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. We derived the following selected financial information as of December 31, 2004 and 2005 and for each of the three years in the period ended December 31, 2005 from our audited consolidated financial statements and the related notes included elsewhere in this report. We derived the selected financial information as of December 31, 2001, 2002 and 2003 and for each of the two years in the period ended December 31, 2002 from our audited consolidated financial statements and the related notes not included elsewhere in this report.
Although we were founded in August 1998, we commenced our operations on January 1, 1999. In each year since we commenced operations, we have completed a significant number of acquisitions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Acquisitions.” As a result of our acquisitions, the results in the periods shown below may not be directly comparable.
(a) We adopted SFAS No. 142 on January 1, 2002. Under SFAS No. 142, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are reviewed annually (or more frequently if impairment indicators arise) for impairment. Separable intangible assets that are not deemed to have indefinite lives will continue to be amortized over their useful lives (but with no maximum life). Goodwill amortization was $5.5 million in 2001. In accordance with SFAS No. 142, we recognized an impairment loss on goodwill and identifiable intangible assets not subject to amortization of $0.8 million in 2002, $5.7 million in 2003, $2.4 million in 2004 and 3.1 million in 2005. Prior to the adoption of SFAS No. 142, we accounted for long-lived assets in accordance with SFAS No. 121. For the year ended December 31, 2001, we recorded an impairment loss on goodwill of $2.1 million.
The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report. In addition to historical information, this discussion includes forward-looking information that involves risks and assumptions which could cause actual results to differ materially from management’s expectations. See “Forward-Looking Statements” included elsewhere in this report.
all future earnings of the acquired business in excess of the base earnings up to target earnings; and
Substantially all of our acquisitions have been paid for with a combination of cash and our common stock, valued at its then fair market value. We require our principals to take typically at least 30% of the total acquisition price in our common stock; however, through December 31, 2005, principals have taken on average approximately 41% of the total acquisition price in our common stock. The following table shows acquisition activity (including sub-acquisitions) in the following periods:
Although management believes that we will continue to have opportunities to complete a similar number of acquisitions as we have had in the past three years, there can be no assurance that we will be successful in identifying and completing acquisitions: During 2005, we have completed a number of large acquisitions during comparable time periods in the future. See “Risk Factors-Risks Relating to Our Company-We may be unsuccessful in acquiring suitable acquisition candidates, which could adversely affect our growth.” Any change in our financial condition or in the environment of the markets in which we operate could impact our ability to source and complete acquisitions.
Life insurance commissions and estate planning fees. Insurance and annuity commissions paid by insurance companies are based on a percentage of the premium that the insurance company charges to the policyholder. First-year commissions are calculated as a percentage of the first twelve months’ premium on the policy and earned in the year that the policy is originated. In many cases, our firms receive renewal commissions for a period following the first year, if the policy remains in force. Some of our firms receive fees for the settlement of life insurance policies. These fees are generally based on a percentage of the settlement proceeds. Our firms also earn fees for developing estate plans. Revenues from life insurance activities also include amounts received by our life brokerage entities, including our life settlements brokerage entity, that assist non-affiliated producers with the placement of life insurance.
NFPSI, our registered broker-dealer and investment adviser, also earns commissions and fees on the transactions effected through it. Most principals of our firms, as well as many of our affiliated third-party distributors, conduct securities or investment advisory business through NFPSI. Incidental to the corporate and executive benefits services provided to their customers, some of our firms offer property and casualty insurance brokerage and advisory services. We believe these services complement the corporate and executive benefits services provided to our clients. We earn commissions and fees in connection with these services.
Although our operating history is limited, we believe that our firms earn approximately 65% to 70% of their revenue in the first three quarters of the year and approximately 30% to 35% of their revenue in the fourth quarter.
Operating expenses. Our firms incur operating expenses related to maintaining individual offices, including compensating non-producing staff. Firm operating expenses also include the expenses of NFPSI and NFPISI, two subsidiaries that serve our acquired firms and through which our acquired firms and our affiliated third-party distributors access insurance and financial services products and manufacturers. Amortization and depreciation expense related to our firms are recorded within the respective captions of amortization and depreciation under corporate and other expenses.
Management fees. We pay management fees to the principals of our firms and/or certain entities they own based on the financial performance of the firms they manage. We typically pay a portion of the management fees monthly in advance. Once we receive cumulative preferred earnings (base earnings) from a firm, the principals and/or an entity the principals own will earn management fees equal to earnings above base earnings up to target earnings. An additional management fee is paid in respect of earnings in excess of target earnings based on the ratio of base earnings to target earnings. For example, if base earnings equal 40% of target earnings, we receive 40% of earnings in excess of target earnings and the principal and/or the entity receives 60%. Management fees also include an accrual for certain performance-based incentive amounts payable under our ongoing incentive program. See “Business-Acquisition Model-Performance incentives.”
The ratio of management fees to gross margin before management fees is dependent on the percentage of total earnings of our firms capitalized by us, the performance of our firms relative to base earnings and target earnings, the growth of our firms in the periods after their first three years following acquisition, and the earnings of NFPISI and NFPSI, from which no management fees are paid. Because of our cumulative preferred position, if a firm produces earnings below target earnings in a given year, our share of the firm’s total earnings would be higher for that year. If a firm produces earnings at or above target earnings, our share of the firm’s total earnings would be equal to the percentage of the earnings capitalized by us in the initial transaction, less any percentage due to additional management fees earned under ongoing incentive plans.
The following table summarizes the results of operations of our firms for the periods presented and shows our management fees as a percentage of gross margin before management fees:
General and administrative. At the corporate level, we incur general and administrative expense related to the acquisition of and administration of our firms. General and administrative expense includes compensation, occupancy, professional fees, travel and entertainment, technology, telecommunication, advertising and marketing, internal audit and certain corporate compliance costs. Stock-based compensation expense is disclosed separately.
Stock-based compensation. Stock-based compensation expense consists of expenses for awards (stock options and restricted stock) granted to employees, directors and non-employee principals. Stock options granted to employees through December 31, 2002 were accounted for under the intrinsic-value-based method of accounting in accordance with Accounting Principles Board, or APB, Opinion No. 25. On January 1, 2003, we adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” in accordance with SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” and adopted the “prospective” method of transition. Under this method, the cost of awards granted to employees after January 1, 2003 is included in the determination of net income.
In addition to these incentive programs, we incur stock-based compensation expense related to stock option grants under two incentive programs offered to the principals and certain employees of our earlier acquisitions. As an inducement to the sellers of the first 27 firms we acquired, the first incentive program allowed principals and certain employees to earn options at a fixed exercise price of $10.00 per share. The incentive program under which these stock options were granted expired, and therefore the stock-based compensation expense related to this program has ended. The second program, offered to the sellers of the next 40 firms we acquired, allows principals and certain employees to earn options with a strike price equal to the price of our common stock at the time the options were earned. The second incentive program expired at the end of 2003.
Amortization. We incur amortization expense related to the amortization of intangible assets related to the acquisition of our firms.
Depreciation. We incur depreciation expense related to capital assets, such as investments in technology, office furniture and equipment as well as amortization for our leasehold improvements. Depreciation expense related to our firms as well as our corporate office is recorded within this line item.
Loss (gain) on sale of businesses. From time to time, we have disposed of acquired firms or certain assets of acquired firms. In these dispositions, we may realize a gain or loss on the sale of acquired firms or certain assets of acquired firms.
Non-GAAP financial measures. We analyze our performance using non-GAAP measures called cash earnings and cash earnings per diluted share. Cash earnings are defined as net income, excluding amortization of intangibles, depreciation and impairment of goodwill and intangible assets. Cash earnings per diluted share are calculated by dividing cash earnings as defined above by the number of weighted average diluted shares outstanding for period indicated. We also use non-GAAP measures called gross margin before management fees and gross margin before management fees as a percentage of revenue. We believe these non- GAAP measures provide additional meaningful methods of evaluating certain aspects of our operating performance from period to period on a basis that may not be otherwise apparent under GAAP. Cash earnings and cash earnings per diluted share should not be viewed as substitutes for GAAP net income and GAAP net income per diluted share, respectively. Gross margin before management fees and gross margin before management fees as a percentage of revenue should not be viewed as substitutes for GAAP gross margin and GAAP gross margin as a percentage of revenue, respectively. A full reconciliation of net income to cash earnings and cash earnings per diluted share is provided in the following table:
As a measure of financial performance, we calculate the internal growth rate of the revenue of our firms. This calculation compares the change in revenue of a comparable group of firms for the same time period in successive years. We include firms in this calculation at the beginning of the first fiscal quarter that begins one year after acquisition by us unless a firm has merged with another owned firm or has made a sub-acquisition that represents more than 25% of the base earnings of the acquiring firm. With respect to two owned firms that merge, the combined firm is excluded from the calculation from the time of the merger until the first fiscal quarter that begins one year after acquisition by us of the most recently acquired firm participating in the merger. However, if both firms involved in a merger are included in the internal growth rate calculation at the time of the merger, the combined firm continues to be included in the calculation after the merger. 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-Operations-Sub-Acquisitions.” With respect to dispositions, we include these firms up to the time of disposition and exclude these firms for all periods after the disposition. The calculation described above is not adjusted for intercompany transactions that result in the same item of revenue being recorded by two firms.
Impairment of goodwill and intangible assets. Impairment of goodwill and intangible assets increased $3.3 million, to $8.1 million in 2005 compared with $4.8 million in 2004. The impairments were related to eight firms in 2005 and seven firms in 2004 and resulted in a reduction of the carrying value of the identifiable intangible assets and goodwill associated with these firms to their fair value. As a percentage of revenue, impairment of goodwill and intangible assets was 0.9% in 2005 compared with 0.8% in 2004.
Depreciation. Depreciation expense increased $1.1 million, or 16.4%, to $7.8 million in 2005 compared with $6.7 million in 2004. The increase in depreciation resulted from an increase in the number of owned firms, capital expenditures at our existing firms and at the corporate office. As a percentage of revenue, depreciation expense was 0.9% in 2005 and 1.1% in 2004. Depreciation expense attributable to firm operations totaled $5.3 million and $5.1 million in 2005 and 2004, respectively, which has not been included in “Cost of services”.
Income tax expense. The effective tax rate was 42.1% in 2005 compared with 44.4% in 2004. The effective tax rate differs from the provision calculated at the federal statutory rate primarily because of certain expenses
Year ended December 31, 2004 compared with the year ended December 31, 2003
Net income. Net income increased $16.6 million, or 70.6%, to $40.1 million in 2004 compared with $23.5 million in 2003. The increase in 2004 was primarily a result of the continued growth of existing firms, the acquisition of new firms and a decrease in the estimated effective tax rate to 44.4% in 2004 from 49.8% in 2003.
Commissions and fees. Commissions and fees expense increased $52.2 million, or 46.8%, to $163.8 million in 2004 compared with $111.6 million in 2003. The increase was principally due to business generated by firms which were acquired in 2003 and in 2004, as well as an increased volume of business from our existing firms. As a percentage of revenue, commissions and fees expense increased to 25.6% in 2004 from 24.0% in 2003. The increase as a percentage of revenue was primarily attributable to the impact of two acquisitions completed early in 2004, both of which are wholesale operations that pay out a relatively high percentage of revenue in the form of commissions to producers. Commissions and fees expense from new acquisitions was approximately $28.4 million in 2004. Commissions and fees expense from existing firms was approximately $135.4 million in 2004 compared with $111.6 million in 2003.
Stock-based compensation. Stock-based compensation expense increased $1.2 million to $1.4 million in 2004 compared with $0.2 million in 2003. The increase was primarily due to new awards granted during 2004.
The 2003 amount of $0.2 million includes a reduced accrual for accrued stock-based compensation expense related to options expected to be issued under the option incentive programs (see “Business-Acquisition Strategy-Option incentive programs”). One program expired during the second half of 2002 and the other program expired in the fourth quarter of 2003. In conjunction with the ending of these programs, we reduced accruals for options which were not issued by $2.1 million during 2003. The reduction of these accruals offset option expense of $1.8 million recorded in connection with the option incentive programs and $0.5 million of option compensation expense for the stock-based employee compensation plans. As a percentage of revenue, option compensation expense was 0.2% in 2004 compared with less than 0.1% in 2003.
Impairment of goodwill and intangible assets. Impairment of goodwill and intangible assets decreased $5.1 million, to $4.8 million in 2004 compared with $9.9 million in 2003. The impairments were related to seven firms in 2004 and five firms in 2003 and resulted in a reduction of the carrying value of the identifiable intangible assets and goodwill associated with these firms to their fair value. As a percentage of revenue, impairment of goodwill and intangible assets was 0.8% in 2004 compared with 2.1% in 2003.
(Gain) loss on sale of businesses. Loss on sale of businesses decreased $1.9 million to $(0.1) million in 2004 compared with $1.8 million in 2003. The gain on sale resulted from the disposal of one subsidiary in 2004 and the loss on sale resulted from the disposal of four subsidiaries in 2003.
Interest and other expense. Interest and other expense decreased $0.8 million, or 22.2%, to $2.8 million in 2004 compared with $3.6 million in 2003. The decrease was due to lower average borrowings under our bank line of credit offset, in part, by a $1.1 million write-off of leasehold improvements and furniture and fixtures related to the relocation of our headquarters.
Income tax expense. Income tax expense increased $8.7 million, or 37.3%, to $32.0 million in 2004 compared with $23.3 million in 2003. The increase is a direct result of a 54.1% increase in pretax income for the year ended December 31, 2004 of $72.1 million compared with $46.8 million for the year ended December 31, 2003, offset by a decrease in our effective tax rate to 44.4% from 49.8%. The effective tax rate differs from the provision calculated at the federal statutory rate primarily because of certain expenses that are not deductible for tax purposes, as well as the effects of state and local taxes. The effective tax rate declined in 2004 as a direct result of the proportional increase in pretax income relative to nondeductible expenses, as well as benefits obtained through state tax planning initiatives commenced during the year.
A summary of the changes in cash flow data is as follows (in thousands):
including tax benefit. In 2003 cash provided by financing activities was largely the result of the sale of 4.3 million shares of our common stock in our initial public offering in September 2003 and was partially offset by cash used in the repayment of borrowings under our credit facility.
Some of our firms maintain premium trust accounts, which represent payments collected from insureds on behalf of carriers. Funds held in these accounts are invested in cash, cash equivalents and securities purchased under resale agreements (overnight). At December 31, 2005, we had cash, cash equivalents and securities purchased under resale agreements in premium trust accounts of $52.4 million, a decrease of $1.3 million from the balance of $53.7 million at December 31, 2004. Changes in these accounts are the result of timing of payments collected from insureds on behalf of insurance carriers. At December 31, 2004, we had cash, cash equivalents and securities purchased under resale agreements in premium trust accounts of $53.7 million, an increase of $12.4 million from the balance of $41.3 million at December 31, 2003. The increase was due primarily to acquisitions of firms with premium trust accounts.
Borrowings under our credit facility bear interest, at our election, at a rate per annum equal to (i) at any time when our consolidated leverage ratio is greater than or equal to 1.5 to 1, the ABR plus 0.5% or the Eurodollar Rate plus 1.5% and (ii) at any time when our consolidated leverage ratio is less than 1.5 to 1, the ABR plus 0.25% or the Eurodollar Rate plus 1.25%. As used in the credit agreement, “ABR” means, for any day, the greater of (i) the rate of interest per annum publicly announced by JPMorgan Chase Bank as its prime rate and (ii) the federal funds effective rate in effect on such day plus 0.5%.
Our credit facility is structured as a revolving credit facility and is due on June 15, 2008, unless we elect to convert the credit facility to a term loan, in which case it will amortize over one year, with a principal payment due on December 15, 2008 and a final maturity on June 15, 2009. Our obligations under our credit facility are collateralized by all of our and our subsidiaries’ assets. Up to $10 million of our credit facility is available for the issuance of letters of credit. Our credit facility contains various customary restrictive covenants that prohibit us and our subsidiaries from, subject to various exceptions and among other things, (i) incurring additional indebtedness or guarantees, (ii) creating liens or other encumbrances on property or granting negative pledges, (iii) entering into a merger or similar transaction, (iv) selling or transferring certain property, (v) declaring dividends or making other restricted payments, and (vi) making investments. In addition to the foregoing, the credit facility contains financial covenants requiring us to maintain a minimum interest coverage ratio and a maximum consolidated leverage ratio. As of December 31, 2005, management believes we were in compliance with all covenants under the credit facility.
Our prior borrowings were made under a bank line that was structured as a revolving credit facility and was due on September 14, 2005, unless we elected to convert the credit facility to a term loan, at which time it would have amortized over one year, with a principal payment due on March 14, 2006 and with a final maturity on September 14, 2006.
We had a balance of $40.0 million under our credit facility as of December 31, 2005. There was no outstanding balance under our prior credit facility at December 31, 2004.
During 2004, several of our 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. We have cooperated and will continue to cooperate fully with all governmental agencies.
We cannot predict at this time the effect that any current or future regulatory activity, investigations or litigation will have on our business. Given the current regulatory environment and the number of our subsidiaries operating in local markets throughout the country, it is possible that we will become subject to further governmental inquiries and subpoenas and have lawsuits filed against us. Our ultimate liability, if any, in connection with these matters and any possible future such matters is uncertain and subject to contingencies that are not yet known.
Certain principals and employees of our acquired firms were eligible to participate in two option incentive programs. Under our original option incentive program, principals and certain employees of 27 firms (certain acquisitions that closed during the period from January 1, 1999 to October 1, 1999) were eligible to receive option grants with a $10.00 strike price based on each such firm’s growth in earnings over a three-year measurement period which ended in the fourth quarter of 2002. The second option program was open to principals and certain employees of 40 firms (certain acquisitions that closed during the period from April 1, 1999 to October 31, 2000). Under this program, principals and certain employees of these firms are eligible to receive option grants at the fair market value of our common stock at the time the options were granted based on their firm’s growth in earnings over a three-year measurement period. Both option incentive programs expired and all options earned under these programs have been granted. For the year ended December 31, 2003, previous accruals related to these programs were reduced by $(2.1) million. The reduction of these accruals offset stock-based compensation expense of $1.8 million recorded in connection with the option incentive programs.
In order to better determine the economic value of the businesses we have acquired, we have incorporated contingent consideration, or earnout, provisions into the structure of our acquisitions since the beginning of 2001. These arrangements generally provide for the payment of additional consideration to the sellers upon the firm’s satisfaction of certain compounded growth rate thresholds over the three-year period following the closing of the acquisition. In some cases, contingent consideration may be payable after shorter periods. As of December 31, 2005, 56 acquisitions are within their initial three-year contingent consideration measurement period.
Contingent consideration is recorded when the outcome of the contingency is determinable beyond a reasonable doubt. Contingent consideration paid to the selling stockholders of our acquired firms is treated as additional purchase consideration.
In connection with certain acquisitions, we also have agreed to make certain contingent payments to employees of our acquired firms, contingent upon the satisfaction of established performance milestones. These payments are expensed as employee compensation.
The minimum contingent payments which could be payable as purchase consideration and employee compensation in each year is zero. The maximum contingent payment which could be payable as purchase consideration and employee compensation based on commitments outstanding as of December 31, 2005 consists of the following:
The table below shows our contractual obligations as of December 31, 2005:
In June 1997, the FASB issued SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” This statement establishes standards for the way companies report information about operating segments in financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. In accordance with the provisions of SFAS No. 131, we have determined that we operate in a single segment within the financial services industry entirely within the United States of America and its territories.
We allocate the excess of purchase price over net assets acquired to book of business, management contracts, institutional customer relationships, trade name and goodwill. We amortize intangibles over a 10-year period for book of business, a 25-year period for management contracts and an 18-year period for institutional
In accordance with SFAS No. 144, we recognized an impairment loss on identifiable intangible assets subject to amortization of $4.2 million, $2.4 million and $5.0 million for the years ended as of December 31, 2003, 2004 and 2005, respectively.
cases, our firms receive renewal commissions for a period following the first year, if the policy remains in force. Our firms also earn commissions on the sale of insurance policies written for benefit programs. The commissions are paid each year as long as the client continues to use the product and maintain its broker of record relationship with us. Our firms also earn fees for the development and implementation of corporate and executive benefit programs as well as fees for the duration that these programs are administered. Asset-based fees are also earned for administrative services or consulting related to certain benefits plans. Insurance commissions are recognized as revenue, when the following three criteria are met (1) the policy application is substantially complete, (2) the premium is paid, and (3) the insured party is contractually committed to the purchase of the insurance policy. We carry an allowance for policy cancellations, which is periodically evaluated and adjusted as necessary. Miscellaneous commission adjustments are recorded as they occur. Contingent commissions are recorded as revenue when received which, in many cases, is our 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 obtained prior to receipt of the commission. Certain of our firms may also receive fees for the settlement of life insurance policies. These fees are generally based on a percentage of the settlement proceeds received by their clients, and recognized as revenue when the policy is transferred and the rescission period has ended.
We apply the intrinsic-value-based method of accounting prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations including the Financial Accounting Standards Board, or FASB, Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” an interpretation of APB Opinion No. 25, issued in March 2000, to account for our fixed-plan stock options to employees for options granted through December 31, 2002. Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, “Accounting for Stock-Based Compensation,” established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, we have elected to continue to apply the intrinsic-value-based method of accounting
In connection with the issuance of SFAS 123R the SEC issued, in March 2005, Staff Accounting Bulletin No. 107, “Share-Based Payment” (SAB 107) which stated that a company should present the expense related to share-based payment arrangements in the same line or lines as cash compensation paid to the same employees. Upon adoption of SFAS 123R we will report stock-based compensation expense related to stock awards to employees of our acquired firms in “Cost of services.” Stock-based compensation for stock awards to employees of our acquired firms totaled $0.1 million, $0.2 million and $1.1 million in 2003, 2004 and 2005, respectively.