoverable costs and are collected from the franchisee upon the Closing. We consider an account to be delinquent when the customer fails to make payment within the timeframe specified in the applicable sales contract or invoice. We establish an allowance for doubtful accounts and for potentially uncollectible recoverable costs based on a review of the current status of the receivable, customer or franchisee credit evaluations, collection history and other pertinent information. Receivables are generally not collateralized.
A summary of the changes in the allowance for doubtful accounts for the years ended December 31, 2005, 2004 and 2003 is as follows:
A summary of the changes in the allowance for uncollectible recoverable costs for the years ended December 31, 2005, 2004 and 2003 is as follows:
based on a variety of different methods, including, but not limited to, reference to quoted market prices, discounted cash flow projections, reference to relevant market data, replacement cost analysis and independent third-party valuations. Determining the estimated useful life of intangible assets is dependent upon an evaluation of numerous factors, such as the competitive environment, our market share and our ability to maintain that market share in the future, any legal, regulatory or contractual provisions that limit, or could limit, the assets’ life and the expected macroeconomic environment and its impact on the industries in which we operate. Intangible assets are amortized over their estimated useful life.
Fair value is defined as the amount at which an asset can be purchased in a current transaction between willing parties, other than in a forced liquidation sale. As a result of the offers received as part of the ongoing formal sale process for Primrose and the balance of the Company, management determined that at December 31, 2005, the fair value of the reporting units exceeded their carrying value and that further impairment testing was not required.
Financial instruments include cash and cash equivalents, restricted cash, receivables, accounts payable, long-term debt and interest rate swaps. The carrying value of cash and cash equivalents, restricted cash, receivables and accounts payable approximates fair value due to the short-term nature of these items. Long-term debt, including the current portion, bears interest at current market rates and, accordingly, its carrying value approximates fair value. The fair value of interest rate swaps is obtained from a major financial institution based on current market prices of similar instruments. This value represents the estimated amount the Company would receive or pay to terminate the agreement.
Advertising costs are expensed when incurred and aggregated $229, $172 and $211 for the years ended December 31, 2005, 2004 and 2003, respectively.
Under SFAS 123R, share-based awards result in a cost measured at fair value on the awards’ grant dates. Share-based awards are currently limited to stock options granted to employees and non-employee directors. We determine the fair value of stock options using the Black-Scholes option pricing model. The Black Scholes option pricing model requires the input of highly subjective assumptions, including the expected life of the option and expected volatility of the underlying security. The expected life of the option is the length of time the option holder is expected to hold the options. When estimating the expected life of an option, management will consider, among other things, the level of the employee receiving the option and the historical exercise behavior of option holders. The expected life of an option is a significant assumption as it determines the period for which the risk-free interest rate, volatility and dividend yield must be applied. The risk-free interest rate is based on the expected U.S. Treasury rate over the expected life. Volatility reflects the movement in our stock price over the most recent historical period equivalent to the expected life. The dividend yield represents the dividend the Company expects to pay over the expected life.
The fair value of the estimated number of awards expected to vest is recognized ratably through earnings over the requisite service period, which is generally the vesting period. Because less than 20% of our common stock is held by the general public, daily trading volume of our shares tends to be minimal and thus the market for our common stock may not be as liquid as the market for more widely-held shares. Accordingly, in management’s opinion, the Black-Scholes option pricing model may not necessarily provide a reliable single measure of the fair value of options granted.
Prior to July 1, 2005, we applied the intrinsic value method in measuring stock-based compensation 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 equaled the market value of the underlying stock on the date of the grant, no compensation expense was recognized.
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. Certain judgment is required in determining our annual effective tax rate and in evaluating our tax positions. While we believe that our tax return positions are fully supportable, we expect that certain positions could be challenged and that we may not be able to successfully defend our positions. Accordingly, we establish certain reserves, including interest, for these items. We adjust these reserves in light of changing facts and circumstances. See Note 13 for additional information.
On March 31, 2005, the Company, through its indirect, majority-owned subsidiary, Octagon Risk Services, Inc. (“Octagon”), acquired 100% of the outstanding capital stock of Managed Care Holdings Corporation (“MCHC”) and its wholly owned subsidiary, Caronia Corporation (“Caronia”), for $16,000, plus $962 of transaction costs. Caronia provides third-party professional medical liability claims administration and risk management services to hospitals and healthcare systems, physician and paraprofessional groups, nursing homes, rehabilitation centers and clinics. Caronia is based in Melville, New York and services clients through 40 locations nationwide. Upon the consummation of the transaction, Caronia became part of our Employer Cost Containment and Health Services operating segment.
Additions to goodwill in 2004 included $406 from the acquisition of KRAMMCO, Inc., $997 from the acquisition of ICS and a purchase price adjustment of $364 relating to the prior acquisition of Barron Risk Management Services. Deductions represent net purchase price adjustments related to the 2003 acquisition of Octagon. Additions to goodwill in 2005 resulted from the acquisition of Caronia.
Discontinued operations included the results of Pumpkin and Possible Dreams. Pumpkin was a wholly owned subsidiary engaged in the business of designing and distributing Halloween-oriented pumpkin carving kits and related accessories throughout the United States and in Canada. During the fourth quarter of 2003, we committed to a plan to sell the operations of Pumpkin, and in October 2004, we sold substantially all of the assets of Pumpkin for $8,741, which included an additional working capital payment of $1,741. A net loss of $3,928 was recognized on the sale and included in the loss from discontinued operations reported in the consolidated statement of income for the year ended December 31, 2004.
At December 31, 2005 and 2004, debt consisted of the following:
On September 15, 2005, Primrose entered into the Fifth Amendment to Loan Agreement (the “Amendment”). The Amendment provided Primrose with a $1,000 five-year loan (the “Primrose Term Loan”) and extended the maturity of the $1,000 revolving line of credit (the “Primrose Revolver”) until December 31, 2006. The proceeds from the Primrose Term Loan were used to pay a portion of a dividend to the Primrose stockholders (see Note 11). The Primrose Term Loan was repaid in full prior to December 31, 2005. Borrowings under the Primrose Revolver bear interest at LIBOR plus 2.0% or Prime, at the Company’s option.
Revolver, or the Primrose Revolver. WC had outstanding letters of credit aggregating $1,250 at December 31, 2005 and 2004. These letters of credit reduce the available borrowing amount under the WC Revolver on a dollar-for-dollar basis. Accordingly, WC could have borrowed up to a maximum of $6,750 under the WC Revolver or Prior WC Revolver at December 31, 2005 and 2004. The weighted average borrowing rate of debt at December 31, 2005 and 2004 was 6.5% and 5.9% respectively.
Our use of derivative financial instruments is currently limited to interest rate swap agreements utilized to mitigate exposure to changes in interest rates on variable rate debt. We do not use derivatives for trading or speculative purposes.
In February 2004, WC entered into an interest rate swap agreement 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, WC pays a fixed rate of 3.44% and receives 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. To the extent the swap does not provide an effective hedge, changes in the fair value of the swap are recorded in other expense. There was no ineffectiveness recorded through earnings for the 12 months ended December 31, 2005 or 2004. The interest rate swap expires in 2009.
Changes in the fair value of the interest rate swaps were as follows:
The fair value of derivatives at December 31, 2005 is recorded as other assets, and the fair value of derivatives at December 31, 2004 is recorded as other long-term obligations, in the consolidated balance sheets.
During 2004 and 2003, we had issued 500,000 shares of Redeemable Convertible Preferred Stock (the “Preferred Stock”), with a stated redemption value of $10 per share. The Preferred Stock was convertible into Class A Common Stock on a 1:1 basis. The Preferred Stock was redeemable at the option of the stockholder upon the occurrence of certain events or on April 6, 2006. On November 10, 2004, we redeemed all shares of Preferred Stock for $5,000, or $10 per share.
The minority stockholders of WC (with an aggregate ownership interest of 15.6%) and Primrose (with an aggregate ownership interest of 1.5%) have entered into agreements with the Company providing for restrictions on the transfer of such shares, and other related share restrictions. See Note 17 for information with respect to the agreement to sell Primrose.
In September 2005, Primrose paid a dividend of $3,453 to its stockholders. As the 98.5% stockholder of Primrose, we received $3,400 of the dividend and the 1.5% minority stockholders in Primrose received $53. We used the proceeds from the dividend to purchase shares of WC held by minority stockholders in WC as described below.
The fair values of options granted in 2005, 2004 and 2003 were estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions:
Unrecognized share-based compensation expense related to unvested options at December 31, 2005 is $407 and will be recognized as follows: $208 in 2006, $60 in 2007 and 2008, $53 in 2009 and $26 in 2010.
We also grant stock options to certain key employees of Primrose to purchase shares of Primrose. The options are granted at the fair market value of a share of Primrose stock, as determined by the Company’s Board. The options vest ratably over three to five years and expire 10 years from the grant date. For certain option grants to Primrose employees, the option holder was 100% vested with respect to 40% of the total number of stock options granted.
Stock options to acquire 129 shares of WC stock at December 31, 2005 consisted of 63 options at an exercise price of $694 (of which 23 were exercisable) and 66 options at an exercise price of $1,626 (of which 16 were exercisable). There were 628 WC shares available for future option grants.
Stock options to acquire 1,972 shares of Primrose stock at December 31, 2005 consisted of 1,387 options at an exercise price of $500 (of which all are exercisable) and 585 options at an exercise price of $702 (of which 468 were exercisable). There were 628 Primrose shares available for future option grants.
Prior to adopting SFAS 123R, the Company applied the disclosure only provisions of Statement of Financial
The Company’s subsidiaries each sponsor a defined-contribution 401(k) plan in which qualifying employees greater than 21 years of age who meet minimum service requirements may participate. Eligible employees may elect to make pre-tax contributions of up to 15% of their eligible earnings. The subsidiary companies also make matching contributions. At WC, the contribution is equal to 50% of each participant’s contribution up to 6% of eligible compensation, and at Primrose, the contribution is equal to 50% of each participant’s contribution up to 3% of eligible compensation. The aggregate matching contributions were $1,435, $1,162, and $750 for the years ended December 31, 2005, 2004 and 2003, respectively.
The valuation allowance is provided for certain state net operating losses (“NOL”).
A reconciliation of the tax provision at the Federal statutory rate to the reported tax provision is as follows:
At December 31, 2005, Octagon had NOL carryforwards for federal income tax purposes of approximately $11,011. The use of the NOL carryforwards is subject to certain limitations under Internal Revenue Code Section 382. The NOL carryforwards expire between 2018 and 2022.
The amount of goodwill deducted for tax purposes was $2,789, 2,789 and $1,818 for the years ended December 31, 2005, 2004 and 2003, respectively. Approximately $25,000 remains to be deducted for tax purposes through 2017.
(1) The assumed exercise of stock options of subsidiary companies has the effect of reducing our earnings (“diluted earnings”) since our overall ownership interest in the subsidiary companies, and thus our share of the net income of the subsidiaries, would be reduced. The calculation of diluted earnings per share is based on diluted earnings.
The Company has an Advisory Service Agreement with Capital Partners, Inc. (“Capital Partners”), the representative of the Company’s controlling stockholder, whereby Capital Partners provides certain advisory services related to investments, general administration, corporate development, strategic planning, stockholder relations, financial matters and general business policy. The Advisory Services Agreement was approved by the Audit Committee, the Compensation Committee and the full Board of Directors and is effective for the calendar year. It can be terminated by either the Company or Capital Partners upon at least 60 days’ prior written notice to the other. Fees are payable quarterly at the beginning of the quarter and were $1,550, in each of the years ended December 31, 2005 and 2004, and $1,400 in the year ended December 31, 2003. Fees paid to Capital Partners are generally subordinate to the rights of the lenders to the Company. The Company will also reimburse Capital Partners for certain expenses incurred and paid by Capital Partners on the Company’s behalf.
Amounts due to Capital Partners at December 31, 2005 and 2004 were not material.
On December 23, 2005, we entered into the Second Amended and Restated Advisory Service Agreement (the “Amended Advisory Services Agreement”) with Capital Partners. The Amended Advisory Services Agreement is effective January 1, 2006 and the annual fee remains unchanged at $1,550. Under the terms of the Amended Advisory Services Agreement, if the Company is sold prior to June 30, 2006, Capital Partners will continue to provide services under the agreement for a period of six months following the effective date of a sale. In addition, under the Amended Advisory Services Agreement, Capital Partners will provide advisory services to the Company in connection with managing the formal sale process, including in the areas of planning such sale process, selecting and evaluating potential buyers, negotiating directly or indirectly with potential buyers and consummating a sale of the Company, or if applicable, the sale of Primrose and the sale of the balance of the Company in two separate transactions. In exchange for such services, the Company will pay to Capital Partners a sale bonus of $2,000 (the “Incentive Sale Bonus”). The Incentive Sale Bonus will be increased or decreased depending on the ultimate aggregate sale proceeds obtained (the “Adjustment Amount”). In the event a sale of Primrose occurs in a separate transaction, no amount will be due. Rather, the Incentive Sale Bonus, including the Adjustment Amount, will be earned and payable upon the sale of the balance of the Company.
CMI is party to a complaint 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 those of any other Ohio workers’ compensation third-party administrator and do not constitute the unauthorized practice of law.
In May 2004, the Board of Commissioners on the Unauthorized Practice of Law (the “UPL Board”) found that the activities of CMI and its hearing representatives constituted the unauthorized practice of law; CMI appealed these findings to the Ohio Supreme Court (the “Supreme Court”). In December 2004, the Supreme Court ruled that the activities engaged in by CMI and its hearing representatives 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 that were the subject of the original suit were in violation of certain Industrial Commission resolutions.
After hearing oral arguments, the UPL Board issued a recommendation released on December 14, 2005 that CMI did engage in specific activities that constituted the unauthorized practice of law. CMI, along with 80 trade associations, has objected to those recommendations and asked the Supreme Court to consider the matter. The recommendations of the UPL Board included a recommendation that the Supreme Court not assess any civil monetary penalties. The Cleveland Bar Association has filed an objection to the recommendation of the UPL Board relative to the finding of no penalties and requested, in a filing dated February 8, 2006, that a $28,000 assessment be levied against CMI.
The matter is pending a hearing with the Supreme Court. CMI believes its practices were in compliance with the Industrial Commission resolutions and subsequent guidance memorandums, and intends to vigorously defend itself in this
matter. However, at this time, management is unable to evaluate the outcome or determine whether penalties ultimately will be assessed.
We are party to several legal actions arising in the ordinary course of business. It is management’s opinion that we have adequate legal defenses to these actions, and that the resolution of such matters will not have a material adverse effect on our financial condition, results of operations or cash flows.
*Basic and diluted EPS for each quarter is calculated based on the weighted average number of shares outstanding during that quarter, while basic and diluted EPS for the full year is calculated based on the weighted average number of shares outstanding for the year. As a result, the sum of the four quarters’ EPS may not equal the full-year EPS.
(1) The first quarter of 2005 included expenses of $2,100 related to certain supplemental procedures and an internal investigation.
(2) The second quarter of 2005 included the reversal of previously provided tax reserves of $1,684, which management believed were no longer necessary.
(4) Net income in 2004 included a (loss) income from discontinued operations of $(572), $(247), $(1,960) and $1,549 for the first, second, third and fourth quarters, respectively.
(5) Income (loss) available to common stockholders was after a deduction for the accretion of Preferred Stock of $119, $133 and $1,023 for the first, second and third quarters of 2004, respectively. The Preferred Stock was redeemed in October 2004, and the third quarter of 2004 included accelerated accretion to increase the carrying value of the Preferred Stock to its redemption value.
The Company’s investment in subsidiaries is stated at cost plus equity in undistributed earnings of the subsidiaries. The Company has a 98.5% ownership interest in Primrose and an 84.4% ownership interest in WC. During 2005, the Company’s ownership interest in WC increased from 80% to 84.4%. See Note 3.
On January 14, 2004, the Company issued a $30,000 Senior Subordinated Promissory Note (the “Note”) that was due September 30, 2008. The interest rate was 10% per annum and would increase to 16% on September 30, 2004. Due to the availability of less expensive financing alternatives, the Note was prepaid without penalty prior to September 30, 2004.
In October 2003, P.D. Holdings, Inc. (“Possible Dreams”) filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. In November 2004, we settled all outstanding claims against the Company with the bankruptcy Trustee for $442. An after-tax gain of $1,516 was recognized from the settlement and is reflected in other income in the condensed statements of income.
On February 10, 2006, the Company signed a definitive agreement for the sale of Primrose to an affiliate of American Capital Strategies, Ltd. for an aggregate purchase price of $85,000, subject to adjustment. After adjustment for transaction costs and certain items specified in the agreement, the net purchase price is anticipated to be approximately $82,800. The Company expects to net, after taxes, approximately $58,200 for its 91.5% fully diluted interest in Primrose. The sale is subject to customary closing conditions and is anticipated to close by March 31, 2006.
On March 9, 2006, the Company and its WC business entered into a Settlement Agreement and Release with two former executives of the WC business (the “Agreement”). Pursuant to the Agreement, the former executives agreed to three-year covenants not to complete and non-solicitation agreements, the Company and the former executives agreed to be bound by a “drag/tag” arrangement with respect to the shares of WC held by the former executives in the event of a change of control of the Company or WC, the former executives agreed to dismiss their wrongful termination suit with prejudice, and the parties entered into mutual releases and non-disparagement agreements. Under the Agreement, the Company agreed to pay the former executives an aggregate of $1,781, with $846 of that amount payable upon a change of control of the Company or WC. The Company accrued $935 at December 31, 2005, representing the amount payable at the time of the signing of the Agreement and the amounts to be paid on the first and second anniversary date of the signing of the Agreement. The $846 payable upon a change in control of the Company or WC, was not accrued at December 31, 2005.