We conduct our title insurance business operations primarily in leased office space. We currently lease branch offices in approximately 130 locations. Our office leases generally provide for initial terms ranging from three to five years, and our current leases have remaining terms ranging from one to 84 months. We believe that the use of short-term office leases enhances our operating flexibility, which is particularly important because of the cyclical nature of the real estate industry.
The following table contains our selected consolidated financial data as of and for the five fiscal years ended December 31, 2004, which have been derived from our audited consolidated financial statements and notes thereto, with the exception of “Other Data.” You should review the information that we have presented below in conjunction with our consolidated financial statements, related notes and other financial information included elsewhere herein.
(3) Preferred stock is non-convertible and may be redeemed after 2023 for $17.5 million. The preferred stock has an 8% cumulative dividend, payable quarterly.
(4) Represents the percentage of title insurance premiums from policies we issued through our own insurance underwriting subsidiary, which we acquired in September 2002. This percentage declined in 2004 resulting from our acquisition of Nationwide Appraisal, which has historically utilized third-party title insurance underwriters exclusively for the title policies it issued. During 2004, United Capital Title Insurance Company, our title insurance underwriter, commenced efforts to become licensed in additional states in order to capture more of the premiums resulting from title policies we issue.
revenue from the flood zone determination services we provide, we defer a portion of revenue that relates to services we are contractually required provide in future periods. This deferred revenue is reflected in other liabilities on our balance sheet at December 31, 2004. Typically, we receive payment for our services at the time the related real estate transaction closes. In some cases, we bill for services provided, principally related to our Lender Services business, and collect the accounts receivable at a later date.
During fiscal 2005, we anticipate that refinance transactions will decline from record levels experienced in 2003 and 2004, which we expect will result in a decrease in our revenues and profits from existing operations. While we believe mortgage interest rates will begin to rise during 2005, we do not anticipate a dramatic increase, so when coupled with a strong economy, we believe this will continue to provide an attractive environment for residential resales and new home purchases. Additionally, as synergies continue to develop between our Lender Services operations and our traditional title and escrow operations, we believe there is opportunity for profitable growth. However, despite these potentially positive factors, we continue to believe maintaining operating flexibility in 2005 and beyond is imperative. The cyclical nature of the mortgage industry, and hence the title insurance and settlement services industry, requires us to tightly manage operating expense levels in response to market fluctuations. Larger than anticipated declines in revenue or the inability to maintain costs could result in a decline in profitability or future operating losses.
We believe that the estimates and assumptions that are important to the portrayal of our financial condition and results of operations require us to make difficult, subjective and complex judgments, which form the basis for our critical accounting policies. Our most critical accounting policies relate to reserves for title insurance and escrow losses, related contingencies and litigation surrounding title and escrow losses and impairment of intangible assets and long lived assets.
Contingencies and litigation are reviewed by us on an ongoing basis and, in conjunction with legal counsel, determinations are made as to the outcome of any lawsuits and advice of claims. Based on this assessment, any required reserves are reflected in our financial statements. To the extent a litigation claim or other contingency is settled for an amount greater than or less than what was anticipated, the difference would be reflected in a future period.
We perform a test of each reporting unit for which goodwill is attributed to evaluate for any impairment of intangible assets at least annually. This includes, among other things, a review of events or circumstances which would indicate an impairment of goodwill. As required by Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, we completed an annual goodwill impairment test on its reporting units and have determined that each of our reporting units have a fair value in excess of its carrying value. Accordingly, no goodwill impairment has been recorded. Future losses from reporting units to which goodwill is attributed may lead to an impairment charge in future periods.
In May of 2004, we acquired Nationwide Appraisal, which provides appraisal, title and settlement services to its customers in the mortgage and real estate industry through its centralized processing center near Pittsburgh, Pennsylvania. The transaction included a $25.0 million payment of cash and calls for an additional $1.2 million of payments which is planned to be made in March 2005.
We also acquired the assets of Real Estate Appraisal Services, Inc. in November 2004 for $0.8 million in a combination of $0.3 million in cash and $0.5 million in a one year note payable bearing interest of 5.5%.
Included in the results of operations during 2004 was revenue of approximately $38.3 million and pre-tax income of $2.0 million related to the aforementioned operations.
In January 2003, we acquired Land Title of Nevada, Inc. The acquisition marked our entrance into the Las Vegas, Nevada market, adding five branch offices and 94 employees. The transaction included payment of $1.25 million in cash and issuance of a $2.25 million, five-year note to the seller for a total purchase price of approximately $3.5 million.
In September 2002, we acquired Nations Holding Group, including its wholly owned subsidiaries United Title Company, First California Title Company and United Capital Title Insurance Company. The acquisition significantly increased our presence in California and enabled us to internally underwrite the vast majority of all title insurance policies that we issued in 2003. This acquisition has significantly improved the profitability of our existing operations because we no longer have to share all title insurance premiums with third party underwriters on transactions for which we issue and underwrite title insurance policies. The purchase price, including direct transaction costs, was approximately $36.9 million, which consisted of $19.2 million in cash and $17.5 million in redeemable preferred stock. As part of the purchase we also issued warrants, valued at $213,000, to purchase up to 300,000 shares of common stock at an exercise price of $2.27 per share. The redeemable preferred stock includes an 8% cumulative dividend, payable quarterly, and is redeemable after September 2023 at a redemption value of $17.5 million. A seven-year term loan provided $14.0 million to assist in the financing of the cash portion of the purchase price. The term loan, which had a balance of $7.0 million at December 31, 2004, currently bears interest at a fixed rate of 4.75%. We funded the remaining cash portion of the purchase price from our working capital.
As a result of anticipated changes in the interest rate environment in 2005, and the impact that it will have on the demand for our services, we expect a decline in opened orders in 2005 compared to 2004 in our traditional title and escrow operations, resulting in a decrease in title and escrow related revenue. Potential increases in market share and our Lender Services segment may partially offset this anticipated decrease.
The significant components of other income include interest income from invested cash balances and fixed maturity bonds, investment dividends, revenue from servicing seller-financed mortgages and revenue from flood zone determinations services. Other income increased as a percentage of revenue for the year ended December 31, 2004 to 3.4% from 1.8% compared to the prior year. The increase resulted from the inclusion of $1.9 million of flood determination revenue, a new revenue stream in 2004. Additionally, the upward trend in market interest rates and higher investment balances increased investment income in 2004.
Overall operating expenses have increased $42.4 million, or 19.0% for the year ended December 31, 2004, compared to the prior year, primarily resulting from expansion of our operations via acquisitions. Operating expenses as a percentage of total revenue increased to 91.2% for the year ended December 31, 2004 compared to 89.0% for the prior year.
The significant components of other operating expenses include title plant maintenance and access, supplies, utilities, insurance, allowance for bad debt, depreciation, delivery and professional fees. Other operating expenses increased $9.1 million, or 20.8% to $53.1 million for the year ended December 31, 2004 compared to $44.0 million for the prior year. The increase is the result of several costs in this category that vary directly with our volume of business such as title plant and other data purchased from third parties, supplies and delivery expense. Additionally, we experienced an increase in costs related to title plant and other data purchased from third parties, which are typically variable in relation to revenue, but these contractual costs rose in relation to the prior year.
An income tax provision of $10.1 million for the year ended December 31, 2004 provides an effective tax rate of 39.3% for the year ended December 31, 2004. This compares to an effective tax rate of 39.7% for the year ended December 31, 2003.
The significant components of other income include interest income from invested cash balances and fixed maturity bonds, investment dividends and revenue from servicing seller-financed mortgages. Other income decreased as a percentage of revenue for the year ended December 31, 2003 to 1.8% from 3.0% compared to the prior year. The decrease was the result of the larger increase in revenue resulting from title service revenue and escrow and related fees. The overall increases in other income was primarily due to a full year of investment income from our title insurance underwriter, which was acquired in September 2002.
Overall operating expenses have increased $107.4 million, or 93% for the year ended December 31, 2003, compared to the prior year, primarily resulting from expansion of our operations via acquisitions. Operating expenses as a percentage of total revenue decreased to 89.0% for the year ended December 31, 2003 compared to 90.4% for the prior year. The decrease was the result of higher revenue in relation to the fixed costs component of our operating expenses, which include, but are not limited to, occupancy costs, the fixed component of our personnel costs related to management and administration salaries, depreciation and insurance.
Personnel costs are the most significant component of our operating expenses, and consist of salaries and other related personnel expenses, commissions and incentives. Total personnel expenses increased $75.4, or 95.2%, to $154.5 million for the year ended December 31, 2003 compared to the prior year. Salaries and other related personnel expenses, excluding commissions and incentives, decreased as a percentage of total revenue to 41.1% for the year ended December 31, 2003 compared to 43.8% for the prior year, due primarily to increased productivity during the period. Commissions and incentives increased as a percentage of total revenue to 20.6% for the year ended December 31, 2003 compared to 18.2% for the prior year, primarily due to the growth of our California operations, which typically have higher incentive-based compensation packages.
Rent expense decreased as a percentage of revenue for the year ended December 31, 2003 to 5.7% from 6.2% for the prior year. The decrease was the result of the fixed nature of these costs in relation to the increase in revenue. Rent expense overall is higher in 2003 compared to 2002, resulting from additional office locations which were acquired during 2002 and early 2003, as previously discussed.
The significant components of other operating expenses include title plant maintenance and access, supplies, utilities, insurance, allowance for bad debt, depreciation, delivery and professional fees. Other operating expenses increased $19.3 million, or 78% to $44.0 million for the year ended December 31, 2003 compared to $24.7 million for the prior year. The increase is the result of several costs in this category that vary directly with our volume of business such as title plant and other data purchased from third parties, supplies and delivery expense. As a result, for the year ended December 31, 2003, approximately 61% of this expense category is relatively variable in relation to revenue. Other operating expenses decreased as a percentage of total revenue to 17.6% for the year ended December 31, 2003 from 19.4% for the prior year. The decrease as a percentage of revenue in this expense category is a result of expenses which are relatively fixed, such as telecommunication costs, insurance, depreciation and utilities. During 2003, we provided $1.7 million for allowance for uncollectible accounts receivable and subsequently charged $1.4 million against the allowance to write-off accounts receivable that became uncollectible during 2003.
An income tax provision of $10.9 million for the year ended December 31, 2003 provides an effective tax rate of 39.7% for the year ended December 31, 2003. This compares to an effective tax rate of 40.7% for the year ended December 31, 2002.
We require capital above our ongoing operating needs to expand our geographical base, further implement our market penetration program, recruit and train new personnel and purchase additional property and equipment to implement our expansion program. During the year ended December 31, 2004, we financed our operating, business development and acquisition activities through the use of cash on hand, operating cash flows, debt borrowings and a private placement of our common stock. The details of our debt borrowings and private placement of common stock are further discussed below.
In July 2004 we acquired Determination Processing Services, Inc., subsequently renamed Nationwide TotalFlood. Under the terms of the acquisition, approved by the Board of Directors for each company, the purchase price was $1.7 million. The purchase price was financed by cash on hand.
Our Board of Directors declared quarterly cash dividends totaling $0.08 per common share during 2004. We paid a cash dividend totaling $0.4 million on January 10, 2005 to stockholders of record at the close of business on December 27, 2004. This common dividend payable was reflected in accounts payable and accrued expenses on the consolidated balance sheet at December 31, 2004. We intend to continue paying a comparable quarterly cash dividend on our common stock. However, the payment of dividends depends entirely upon a decision by our Board of Directors and may be discontinued at any time, for any reason. Further, under Delaware corporate law, in the absence of current or retained earnings, we may be prohibited from paying dividends, whether in cash or otherwise.
We have two $3.0 million revolving lines of credit. Outstanding borrowings bear interest at the prime rate (5.25% at December 31, 2004). At December 31, 2004, there were no borrowings under either of these credit facilities. There is $0.8 million committed against one of the credit lines for standby letters of credit pursuant to office leases and an insurance policy.
Capital Title Group, Inc. (the “Company”), a Delaware corporation, through its subsidiaries, is engaged in the business of issuing title insurance policies and performing other real estate-related services, such as escrow activities, appraisal services and flood zone determinations. The Company is the parent holding company of the following subsidiaries:
New Century Title Company (“New Century”), a California corporation that commenced operations in July 1998, is an independent title agency that provides escrow and title services to the real estate industry in selected California counties. New Century is licensed to conduct business in San Diego, Orange, Riverside, San Bernardino and Los Angeles Counties. New Century also has operations in northern California, which it obtained by acquisition in November 1998, and expanded through another acquisition in April 2002. New Century’s northern California operations is licensed to conduct business in Sonoma, Sacramento, Contra Costa, Alameda, San Mateo and Santa Clara Counties.
Nations Holding Group (“Nations”), a California corporation, was acquired in September 2002 and includes the following wholly-owned subsidiaries:
United Title Company (“United Title”), a California corporation that commenced operations in 1978, is an independent title agency that provides escrow and title services to the real estate industry in southern California. United Title is licensed in Los Angeles, Riverside, San Bernardino, Orange, San Diego, Ventura and Santa Barbara Counties in California.
First California Title Company (“First California”), a California corporation that commenced operations in 1964 and was acquired by Nations in 1997, is an independent title agency serving the real estate industry with escrow and title services in the northern California Counties of Alameda and Contra Costa.
The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation.
Investments in fixed maturity bonds and equity securities are classified as available-for-sale and, accordingly, are carried at fair value. Fair values of fixed maturity bonds and equity securities are based on quoted market prices.
Title premiums earned and title and escrow fees are recognized as revenue at the time of closing the related real estate transaction. The Company reports title service revenue net of underwriting fees paid pursuant to agreements the Company has with third party title insurance underwriters. Underwriting fees incurred relating to third party title insurance underwriters for the years ended December 31, 2004, 2003 and 2002 were $3.7 million, $3.2 million and $5.4 million, respectively. Revenue from real estate appraisal services, account servicing and other fees are generally recognized when the service is performed. For flood zone determination services, the Company must defer a portion of revenue that relates to services the Company is contractually required to provide in future periods, and recognizes the deferred revenue over the period of time it is contractually required to provide the additional services.
In the ordinary course of business, the Company reinsures certain title insurance risks with another insurer for the purpose of limiting its maximum loss exposure. The Company cedes a portion of certain policy liabilities under an excess loss reinsurance agreement. Reinsurance agreements provide that in the event of loss (including costs, attorneys’ fees and expenses) exceeding the retained amounts, the reinsurer is liable for the excess amount assumed. However, the ceding company remains primarily liable in the event the reinsurer does not meet its contractual obligations. Ceded premiums, expense reimbursements, and benefits are accounted for on a basis consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums ceded have been reported as reduction of title service revenue.
The Company applies the intrinsic-value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, and Interpretation of APB No. 25, issued in March 2000, to account for stock options. 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. FASB Statement 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 Statement No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of Statement No. 123. The following table illustrates the effect on net income if the fair-value-based method had been applied to all outstanding and unvested awards in each period ($ in thousands, except per share data):
The Emerging Issues Task Force (“EITF”) reached a consensus on Issues No. 04-1, Accounting for Pre-existing Relationships between the Parties to a Business Combination for reporting periods beginning after October 13, 2004. This Task Force consensus discusses that consummation of a business combination between two parties that have a pre-existing relationship should be evaluated to determine whether a settlement of a pre-existing relationship exists. We have evaluated this EITF consensus and have determined it will not have a material impact to our consolidated financial statements.
The purchase price, and direct transaction costs were allocated to the assets purchased and liabilities assumed, based on their respective fair values at the date of acquisition. Included in this allocation of the purchase was $23.6 million of goodwill and three other intangible assets; $1.0 million related to existing customer relationships, which will be amortized over a five-year period, approximately $50,000 for a covenant not to compete agreements with former stockholders of Nationwide, which is amortized over the three-year term of the agreement, and approximately $456,000 was allocated to Nationwide’s backlog of opened orders, which was fully amortized during the second quarter 2004. The following table summarizes the estimated fair values of the allocation of the purchase price and direct acquisition costs to the assets and liabilities acquired at the date of purchase ($ in thousands):
The purchase price was allocated to the assets purchased based on their respective fair values at the acquisition date. Included in this allocation of the purchase price was $1.5 million of goodwill and two other intangible assets, approximately $184,000 for a covenant not to compete agreement with the former owner of Land Title, which is amortized over the five-year life of the agreement, and approximately $47,000 was allocated to Land Title’s backlog of opened orders, which was fully amortized during 2003. The following table summarizes the estimated fair values of the allocation of the purchase price and direct acquisition costs to the assets and liabilities acquired at the date of purchase ($ in thousands):
Total current income tax payable was $1.0 million, which was included in Accounts payable and accrued expenses on the accompanying consolidated balance sheet at December 31, 2004.
The activity within the reserve for title insurance and escrow losses is as follows ($ in thousands):
Long term debt components are general obligations of the Company and consist of the following ($ in thousands):
The Company’s future minimum lease commitments after December 31, 2004 were as follows ($ in thousands):
The following supplemental cash flow information is provided with respect to interest and tax payments, as well as certain non-cash investing and financing activities($ in thousands):
Our Board of Directors declared a cash dividend during the fourth quarter 2004 of $0.02 per share to stockholders of record as of December 27, 2004, and we paid this dividend totaling $0.4 million on January 10, 2005.
The Company’s matching contributions were approximately $0.8 million, $0.5 million and $0.2 million for the years ended December 31, 2004, 2003 and 2002, respectively.
The Company maintains an Internal Revenue Code Section 125 Cafeteria Plan as a benefit to its employees. The plan provides for employee and dependent coverage to be paid from before tax compensation. As such, there is no effect on the consolidated financial statements.
The Company’s 1996 Stock Option Plan (“The Plan”) has authorized the grant of common stock options to all the Company’s employees. Currently, 5,650,000 shares of Common Stock are authorized for issuance pursuant to the Plan. As of December 31, 2004, 3,674,526 options are outstanding under the Plan. All options granted have 5-year terms. Fifty percent of each option grant can be exercised after two years from the date granted; the remaining options can be exercised after three years provided the optionee remains employed with the Company at such vesting date. Options granted under the Plan are not transferable and the per share exercise price of an incentive stock option granted under the Plan may not be less than the fair market value of the common stock on the date of grant.
The Company’s Non-Employee Directors Stock Option Plan (“Directors Plan”) has authorized the grant of options to non-employee members of the Board of Directors and advisory boards. Currently, 750,000 shares of Common Stock are authorized for issuance pursuant to the Directors Plan. As of December 31, 2004, 290,000 options are outstanding under the Directors Plan. All options granted have 5-year terms. Fifty percent of each option grant can be exercised after two years from the date granted; the remaining shares can be exercised after three years provided the optionee remains an eligible director at such vesting date. Upon election to the Board of Directors each board member is granted the option to purchase 15,000 shares of common stock. In addition to the foregoing option grants, each year every non-employee director automatically receives an option to acquire 10,000 shares of the Company’s common stock on the third business day following the date the Company publicly announces its annual financial results, provided that such director has attended at least 75% of the meetings of the Board of Directors and the Board Committees of which such non-employee director is a member in the preceding fiscal year.
Changes in the allowance for uncollectible accounts receivable for the years ended December 31, 2004, 2003 and 2002 are as follows ($ in thousands):
The Company’s two reportable segments are Title and Escrow Services and Lender Services. Reportable segments are determined based on the organizational structure, types of products and services and market differentiation. The acquisition of Nationwide precipitated the establishment of the Lender Services segment based upon these factors. Because the operations included in the Lender Services segment were acquired in 2004, there is no comparison of segment results to the prior year presented, as all of the operations in 2003 related to Title and Escrow services.
The following table sets forth unaudited selected quarterly financial data for each quarter of the years ended December 31, 2004 and 2003 ($ in thousands, except per share data):