In the fourth quarter of 2000, net income was $8.3 million; $.65 per diluted share compared with $4.9 million and $.50 per diluted share for the 1999 fourth quarter, an increase of 69.4% in net income and 30.0% in earnings per share.
As we stated in last year's report, our acquisition program remains broadly focused on adding new markets or expanding those in which we already have a presence. We feel we furthered this objective in 2000 by acquiring:
o Compensation Resource Group, a leading company in the executive compensation and benefits market, in the third quarter.
As we have said previously, the companies we acquire are typically privately owned and structured as S corporations for federal income tax purposes, with the income passed on to the shareholders. Our evaluation focus is on the quality of the management and future earnings and growth potential. In the case of life insurance sales acquisitions, we also acquire the financial value embedded in a book of recurring renewal business to be realized for many years after the acquisition takes place. This raises two important financial issues:
Up until now, our future renewal revenue stream has been a major source of collateral for continued acquisitions. As we acquire more businesses that do not have this attribute, our cash flow potential from renewals will be less of a factor to be considered as we seek to expand our borrowing availability.
On March 12, 2001, we acquired the business along with certain assets and liabilities of Rich, Florin/ Solutions, Inc., a Boston, Massachusetts compensation consulting company. The assets acquired include accounts receivable, copyrights and office equipment. The liabilities assumed were for employee benefit obligations existing as of the acquisition date.
The purchase price was $20.8 million; before expenses, consisting of a cash payment at closing of $11.3 million and $9.5 million of contingent payments over the next four years based on the attainment of established financial performance criteria. When earned, the contingent payments will consist of 60% cash and 40% CBH common stock.
o the repayment of approximately $13.0 million of CRG's long-term debt.
For the periods prior to the acquisition, CRG had revenue and net income as follows:
The $25.1 million cash portion of the purchase price was borrowed under our credit facility with Bank One.
In connection with the acquisition, we entered into a bonus arrangement for present and future key executives and employees of CRG. This arrangement will provide for the payment of bonuses of up to $20 million if certain stipulated financial objectives are achieved during the years ended December 31, 2003 to 2005.
In addition to the initial purchase price, $2.0 million of additional cash consideration will be paid in the first quarter of 2002 upon the achievement of a defined performance objective during the eighteen months subsequent to the purchase. This payment, when earned, will be accounted for as additional purchase price to be amortized over the remainder of the original twenty-year period.
On May 5, 2000, we acquired the business of Insurance Alliances Group, Inc. ("IAG"). There were no identifiable assets acquired or liabilities assumed. IAG is a Stamford, Connecticut insurance firm specializing in executive estate planning.
In addition to the purchase price, $167,000 cash and 171,632 shares of our common stock are issuable to the former principals of Christiansen & Associates on the attainment of stipulated financial objectives. These payments, when earned, will be accounted for as additional purchase price to be amortized over the remainder of the original twenty year period.
Upon reaching certain stipulated financial goals, former shareholders of The Watson Company will earn the right to receive up to $900,000 of our common stock based on market values at the time of achievement. These payments, when earned, will be accounted for as additional purchase price to be amortized over the remainder of the original twenty-year period.
In January 2001, the Treasury Department and the Internal Revenue Service served notice on taxpayers of their intent to consider taxing the equity increase in what are known as "equity split dollar" arrangements, to the individual beneficiary of the coverage. Heretofore, the individual did not sustain a tax liability until the policy was closed and the equity distributed. The implementation of this notice may have a negative impact on our ability to market new equity split dollar arrangements and could potentially affect existing split dollar arrangements.
Since our initial public offering on August 19, 1998, our Company has increased in both size and complexity resulting from both internal growth as well as acquisitions. Assisting the reader in assessing our financial performance and preparing statements enhance that understanding, has always been one of our goals. In furtherance of this goal, we are including earnings guidance in the form of a projection with this report.
o program design and administrative service fees paid by clients; and
o First Year Revenue. First year revenue is derived from two principal sources; (a) the commission we earn when the client first purchases the policies underlying the program. It is the financial result of our sales efforts. First year revenue is recognized at the time the application is substantially completed, the client is contractually committed to purchase the insurance policies and the premiums are paid by the client, to the insurance company; and (b) fees for the services we perform in advising our clients on their executive compensation programs. These fees are based on a rate per hour arrangement and are earned when the service is rendered and billed to the client.
o Various consulting fees we may charge incident to the studies we perform in the development of a specific benefit program;
o Fees we charge our clients for the administration of their benefit program.
Both of these fees are recorded as revenue as they are earned in accordance with the governing agreement.
Many of these factors are beyond our control. Sales cycles often take between twelve to eighteen months, with first year revenue coming from a few large cases. Our revenue is thus difficult to forecast, and we believe that comparing our consecutive quarterly results of operations is not necessarily meaningful, nor does it indicate what results we will achieve for any subsequent period.
Years Ended December 31, % Change ---------------------------------- -------------- 2000 1999 1998 00/99 99/98 ----------- ---------- ----------- ------- ------ Total revenue.............. $ 147,613 $ 120,760 $ 74,766 22.2 61.5 Commissions and fees expense (50,804) (53,108) (46,111) (4.3) 15.2 Gross profit............... 96,809 67,652 28,655 43.1 136.1 % of total revenue 65.6% 56.0% 38.3% General and administrative expenses................. 68,189 45,153 19,616 51.0 130.2 % of total revenue 46.2% 37.4% 26.2% Operating income, excluding amortization, and non-recurring expenses................. 28,620 22,499 9,039 27.2 148.9 % of total revenue 19.4% 18.6% 12.1% Interest-- net............. (4,692) (3,219) (2,601) 45.8 23.8 % of total revenue 3.2% 2.7% 3.5% Income taxes............... 8,064 7,866 12,953 Effective tax rate 33.7% 40.8% 201.2% (2.5) (39.3) Income before amortization and non-recurring expenses and income................. 15,864 11,414 (6,515) 38.9 nmf % of total revenue 10.7% 9.5% (8.7)% Amortization, non-recurring expenses and non-recurring income--net of taxes........ 4,416 2,583 (6,106) 70.9 nmf
The major component of the Banking Practice Division is Bank Compensation Strategies. Operating income was up 71.1% or $2.6 million over 1999 because of several factors;
The year 1999 was a particularly difficult year for the banking division as operating expense increases of $5.9 million offset a $6.2 million gross profit improvement over 1998.
The Healthcare Group is the result of our acquiring MCG/Healthcare in April 1999, consequently, 1999 results only reflect nine months of operating performance. On an operating basis, this Division continued to experience the difficulties of healthcare providers, in general. Until the outlook for this industry stabilizes, we do not foresee an appreciable improvement in this Division's financial performance.
Year Ended December 31, Revenue First year......... $6,027 Renewal............ -- ----- Total...... 6,027 Commission expense... -- ----- Gross profit......... 6,027 % of revenue 100.0% ------ Expenses General and administrative....... 4,095 % of revenue 67.9% Amortization of intangibles.......... 626 % of revenue 10.4% ------ Total...... 4,721 Operating income..... $1,306 % of revenue 21.7% ------
As an acquirer, our operating results are significantly influenced by the contributions of our acquired businesses. For reporting purposes, we consider the operating results from any business not appearing in four complete quarters as being from acquisitions. After that, they become part of existing business. An analysis of our operating results, separating acquisitions from existing business is as follows:
In 2000, approximately 12.9% of gross revenue and 9.4% of operating income came from acquisitions while 13.6% of revenue and 25.1% of operating were from acquisitions in 1999. We do not attribute a great deal of significance to these statistics for several reasons:
o acquisitions have made, and will continue to make, a substantial contribution to our operating performance and growth, however, the resources dedicated to our acquisition program could have had an impact on the performance of the existing business had the acquisitions not been made.
In 1998, we recognized a $4.8 million expense for the increased market value of certain put warrants. Other than our employee stock option plans, we do not have any other convertible securities outstanding.
In the fourth quarter of 2000, we received $1.0 million of life insurance proceeds as the result of the death of one of our employees.
Our statutory tax rate is 38%-35% for the federal rate and 4.6% overall for the states, which, when reduced by the federal benefit, is 3%. There are a number of factors that influence our tax rates, the most important of which is the effect of non-deductible amortization arising from our acquisition program. While we make every effort to assure that our tax expense is the lowest we can legally incur, we can give no assurance that our overall effective tax rate can be held to 38%.
2000 1999 1998 -------- -------- ------ Cash and cash equivalents..... $7,598 $4,832 $12,102 Working capital............... $(2,317) $(1,821) $ 7,155 Current ratio-- to one........ .95 .93 1.55 Shareholders' equity per common $ 8.88 $ 6.47 $ 3.62 share(1)...................... Debt to total capitalization(2) 36.5% 40.7% 49.5% - ----------
In addition to our recognized balance sheet assets and liabilities, we have an on going renewal revenue stream, estimated to be $636 million over the next ten years. Discounting these renewals to net present value, adjusted for a 95% persistency rate, at the U.S. Treasury ten year note yield was as follows for the last three years:
Our working capital ratio at December 31, 2000 was .95 to 1 compared to the ratio of .93 to 1 at December 31, 1999. As an acquiring company, a significant amount of borrowing is done to finance our acquisitions. Because of this and the strong cash generated by operations, management has determined to dedicate all excess cash to the reduction of bank borrowings and, as a result, only cash for reasonably foreseeable needs and expenses is retained. It should be noted that our loan agreements do not impose a working capital covenant or restriction. This is because of the value of our renewal revenue.
Acquisitions accounted for $59.2 million of the $62.7 million used in investing activities. The balance was comprised of $3.5 million for purchases of equipment.
The Wamberg Organization $ 4.8 earn out.................. Insurance Alliances Group. 2.9 Pearl Meyer & Partners.... 22.0 Compensation Resource Group 25.1 Forrest, Wagner & Associates 3.5 All Others................ .9 ------ $ 59.2
In an effort to reduce interest costs, all cash beyond reasonably foreseeable needs is used to pay down debt. In September, we sold 1,888,887 shares of common stock to for $25.1 million in a private placement. Approximately $22.0 million was used to pay the debt on our acquisition credit facility.
o London InterBank offered rate, which is based on the published rate at the time of the borrowing and remains fixed at that rate for as long as this segment, or any part of it, is outstanding.
The following table provides information about our debt obligations that are sensitive to changes in interest rates. The table presents principal cash flows and related weighted average interest rates by expected maturity dates totaling $64.6 million.
The table incorporates only those exposures that exist as of December 31, 2000, and does not consider exposures or positions that could arise after that date. In addition, because firm commitments are not represented in the table above, the information presented therein has limited predictive value. As a result, our ultimate realized gain or loss with respect to interest rate fluctuations would depend on the exposures that arise during future periods, prevailing interest rates, and our hedging strategies at that time. There is inherent rollover risk for borrowings as they mature and are renewed at current market rates. The extent of this risk is not quantifiable or predictable because of the variability of future interest rates and our financing requirements.
Securities and Exchange Commission Staff Accounting Bulletin No. 101 -- Revenue Recognition in Financial Statements
Because of our minimal use of derivatives, management does not anticipate that the adoption of the new Statement will have a significant effect on our earnings or financial position. The Statement will require us to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in other comprehensive income until the hedged item is recognized in earnings. The ineffective portion of a derivative's change in fair value will be immediately recognized in earnings.
The risks described below are not the only risks we face. Any of the following risks could have a material adverse effect on our business, financial condition and operating results. Additional risks and uncertainties of which we are unaware or currently believe may be immaterial may also impair our business operations. You should carefully consider these risks in reviewing this Form 10-K, and these risks qualify, in their entirety, each forward looking statement herein.
If any changes in federal tax laws reduce or eliminate these advantages, many policies could be surrendered. As a result, we could lose a substantial amount of renewal income and our ability to write new business could be curtailed.
State governments extensively regulate life insurance activities. We sell our insurance products in all 50 states through licensed insurance producers operating as independent agents as well as Company owned offices. States have broad powers over licensing, payments of commissions, business practices, policy forms and premium rates. Insurance laws related to licensing, marketing activities and the receipt of commissions vary from state to state. While we have not encountered regulatory problems in the past, we cannot assure you that we and the consultants through whom we sell, will always be in compliance with all applicable regulatory requirements of each state.
During the past two years, the Internal Revenue Service ("IRS") has begun two major enforcement initiatives:
(1) To disallow the interest deduction on certain leveraged COLI programs sold prior to 1995. To our knowledge, the IRS has prevailed on every issue it has litigated.
(2) Under a recently issued Treasury Notice, the IRS and the Treasury Department are advising companies of their intent to recant the tax treatment accorded so called "equity split dollar arrangements" wherein the individual insured would be taxed on the increase in his or her equity in the underlying policy.
We are working with a number of industry groups in an effort to mitigate the impact of this Treasury Notice. It is impossible to assess the impact of this enforcement initiated on our business, at this time.
We depend heavily on a select group of insurance companies to underwrite the insurance policies underlying the programs we sell. During 2000, 20 life insurance companies underwrote substantially all of the insurance policies underlying our clients' programs. Seven of these companies accounted for approximately 53.6% of 1999 first year commission revenue and 66.3% of our first year commission revenue for the year ended December 31, 2000. While we are confident they will, we cannot be sure that these relationships will continue or if we will be able to develop relationships with other insurance companies.
Our business is highly competitive. We compete with consulting firms, insurance agents, brokers, third party administrators, producer groups and insurance companies. A number of our competitors offer attractive alternative programs. The direct competitors of our Clark/Bardes Consulting -- Compensation Resource Group division include; Management Compensation Group, Newport Group, TBG Financial, and The Todd Organization.
The competitors of our Banking Practice division include The Benefit Marketing Group; Harris, Crouch, Miller, Scott, Long and Mann; and individual insurance agents where community banks are located. Additionally, the community banking industry is constantly consolidating, which may reduce the number of potential bank clients for our division. The primary competition for our Healthcare Group division is Hewitt Associates, Towers, Perrin; Mercer Consulting Group and Hay Group Inc.
Although Pearl Meyer & Partners is one of the best established firms in the high level executive compensation consulting market, there are a number of firms that offer this service.
Our performance depends largely on the performance of our executive officers and key employees. It is important to us to keep and motivate high quality personnel, especially our management, consultants and program development teams. The loss of the services of any of our key employees particularly W. T. Wamberg, chairman of our board of directors and chief executive officer, William L. MacDonald, president of Clark/Bardes Consulting -- Compensation Resource Group, Richard C. Chapman, president of Banking Practice, Donald C. Wegmiller, president of Healthcare Group and Pearl Meyer, president of Pearl Meyer & Partners division, could have a material adverse effect on our business, financial condition and operating results. We cannot assure you that we will be successful in retaining our key personnel.
o the diversion of our management's time and attention to the negotiation of the acquisition and to the assimilation of the businesses acquired;
o the possible need to modify financial and other systems and add management resources;
When we acquire a company, we normally acquire little in the way of tangible assets such as receivables, furniture and the like. Therefore, virtually the entire purchase price is allocated to intangible assets. Two important elements of our intangible assets affect our cash flow:
o a potential future tax benefit over the next fifteen years. Approximately $141.1 million of our gross intangible assets are expected to be tax deductible.
Net intangible assets arising from our purchased businesses consist of the following:
The amounts allocated to inforce revenue are determined using the discounted cash flow of future commission adjusted for expected persistency, mortality and associated costs. The balance of the excess purchased price over the net tangible assets is allocated to goodwill. The inforce revenue is amortized over its period of duration, which is normally twenty to thirty years. Many factors outside our control determine the persistency of our inforce business and we cannot be sure that the value we allocated will ultimately be realized.
Goodwill is being amortized over periods of twenty to forty years. Non-competition agreements are amortized over five to ten years, according to the terms of the agreements.
Our operating results can fluctuate considerably, especially when compared on a consecutive quarterly basis. Because many of our clients' programs are implemented late in the year, we can experience large increases in both first year and renewal revenue in the fourth quarter. Operating results are also affected by a number of other factors, including:
o new or enhanced programs and services by us or our competitors and client acceptance or rejection;
Delaware law and our charter documents could prevent an unsolicited takeover.
o a board of directors classified into three classes of directors with the directors of each class having staggered, three-year terms;
o our Board's authority to issue shares of preferred stock without shareholder approval; and
o provisions of Delaware law that restrict many business combinations and provide that directors serving on staggered boards of directors, such as ours, may be removed only for cause.
Failure to achieve the projected results could have a severely adverse impact on the market price of our common stock.
During the past year, three lawsuits were filed against us. While we intend to contest these actions and are confident we will prevail, we can offer no assurance that we will.