Our principal executive offices are located in leased premises at 10950 Grandview Drive, Suite 600, Overland Park, Kansas 66210, and our telephone number is (913) 661-0123. In addition to serving as our principal executive offices, this facility also functions as the national sales office, the Kansas City regional franchise sales office and a franchise customer service center.
The properties from which operations are conducted are not materially important to us. Management believes that our facilities will be adequate for current and proposed operations. In management’s opinion, adequate insurance has been purchased for each of the above-referenced properties.
The following income statement data for the years ended December 31, 2004, 2003 and 2002 and balance sheet data as of December 31, 2004 and 2003 are derived from our audited financial statements, which are included elsewhere in this report. The following income statement data for the years ended December 31, 2001 and 2000 and balance sheet data as of December 31, 2002, 2001 and 2000 are derived from our audited financial statements not included in this report. You should read this data together with our financial statements and related notes included elsewhere in this report and the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Brooke Franchise Most of our revenues are from commissions paid to Brooke Franchise, our wholly owned franchise subsidiary, by insurance companies for the sale of insurance policies on a retail basis through exclusive franchisees. Brooke Franchise primarily relies on the recruitment of additional franchisees to increase retail insurance commission revenues. Brooke Franchise’s franchisees specialize in general insurance sales, auto insurance sales, financial services and final expense/funeral services. Brooke Franchise also consults with business sellers and lenders.
Brooke Credit Brooke Credit, our wholly owned finance subsidiary, generates most of its revenues from interest income resulting from loans held on our balance sheet in the form of inventory loans held for sale, which are mostly made to Brooke Franchise’s franchisees. Brooke Credit also generates revenues from gains on the sale of franchisee loans when they are removed from our balance sheet. Brooke Credit funds its loan portfolio primarily through the sale of loan participation interests to other lenders, commercial bank loans secured by loan assets and the sale of securities, backed by loan assets, to accredited investors. During 2003 and 2004, Brooke Credit sold three issues of asset backed securities totaling approximately $52,000,000. During 2004, Brooke Credit secured a $50,000,000 line of credit with DZ Bank AG Deutsche Zentral-Genossenschaftsbank (DZ Bank) for the purpose of warehousing loans until securitized.
Expenses are also expected to continue to increase as a result of opening new franchise locations in 2005. The increase of commission expense in 2004 is primarily attributable to increases in insurance commissions
received from insurance companies, because a share of insurance commissions is typically paid to franchisees. Payroll expenses, which include wages, salaries, payroll taxes and compensated absences expenses, and other operating expenses, which includes advertising, rent, travel, lodging, office supplies and insurance expenses, increased primarily as a result of the expansion of our franchise operations, the opening of additional service/sales centers and the acquisition of Texas All Risk General Agency in 2003. Payroll expenses, as a percentage of total operating revenue, were approximately 20% in 2004, 17% in 2003, and 17% in 2002. Other operating expenses, as a percentage of total operating revenue, were approximately 18% in 2004, 15% in 2003, and 11% in 2002.
Amortization expense increased in 2003 and 2004 primarily as a result of amortization of the servicing asset, which increased significantly as a result of Brooke Credit’s participation loan sales activities.
Depreciation expense increased in 2004 primarily as a result of the renovation of our national office facility in Overland Park, Kansas in the third quarter of 2003. Depreciation expense also increased as the result of equipment purchases associated with the acquisition of Texas All Risk General Agency in 2003. In 2003, depreciation expense increased primarily as a result of the acquisition/renovation of our processing center facility in Phillipsburg, Kansas in the last quarter of 2002.
Net income and net income per share have increased year over year primarily because we have increased the number of new franchises each year and a significant share of our revenues result from initial franchise fees associated with adding new franchise locations. Initial franchise fees typically have larger profit margins than those generated by our other activities.
Assets are expected to continue to increase in 2005 as a result of continued expansion and holding more loans for longer periods of time prior to the sale of participation interests in such loans or securitizing such loans in order to increase interest income. The following table shows selected assets and liabilities (in thousands, except percentages) as of December 31, 2004, 2003 and 2002, and the percentage change from year to year.
The premiums payable liability category is comprised primarily of amounts due to insurance companies for premiums that are billed and collected by our franchisees. Premiums payable decreased in 2004 primarily as a result of an increased emphasis on direct insurance company billing of policies. Premiums payable increased in 2003 primarily as a result of the acquisition of Texas All Risk General Agency, which sells more policies that are agent billed.
Debt increased in 2003 and 2004 primarily to fund increases in our notes receivables and securities.
During 2003, there was an extraordinary reduction in our retained earnings in the amount of $1,957,000 because our stock dividend of 3,820,000 shares at $1.00 par value per share exceeded our paid in capital of $1,863,000. The excess over the paid in capital was allocated to retained earnings.
include recurring revenues, recurring expenses, the ratio of recurring revenues to recurring expenses, non- recurring revenues and the ratio of gain on loan sales to net interest revenues. The following tables provide a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP financial measures for the years ended December 31, 2004, 2003 and 2002.
Recurring expenses, a non-GAAP financial measure, are defined as payroll, other operating expenses and depreciation and amortization. Excluded from recurring expenses are commission expense, other operating interest expense and insurance loss and loss expense incurred because these expenses have been netted against the corresponding revenue. Recurring expenses are generally considered by us to be those expenses that are reasonably likely to be incurred in the next year if no new franchise locations are added. For the years ended December 31, 2004, 2003 and 2002, recurring expenses were $41,438,000, $22,457,000 and $12,094,000, respectively, resulting in ratios of recurring revenues to recurring expenses of 58%, 53% and 47%, respectively. The ratio of recurring revenues to recurring expenses is a non-GAAP financial measure important to us because it helps identify operating losses we would experience in the event that franchise locations are not added and the associated non-recurring initial franchise fees not recorded.
The ratio of gain on sales of notes receivable to net interest revenues is another non-GAAP financial measure important to us. It measures our success in decreasing the relative amount of revenues recorded from gains on sales of notes receivables, which are non-cash revenues and are based on our assumptions. For the years ended December 31, 2004, 2003 and 2002, revenues from gains on sales of notes receivables totaled $2,475,000, $4,368,000 and $2,762,000, respectively, and net interest revenues totaled $4,145,000, $1,154,000 and $240,000, respectively, resulting in ratios of 60%, 379% and 1,151%, respectively.
For the years ended December 31, 2004, 2003 and 2002, we incurred income tax expenses of $3,280,000, $2,083,000 and $747,000, respectively, resulting in effective tax rates of 33%, 33% and 34%. As of December 31, 2004, 2003, and 2002, we had current income tax liabilities of $1,913,000, $1,624,000 and $0, respectively, and deferred income tax liabilities of $481,000, $189,000 and $0, respectively. The deferred tax liability is due to accumulated other comprehensive income that resulted from the sale of notes receivables to participating banks and accelerated depreciation for tax in 2004. We had recorded a deferred tax asset of $160,000 as of December 31, 2002, from the tax benefits resulting from prior period losses. During 2003, all such remaining tax benefits were used.
Brooke Franchise records initial franchise fee revenues for buyers assistance plans using the percentage of completion accounting method, and $410,000, $771,000 and $1,666,000 of initial franchise fee revenues for
Initial Franchise Fees for Start Up Assistance Plans Although Brooke Franchise expects to eventually receive additional initial franchise fees for start up assistance, no such initial franchise fees were received in 2004, 2003 or 2002. A total of 41, 1 and 1 of the new franchise locations in 2004, 2003 and 2002, respectively, represent businesses that were started up as a Brooke franchise and received initial start up assistance.
Seller Related Revenues Seller related revenues typically occur when a business is acquired by Brooke Franchise for sale to a franchisee or an agreement to purchase a business is assigned by Brooke Franchise to a franchisee. Seller related revenues include consulting fees paid directly by sellers, gains on extinguishment of debt to sellers and gains on sale of businesses directly acquired by Brooke Franchise from sellers. Seller related revenues increased $6,022,000, or 133%, to $10,554,000, in 2004 and $2,339,000, or 107%, to $4,532,000, in 2003. Seller related revenues increased in 2004 and 2003 primarily as the result of continued expansion of Brooke Franchise’s franchise operations and the corresponding increase in business acquisitions and franchise conversions by Brooke franchisees.
Consulting fees. Consulting fees paid directly by sellers include services provided by Brooke Franchise to help sellers prepare their businesses for sale by developing business profiles, tabulating revenues, sharing its legal library and general sale preparation. Revenues from consulting fees paid directly by sellers are recognized immediately because Brooke Franchise has no continuing obligation.
Inventory Management The number of total agencies purchased into inventory in 2004, 2003 and 2002 were 51, 50 and 25, respectively. At December 31, 2004, 2003 and 2002, Brooke Franchise held 2, 1 and 1, respectively, insurance agencies in inventory with total balances, at the lower of cost or market, of $1,022,000, $367,000 and $403,000, respectively.
The number of agencies twice-purchased within twenty four months is an important indicator of Brooke Franchise’s success in recruiting qualified buyers. Three of the agencies purchased by Brooke Franchise during 2004 had been first purchased by Brooke Franchise within twenty four months of Brooke Franchise’s second purchase. The purchase prices of those agencies twice-purchased by Brooke Franchise totaled $1,748,000 when first purchased into inventory and $2,153,000 when purchased into inventory the second time. As the result of the sale of twice-purchased agencies, Brooke Franchise recorded a net gain of $311,000 in 2004. None of the agencies purchased by Brooke Franchise during 2003 and 2002 were twice purchased within twenty four months. Brooke Franchise is not aware of any systemic adverse profitability or cash flow trends being experienced by buyers of businesses from its inventory.
The balance of Brooke Franchise’s Allowance for Doubtful Accounts was $575,000 and $45,000, respectively, on December 31, 2004 and 2003. The amount of the December 31, 2004 Allowance for Doubtful Accounts was determined based primarily on the amount of Brooke Franchise’s watch statement balances and our analysis of credit risk. Other factors in determining the Allowance for Doubtful Accounts were statement loss experience, Brooke Franchise’s evaluation of the potential for future losses and Brooke Franchise’s evaluation of the potential for future recoveries.
Credit holds these loans on its balance sheet and earns interest income from the loans. At the time of sale, we may recognize gains related to the portion of the interest income or asset backed securities that we retain. Once a sale is completed, we continue to earn interest income from any portion of the participation interest or asset backed security we retain. We also continue to provide servicing for the loan, including loan accounting, receipt and distribution of interest payments and loan monitoring, and receive compensation for these activities.
To increase recurring revenues from interest income, Brooke Credit retained more loans for longer periods of time prior to the sale of participation interests in such loans or securitizing such loans. Total Notes and interest receivables (net) increased 230% to $49,203,000 at December 31, 2004 from $14,888,000 at December 31, 2003.
Participating Interest Expense A portion of the interest income that Brooke Credit receives on its loans is paid out to the holders of its participation interest. Those payments to these holders are accounted for as participating interest expense, which is netted against interest income. In 2004, participating interest expense increased 48% to $6,767,000 from $4,587,000 in 2003, primarily as a result of the increase in participation interests that were sold in 2004. In 2003, participating interest expense increased 40% to $4,587,000 from $3,284,000 in 2002 as Brooke Credit increased the amount of participation interests sold.
One component of the gain on sales of notes receivable is the gain associated with our ongoing servicing responsibilities. When the sale of a loan participation interest is accounted for as a true sale, Brooke Credit retains servicing responsibilities for which it typically receives annual servicing fees ranging from .25% to 1.375% of the outstanding balance. A gain or loss is recognized immediately upon the sale of a loan participation based on whether the annual servicing fees are greater or less than the cost of servicing, which is estimated at .25% of the outstanding loan balance. The gain or loss associated with loan servicing is determined based on a present value calculation of future cash flows from servicing the underlying loans, net of prepayment assumptions. During 2004, 2003 and 2002, the net gains (losses) from loan servicing totaled $1,998,000, $1,077,000 and $1,262,000, respectively, which consisted of gains from servicing benefits. Losses from servicing liabilities totaled $27,000, $48,000 and $19,000 during 2004, 2003 and 2002, respectively. The decrease in net gains from loan servicing benefits and servicing losses in 2003 is primarily the result of securitization activity and the increase in 2004 is primarily the result of increased loan originations.
In a true sale, Brooke Credit also records a gain on sale for the interest benefit based on a present value calculation of future cash flows of the interest and servicing spread on the underlying loans sold, net of prepayment and credit loss assumptions. This spread is typically approximately 1.75% for participation loans and
Loan Servicing Assets and Liabilities When we recognize non-cash gains for the servicing benefits of loan participation sales, we book that amount as a loan servicing asset on our balance sheet. This amount is equal to our estimate of the present value of future cash flows resulting from the servicing spread. We recognize such assets only when the income allocated to our servicing responsibilities exceeds our cost of servicing, which we typically estimate at 0.25% of the loan value being serviced. Components of the servicing asset as of December 31, 2004 were as follows:
In connection with the recognition of non-cash losses for the servicing liabilities of loan participation sales, the present value of future cash flows were recorded as a servicing liabilities. Components of the servicing liability as of December 31, 2004 were as follows:
Loan Participations-Interest Receivable Asset To the extent that the difference between the rate paid by Brooke Credit to participating lenders and investors and the rate received by Brooke Credit from borrowers exceeds the maximum of 1.375% allocated to the servicing benefit, Brooke Credit recognizes a non-cash asset, called an “Interest Receivable Asset”, on its balance sheet. This amount is equal to our estimate of the present value of future cash flows resulting from this interest spread. Components of the interest receivable asset as of December 31, 2004 were as follows:
* Estimated credit losses from liability on sold recourse loans with balances totaling $3,733,000 as of December 31, 2004. Credit loss estimates are based upon experience, delinquency rates, collateral adequacy, market conditions and other pertinent factors.
Securitization-Interest Receivable Asset The terms of Brooke Credit’s securitizations require the over-collateralization of the pool of loan assets that back the securities sold to investors. Brooke Credit retains ownership of the resulting subordinate interest in the loan pool and borrows money from commercial banks to fund this investment. Brooke Credit therefore retains a credit exposure in each loan pool. As of December 31, 2004 Brooke Credit had subordinate investment interest in loan pools totaling $13,707,000, part of which is the carrying value of our retained interest in asset backed securities, and has borrowed $7,871,000 as of December 31, 2004 from commercial banks to fund this investment.
In connection with the recognition of non-cash gains for the interest benefits of asset backed securities sales, the present value of future cash flows were recorded as an interest receivable asset and included on the balance sheet as part of the investment securities balance. Components of the interest receivable asset as of December 31, 2004 were as follows:
Income Before Income Taxes Brooke Credit’s income before income taxes increased $101,000, or 3%, to $3,351,000 in 2004 and increased $321,000, or 11%, to $3,250,000 in 2003. Although total revenues increased $1,586,000, or 24%, to $8,252,000 in 2004, income before taxes increased marginally because total expenses increased by a similar amount of $1,485,000, or 43%, to $4,901,000. Total expenses in 2004 were significantly affected by a $576,000, or 800% increase in interest expense to $648,000 because Brooke Credit is holding more loans on its balance sheet for longer periods of time which is consistent with our plans to increase net interest revenues and to decrease the relative amount of gains on sale of note receivables. Correspondingly, gains on sale of notes receivable decreased $1,872,000, or 43%, in 2004 to $2,448,000. The increase in net interest revenues had an adverse impact on Brooke Credit’s income before taxes in 2004, but is expected to increase Brooke Credit’s income before taxes in future years. In 2003, gain on sale of notes receivable increased $1,558,000, or 56%, to $4,320,000 but this increase was partially offset in 2003 by the first time assessment of a shared services fee in the amount of $1,200,000.
The terms of Brooke Credit’s securitizations (and a collateral preservation measure) require that payments on the pool of loan assets that back the securities sold to investors be paid from commissions received by Brooke Franchise prior to payment of commissions to the borrower and to most other creditors. As a result, we believe that our primary credit exposure generally results from Brooke Franchise’s collection of monthly franchisees’ statement balances rather than from loan defaults to Brooke Credit. Accordingly, Brooke Credit has not established credit loss reserves separate from the credit loss allowances made on recourse loans referenced above.
Financial Information Financial information relating to Brooke Brokerage and our Insurance Brokerage Segment is as follows (in thousands, except percentages):
Net commission refund expense, or the estimated amount of Brooke Brokerage’s share of wholesale commission refunds due to policyholders resulting from future policy cancellations, increased $24,000, to $87,000, in 2004 and increased $6,000, to $63,000, in 2003. The net commission refund expense increased in 2003 primarily as the result of acquiring Texas All Risk General Agency. On December 31, 2004, 2003 and 2002, Brooke Brokerage recorded corresponding total commission refund liabilities of $455,000, $350,000 and $106,000, respectively.
Brooke Brokerage has also established DB Indemnity, LTD., a captive insurance company wholly owned by Brooke Brokerage, to insure a portion of Brooke Franchise’s professional liability exposure and to provide financial guaranty insurance for Brooke Credit. Although unlikely to have a significant effect on Brooke Brokerage’s long-term profitability, the issuance of policies through DB Indemnity to insure a portion of Brooke Franchise’s professional liability exposure is important to Brooke franchisees and the corresponding premiums are paid by Brooke franchisees. Also, the issuance of financial guaranty policies through DB Indemnity is important to Brooke Credit’s participating lender investors and the corresponding premiums are paid by Brooke Credit’s borrowers.
Income Before Income Taxes Brooke Brokerage’s income before income taxes increased $83,000, or 40%, to $291,000 in 2004 and decreased $453,000, or 69%, to $208,000 in 2003. Income before taxes increased in 2004 primarily as the result of acquiring Texas All Risk General Agency in the fourth quarter of 2003. Income before taxes decreased in 2003 primarily as the result of decreased revenues for CJD & Associates, L.L.C. because access to insurance companies for a niche insurance policy for Home Medical Equipment dealers was interrupted.
Our cash and cash equivalents increased a total of $6,020,000 from December 31, 2003 to December 31, 2004. During 2004, net cash of $5,281,000 was used in operating activities. Cash of $33,834,000 was used to fund an increase in notes receivable and cash of $24,092,000 was provided by an increase in line of credit loans resulting in $9,742,000 in increased notes receivable balances that were not funded by line of credit balances. This increase in notes receivable balances is the primary reason for our negative operating cash flow. Net cash of $9,331,000 was provided by investing activities. A large net cash inflow resulted from business, primarily insurance agency, inventory transactions as cash proceeds of $29,951,000 from sales of business inventory exceeded cash payments of $18,866,000 for purchases of business inventory primarily because cash payments for part of the business purchase prices were deferred. A cash inflow also resulted from the sale of subsidiaries and business assets, primarily auto insurance agencies, as cash proceeds of $12,977,000 from the sale of these assets exceeded corresponding cash purchases of $8,215,000. A cash outflow of $4,882,000 resulted from our purchase of securities related to our loan securitizations in 2004. Net cash of $1,970,000 was provided by financing activities with $19,785,000 of cash provided by loan proceeds from long-term debt and $10,591,000 of cash used to make payments on long term debt.
Our cash and cash equivalents increased a total of $6,531,000 from December 31, 2002 to December 31, 2003. During 2003, net cash of $3,047,000 was used in operating activities. Cash of $9,972,000 was used to fund an increase in notes receivable which is the primary reason for our negative operating cash flow. Cash of $3,509,000 was provided by an accounts receivable decrease which primarily resulted from increased loan balances to franchisees for payment of franchisee statement balances. Cash of $3,097,000 was provided by an increase in accounts and expenses payable which primarily resulted from a $2,739,000 increase in premiums due to insurance companies. Net cash of $4,123,000 was used to fund investing activities. A large net cash inflow resulted from business, primarily insurance agency, inventory transactions as cash proceeds of $17,315,000 from sales of business inventory exceeded cash payments of $10,014,000 for purchases of business inventory primarily because cash payments for part of the business purchase prices were deferred. A cash outflow of $8,516,000 resulted from our purchase of securities related to our loan securitizations in 2003. Net cash of $13,701,000 was provided by financing activities with $14,176,000 of cash provided by loan proceeds on long-term debt and $2,000,000 of cash provided by loan proceeds on short term line of credit borrowings.
Our “Other Assets” account balances totaled $8,719,000, $6,083,000, and $3,963,000 on December 31, 2004, 2003, and 2002 respectively and are comprised primarily of intangible accounts such as excess of cost over fair value of net asset and servicing assets. If our total assets are adjusted to exclude Other Assets, then our total liabilities exceeded our total adjusted assets by $1,383,000, $304,000, and $922,000 on December 31, 2004, 2003, and 2002, respectively. Future acquisitions by us will likely increase the Other Assets account balances and will likely result in total liabilities exceeding adjusted total assets in future periods. Our “Investment in Businesses” account balances of $1,022,000, $367,000, and $403,000 on December 31, 2004, 2003, and 2002, respectively, represent the cost, or market value if lower, of businesses, primarily insurance agencies, held in inventory for resale to franchisees. Although intangible, business inventory is not included in “Other Assets”. We believe that business inventory assets differ from other intangible assets, because business inventory is typically held for a relatively short period of time and has a recently demonstrated value.
We believe that our existing cash, cash equivalents and funds generated from operating, investing and financing activities will be sufficient to satisfy our normal financial needs. Additionally, we believe that funds generated from future operating, investing and financing activities will be sufficient to satisfy our future financing needs, including the required annual principal payments of our long-term debt and any future tax liabilities.
The following summarizes our contractual obligations as of December 31, 2004 and the effect those obligations are expected to have on our liquidity and cash flow in future periods (in thousands):
Our principal capital commitments consist of bank lines of credit, term loans, secured bonds, deferred payments to business sellers and obligations under leases for our facilities. We have entered into enforceable, legally binding agreements that specify all significant terms with respect to the contractual commitment amounts in the table above.
We believe that the following accounting policies are critical. These accounting policies are more fully explained in the referenced footnote number 1 to our consolidated financial statements.
The preparation of our financial statements requires us to make estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and expenses. These significant accounting estimates are summarized in footnote 1(b).
** For the year ended December 31, 2002, the fair value of Robert Orr’s services was estimated at $30,000 even though he did not receive direct compensation from the Company. This value was established after analysis of the time Robert Orr spent on Company activities and not necessarily the amount of contribution made by Robert Orr, the importance of Robert Orr’s contributions, or the Company’s dependence on Robert Orr. On October 1, 2002, Robert Orr began receiving direct compensation from the Company at the rate of $15,000 per month as a result of the increased commitment required from Robert Orr to implement the Company’s plans.
Brooke Credit Corporation, a Kansas corporation, is a licensed finance company that primarily originates loans to insurance related businesses including insurance agencies, financial services practices and funeral homes. Although most of this subsidiary’s loans are made to franchisees, it also makes loans to non-franchised businesses if collateral preservation assistance is provided by Brooke Franchise Corporation. Loans originated by Brooke Credit Corporation are sold on an individual basis to participating lenders or on a pooled basis to investors.
The Brooke Agency, Inc. and Brooke Investments, Inc. subsidiaries acquire businesses and real estate assets for long-term investment. The operations of each acquisition subsidiary are conducted by employees of an affiliated subsidiary of the Company. Separate unaudited financial statements are typically prepared for each acquisition subsidiary because each secures loans from Brooke Credit Corporation and other lenders to fund their acquisitions.
Brooke Investments, Inc. is a Kansas corporation that acquires real estate for lease to franchisees or other purposes. In addition, to help preserve collateral interests, Brooke Investments enters into real estate leases that are subleased or licensed to franchisees.
The DB Group, LTD was incorporated under the laws of Bermuda and is licensed as a Class 3 insurer under the Insurance Act 1978 of Bermuda and related regulations for the purpose of underwriting, as a reinsurer, a portion of the hard to place and niche insurance written by CJD & Associates, L.L.C. There were no premiums written by this subsidiary in 2004 or 2003.
Brooke Agency Services Company LLC is licensed as an insurance agency and was created to offer property, casualty, life and health insurance through the Company’s network of franchisees. Brooke Agency Services Company LLC has acquired ownership of franchise agreements from the Company and/or Brooke Franchise Corporation as part of an arrangement to preserve collateral on behalf of Brooke Credit Corporation as required by the securitization process. Brooke Agency Services Company LLC has contracted with the Company and/or Brooke Franchise Corporation for performance of any obligations to agents associated with all such franchise agreements. The financial information of this subsidiary is consolidated with the Company’s financial information.
Brooke Acceptance Company LLC, Brooke Captive Credit Company 2003, LLC, and Brooke Securitization Company 2004A, LLC are the purchasers of Brooke Credit Corporation loans pursuant to a true sale and the issuer of certain floating rate asset backed notes issued pursuant to various agreements. Brooke Capital Company, LLC was organized in 2004 in anticipation of a 2005 securitization. The financial information of these subsidiaries is not consolidated with the Company’s financial information.
Subsidiaries have been established for contractual operations but any revenues generated by these subsidiaries are assigned to one of the operating subsidiaries for performance of any associated obligations. These subsidiaries include Brooke Life and Health, Inc., The American Heritage, Inc., The American Agency, Inc., Texas All Risk General Agency, Inc., All Risk General Agency, Inc., Brooke Credit Funding LLC, and First Brooke Insurance and Financial Services, Inc.
Subsidiaries have also been established for regulatory, licensing, security or other purposes and do not typically conduct any operations or own any assets. These subsidiaries include Brooke Bancshares, Inc., TAR Holding Company Inc., Brooke Funeral Services Company, LLC, and Brooke Agency Services Company of Nevada, LLC.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of certain assets, liabilities and disclosures. Accordingly, the actual amounts could differ from those estimates. Any adjustments applied to estimated amounts are recognized in the year in which such adjustments are determined.
Amount of future policy cancellations which may result in commission refunds and a corresponding reserve
Amount of future insurance claim losses, loss expense, and earned premium percentages
The discount, prepayment and credit loss rates used to calculate fair value of interest-only strip receivables, servicing assets and servicing liabilities resulting from loan participation sales
Except for the credit loss allowances included in the calculations of retained interests in loans sold, no loss allowances have been made for loans originated by the Company’s finance subsidiary primarily because these loans are typically held for less than one year before sold to investors and therefore have a short term exposure to loss. Additionally, commissions received by the Company’s franchise subsidiary are typically distributed to the finance subsidiary for loan payments prior to distribution of commissions to the franchisee borrower and most other creditors. As a result, the Company’s primary credit exposure more likely results from the collection of franchisees’ account balances than from the collection of loan payments.
The Company estimates that a certain level of accounts receivable, primarily franchisee account balances, will be uncollectible, therefore an allowance has been recognized for uncollectible amounts. The Company’s franchise subsidiary has established allowances of $575,000 and $0 at December 31, 2004 and 2003 respectively, against commission advance amounts owed by franchisees. The Company’s franchise subsidiary regularly assists its franchisees by providing commission advances during months when commissions are less than expected, but expects repayment of all such advances within four months. At December 31, 2004, the amount of allowance was determined after specific analysis of all franchise advances that had not been re-paid in the four month period ended December 31, 2004.
The following schedule entitled “Valuation and Qualifying Accounts” summarizes the Allowance for Doubtful Accounts activity for the years ended December 31, 2004, 2003, and 2002 (in thousands). Additions to the allowance for doubtful accounts are charged to expense. Write offs in 2004 include commission advances to startup franchisees totaling $418,000, most of which we believe will be recovered.
The Company’s brokerage subsidiary has established allowances of $52,000 and $23,000 at December 31, 2004 and 2003 respectively, against amounts owed by agents or insureds. Reserves of $60,000 and $77,000 at December 31, 2004 and 2003, respectively were established for loan loss coverage on financial guaranty policies issued by DB Indemnity, LTD on loans originated by the Company’s finance subsidiary.
As part of its initial services to franchisees, the Company sometimes assists franchisees with the conversion of acquired businesses into its franchise system pursuant to a Buyers Assistance Plan (“BAP”). If part of the initial franchise fees paid by franchisees to the Company is for BAP assistance then the BAP part of the initial franchise fee is allocated to each of the BAP related services provided by the Company and the fee associated with a particular service is recognized as revenue using the percentage of completion accounting method. Substantially all of the BAP services (inspection reports, operations analysis and marketing plan development) are provided by the Company before franchise acquisition. As such, in 2004 approximately 87% of those initial franchise fees related to BAP assistance were immediately recognized as revenue. Remaining BAP related fees are typically recognized throughout the four-month BAP period as the remaining BAP related services are performed.
Revenues from seller consulting fees, gains on sale of businesses, and seller discounts are recognized immediately because the Company has no continuing obligation.
Through its subsidiary DB Indemnity LTD., excess liability premiums are recorded on the written basis and recorded as revenues on a pro-rata basis over the term of the policies. Unearned premium reserves are established to cover the unexpired portion of premiums written and assumed and revenues are correspondingly reduced.
Included in other assets are the unamortized costs of renewal rights purchased by the Company and through subsidiaries (Brooke Life and Health, Inc., The American Agency, Inc., CJD & Associates, L.L.C., TAR Holding Company, Inc. and Texas All Risk General Agency, Inc). The balance is being amortized over a 15-year period using an accelerated 150% declining balance switching to straight-line method. Amortization was $898,000, $291,000 and $163,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
As a result of the acquisition of CJD & Associates, L.L.C. on July 1, 2002, the Company recorded additional Amortizable Intangible Assets of $85,000 (net of accumulated amortization of $111,000).
Net income tax expense is the tax calculated for the year based on the Company’s effective tax rate plus the change in deferred income taxes during the year. During 2003, the deferred tax asset decreased to zero as the
maturity date of the line of credit. Net of amortization, the balance of all such prepaid expenses at December 31, 2004 was $649,000.
As part of its initial services to franchisees, the Company sometimes assists franchisees with the conversion of acquired businesses into its franchise system pursuant to a Buyers Assistance Plan (“BAP”). Substantially all of the BAP services (inspection reports, operations analysis and marketing plan development) are typically provided by the Company before franchise acquisition. However, some BAP related services (advertising and training) are performed during the four months after acquisition and a portion of BAP fees are correspondingly deferred. Unearned Buyer Assistance Plan and other related fees were $410,000 and $771,000 at December 31, 2004 and 2003, respectively.
Cash payments are made monthly to First National Bank of Phillipsburg as trustee for the Industrial Revenue Bonds. These funds are held by the trustee for payment of semi-annual interest and principal payments to bond holders on January 1st and July 1st. The amount of cash held at First National Bank of Phillipsburg at December 31, 2004 and 2003 was $59,000 and $63,000, respectively.
The Company holds insurance commissions for the special purpose entity Brooke Acceptance Company LLC for the purpose of making future loan payments and the use of these funds is restricted until the next monthly loan payment is made. The amount of commissions held at December 31, 2004 and 2003 was $410,000 and $326,000, respectively.
The Company acquired approximately 9% of the stock outstanding in First American Capital Corporation in October, 2003 for $772,000. This investment was subsequently sold in March, 2005 for $770,000.
Insurance losses to be incurred and loss expenses to be paid by the DB Indemnity, LTD. subsidiary are estimated and recorded when advised by the insured. Outstanding losses and loss expense adjustments represent
The Company has granted stock options to employees of the Company pursuant to its 2001 Compensatory Stock Option Plan. The Company’s net income would have been reduced to $6,493,000, $3,952,000, and $1,311,000 for the years ended December 31, 2004, 2003, and 2002 respectively with the Company’s income per fully diluted share being reduced to $.64, $.39 and $.12 at December 31, 2004, 2003, and 2002 respectively, if the compensation cost for the stock options had been determined based on the fair value at the date of grant pursuant to the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”. The Company made the following assumptions when calculating the fair value of the stock option: the expected stock volatility of 30%, risk-free interest rate of 5%, and dividend rate of 1%. See footnote 13 for additional disclosures.
* The Company has a corresponding liability for interest payable to participating lenders in the amounts of $285,000 and $200,000 at December 31, 2004 and 2003, respectively.
On loan participations, the Company is typically paid annual servicing fees ranging from .25% to 1.375% of the outstanding loan balance. In those instances whereby annual service fees paid to the Company are less than the minimum cost of servicing, which is estimated at .25% of the outstanding balance, a servicing liability is recorded. Additionally, the Company often retains interest income. The Company’s right to interest income is not subordinate to the purchaser’s interests and the Company shares interest income with purchasers on a prorata basis. Although not subordinate to purchaser’s interests, the Company’s retained interest is subject to credit and prepayment risks on the transferred assets. Additionally, on loan participations sold with recourse, the Company’s retained interest is subject to credit risk on the transferred assets.
In November 2003, Brooke Credit Corporation sold $23,526,000 of loans to qualifying special purpose entity Brooke Captive Credit Company 2003, LLC. This sale represents a loan securitization for which an interest receivable was retained. Of the loans sold, $18,500,000 of asset backed securities were issued to accredited investors by Brooke Captive Credit Company 2003 LLC. Brooke Credit Corporation received servicing income of $17,000 and $2,000, respectively from the primary servicer for the year ending December 31, 2004 and 2003. The fair value of the difference between loans sold and securities issued to accredited investors and the fair value of interest receivable retained were recorded on the Company’s books as a security with balances of $6,955,000 and $6,924,000, respectively on December 31, 2004 and 2003. This security is comprised of retained interest totaling $984,000 and retained equity in the special purchase entity totaling $5,971,000.
To obtain fair values of retained interests, quoted market prices are used if available. However, quotes are generally not available for retained interests, so the Company typically estimates fair value based on the present value of future expected cash flows estimated using management’s best estimates of key assumptions, credit losses, prepayment speed and discount rates commensurate with the risks involved.
The predominant risk characteristics of the underlying loans of the Company’s retained interest and servicing assets have been analyzed by management to identify how to stratify these assets for the purpose of evaluating and measuring impairment. The underlying loans are very similar in virtually all respects; however management has concluded that those underlying loans with adjustable interest rates should be evaluated separately from loans with fixed interest rates. Accordingly, different key economic assumptions are used when determining the fair value of retained interest and servicing assets resulted from fixed rate loans than have been used for adjustable rate loans. No valuation allowance has been established because the fair value for the adjustable rate loan stratum is not less than the carrying amount of the servicing assets.
Although substantially all of the Company’s loans are adjustable, a discount rate has been applied to reflect the net present value of future revenue streams. As such, changes in the net present value rate, or discount rate, resulting from interest rate variations, would adversely affect the asset’s fair value.
The above adverse changes for prepayment speed and discount rate are calculated on the Company’s retained interests and servicing assets on loans sold totaling $136,288,000. The above adverse changes for expected credit losses are calculated on the Company’s retained interests in loans sold with recourse to participating lenders and loans sold in securitizations.
* Loans 60 days or more past due are based on end of period total loans
Interest incurred on bank loans, notes payable and other long-term obligations for the years ended December 31, 2004, 2003 and 2002 is $3,267,000, $1,241,000 and $749,000, respectively.
Brooke Credit Corporation offered secured bonds (series 2000F) for sale to the public in $5,000 denominations. The bonds were issued in registered form with interest payable semi-annually on January 1st and July 1st of each year. Holders of series 2000F bonds representing $4,315,000 in principal value elected to modify the terms of their bonds by extending the maturity date to July 1, 2006 and permitting the bonds to be called by Brooke Credit Corporation during the period from the original maturity date to the extended maturity date. Holders of series 2000F bonds representing the remaining $705,000 in principal value elected not to modify the terms of their bonds and were paid in full at maturity. Brooke Credit Corporation covenants not to incur debt or obligations superior to its obligations to bondholders or pay dividends to shareholders.
At December 31, 2004 and 2003, the bonds and debentures payable consist of:
Interest payable is $214,000 and $246,000 at December 31, 2004 and 2003, respectively.
Phillips County, Kansas issued Industrial Revenue Bonds in February 2002 for the purpose of purchasing, renovating, and equipping an office building in Phillipsburg, Kansas for use as a processing center. The total bonds issued were $825,000 with various maturities through 2012. The Company leases the building from Phillips County, Kansas although it may be purchased by the Company for a nominal amount at the expiration of the lease agreement. Under the criteria established by SFAS 13, “Accounting for Leases” this asset has been capitalized in the Company’s financial statements.
The Company sells participation interests in loans to numerous banks and finance companies. At December 31, 2004, the Company had sold participation interests in loans totaling $34,091,000 to one financial institution. This represents 33% of the participation interests sold at December 31, 2004, excluding loans sold for securitization.
The Company’s three reportable segments as of and for the years ended December 31, 2004 and 2003 consisted of its Franchise Services Business, Insurance Brokerage Business and its Lending (formerly Facilitator) Services Business. In a change from previous periods, the Company includes all initial franchise fees for basic services, initial franchise fees for buyers assistance plans and seller related fees in its Franchise Services Business segment instead of the Lending Services Business segment because the associated activities are an integral part of franchise services.
The tables below reflects summarized financial information concerning the Company’s reportable segments for the years ended December 31, 2004, 2003 and 2002:
Robert D. Orr and Leland G. Orr own a controlling interest in Brooke Holdings, Inc. which owned 63.06% of the Company’s common stock at December 31, 2004.
Shawn T. Lowry and Michael S. Lowry, President of Brooke Credit Corporation, are the co-members of First Financial Group, L.C. In June 2001, First Financial Group, L.C., guaranteed 65% of a Brooke Credit Corporation loan to Palmer, L.L.C. of Baxter Springs, Kansas and received a 15% profit interest in Palmer, L.L.C. as consideration. The loan was originated on June 1, 2001 and is scheduled to mature on September 1, 2011. At December 31, 2004, the entire loan principal balance of $603,000 was sold to unaffiliated lenders. The Company’s exposure to loss on this loan totals $324,000, which is the recourse obligation by Brooke Credit Corporation on a loan participation balance.
Kyle L. Garst, Senior Vice President of Brooke Franchise Corporation is the sole manager and sole member of American Financial Group, L.C. In October 2001, First Financial Group, L.C. and American Financial Group, L.C. each guaranteed 50% of a Brooke Credit Corporation loan to The Wallace Agency, L.L.C. of Wanette, Oklahoma and each received a 7.5% profit interest in The Wallace Agency. The loan was originated on October 15, 2001 and is scheduled to mature on January 1, 2014. At December 31, 2004 the entire loan principal balance of $369,000 had been sold to unaffiliated lenders. The Company’s exposure to loss on this loan is limited to a recourse obligation by Brooke Credit Corporation on $254,000 of the loan participation balances.
Anita F. Larson, President and Chief Operating Officer of Brooke Corporation, is married to John Arensberg, a partner in Arensberg Insurance of Overland Park, Kansas. Arensberg Insurance is a franchisee of Brooke Franchise Corporation pursuant to a standard form franchise agreement, and utilizes the administrative and processing services of Brooke Franchise Corporation’s service center employees pursuant to a standard form service center agreement. Brooke Franchise Corporation receives in excess of $60,000 in fees from the franchisee in connection with each of these agreements. Prior to 2004, Brooke Credit Corporation made two loans to Arensberg Insurance upon substantially the same terms and conditions as loans were made to other franchise agents. During the fourth quarter of 2004, the loans were paid in full by Arensberg Insurance and, at December 31, 2004, there were no outstanding loan balances.
Anita Lowry is the sister of Robert D. Orr and Leland G. Orr and the mother of Shawn T. Lowry and Michael S. Lowry and is married to Don Lowry. Don and Anita Lowry are shareholders of American Heritage
In November 2003, CJD & Associates, L.L.C. acquired 100% of the outstanding shares of Texas All Risk General Agency, Inc. and TAR Holding Company, Inc. for an initial purchase price of $1,000,000. All of the initial purchase price has been allocated to Amortizable Intangible Assets as disclosed in footnote 1 (g). The sellers are entitled to an increase of the initial purchase price equal to 25% of Texas All Risk’s monthly net revenues during the contingency period of November, 2004 to October, 2008. Any such purchase price increase shall be paid to the sellers monthly during the contingency period and, in accordance with paragraph 28 of FAS 141, “Business Combinations”, the payment shall be recorded as an asset when made. Additional payments of the purchase price have been made in the amount of $472,000 since the initial purchase. Texas All Risk offers hard-to-place and niche insurance as a wholesaler under the trade names of Texas All Risk General Agency and All Risk General Agency.
In February 2004, the Company acquired insurance agency assets from Brent and Haeley Mowery for a total purchase price of $499,000. The Company operates this business asset under the trade name of Brooke Auto Insurance Services of San Leandro, California. Its primary business activities include the sale of auto insurance.
In August 2002, the Company acquired insurance agency assets operating under the trade-name of Bornstein Financial Group for an initial purchase price of $200,000. In August 2003, an additional payment of $100,000 was made and the purchase price increased to $300,000. The seller is not entitled to any additional increases in purchase price based on future revenues. In accordance with FAS 141, “Business Combinations”, this additional payment was recorded as Amortizable Intangible Asset as disclosed in footnote 1 (g). The Company operates this business asset under Brooke Life and Health, Inc. Its primary business activities include the sale of annuities, long term care and final expense insurance to senior citizens.
In July 2002, the Company acquired 100% of the outstanding ownership interest of CJD & Associates, L.L.C. for an initial purchase price of $2,025,000. A portion of the initial purchase price has been allocated to Amortizable Intangible Assets as disclosed in footnote 1 (g). The sellers are entitled to an increase of the initial
purchase price equal to 30% CJD & Associates monthly net revenues during the contingency period of September 1, 2003 to September 1, 2007. Any such purchase price increase shall be paid to the sellers monthly during the contingency period and, in accordance with paragraph 28 of FAS 141, “Business Combinations”, the payment shall be recorded as an asset when made. Additional payments of the purchase price have been made in the amount of $993,000 since the initial purchase. CJD & Associates, L.L.C. offers hard-to-place and niche insurance as a wholesaler under the trade name of Davidson Babcock.
129,760 options to purchase shares were exercisable at December 31, 2004. The following table summarizes information concerning outstanding and exercisable options at December 31, 2004.
Amortization expense for amortizable intangible assets for the years ended December 31, 2005, 2006, 2007, 2008 and 2009 is estimated to be $1,758,000, $1,568,000, $1,401,000, $1,158,000, and $978,000, respectively.
DB Indemnity, LTD. is required by its license to maintain statutory capital and surplus greater than a minimum amount determined as the greater of $120,000, a percentage of outstanding losses or a given fraction of net written premiums. At December 31, 2004 the Company is required to maintain a statutory capital and surplus of $120,000. Actual statutory capital and surplus is $1,053,000 and $301,000 at December 31, 2004, and 2003, respectively. Of the actual statutory capital $120,000 and $120,000 is fully paid up share capital, and accordingly all of the retained earnings and contributed surplus is available for payment of dividends to shareholders.
written premiums. At December 31, 2004 the Company is required to maintain a statutory capital and surplus of $1,000,000. Actual statutory capital and surplus is $1,035,000 and $1,067,000 at December 31, 2004, and 2003, respectively. Of the actual statutory capital $1,000,000 and $1,000,000 is fully paid up share capital, and accordingly all of the retained earnings and contributed surplus is available for payment of dividends to shareholders.
DB Group, LTD. is also required to maintain a minimum liquidity ratio whereby the value of its relevant assets are not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and deposits, investment income accrued and insurance balances receivable. Certain categories of assets do not quality as relevant assets under the statute. The relevant liabilities are total general business insurance reserves and total other liabilities, less sundry liabilities.
The Company had guaranteed the payment of a promissory note in the amount of $500,000 to a funeral home seller on behalf of a franchisee. The contingency was eliminated when the promissory note was paid by the franchisee in February 2005.
On December 16, 2004, the FASB issued SFAS No. 123R, Share-Based Payment. SFAS No. 123R requires companies to expense the value of employee stock options and similar awards. The cost of the awards will be measured at the fair value on the awards’ grant date, based on the estimated number of awards that are expected to vest. Compensation cost for awards that vest would not be reversed if the awards expire without being exercised. When measuring fair value, companies can choose an option-pricing model like Black-Scholes or binominal models. The effective date for public companies is interim and annual periods beginning after June 15, 2005, and applies to all outstanding and unvested share based payment awards at a company’s adoption date. The adoption of SFAS No. 123R for estimated unvested options at the adoption date may have a material effect on our consolidated financial statements. The Company’s compensation committee is considering various options in response to this new pronouncement. As a result, the impact to our consolidated financial statements for future share based payment awards has not been determined.
In March 2005, Brooke Capital Company, LLC, a special purpose entity wholly owned by Brooke Credit Corporation, issued $32,000,000 in asset-backed securities to accredited investors.
Operating results for the quarters ended 2004 and 2003 were as follows: