The following table sets forth selected historical consolidated financial information for the periods ended and as of the dates indicated.
The weighted average number of shares has been adjusted to reflect a 2-for-1 stock split in 2004 and a 6-for-1 stock split in 2003.
(1) Based on net income available to common stockholders (basic) of $9,511, $6,500 and $3,964 for the years ended December 31, 2005, 2004 and 2003, respectively. Net income available to common stockholders (basic) is equal to net income less preferred dividends of $194, $194 and $196 for the years ended December 31, 2005, 2004 and 2003, respectively.
(3) The weighted average number of shares has been adjusted to reflect a 2-for-1 stock split in 2004 and a 6-for-1 stock split in 2003.
(4) Includes special dividend of $0.15 per share paid on August 30, 2004.
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 and from gains on sale of loans when they are removed from our balance sheet. Most of Brooke Credit’s loans are made to Brooke Franchise’s franchisees, although an increasing share of loans have been made to insurance related businesses that are not franchisees. 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.
Brooke Brokerage Our wholly owned insurance and loan brokerage subsidiary generates revenues from commissions paid by insurance companies for the sale of hard-to-place and niche insurance policies on a wholesale basis through non-exclusive agents and our own franchise agents. Brooke Brokerage primarily relies on the recruitment of additional broker agents to increase wholesale commission revenues. Brooke Brokerage Corporation also uses its industry contacts and expertise in insurance brokerage to broker loans for, and consult with, general insurance agencies specializing in hard-to-place insurance sales, captive insurance agencies specializing in captive insurance sales and funeral homes selling final expense insurance.
Operating revenues are expected to continue to increase as a result of opening new franchise locations in 2006. The 2004 and 2005 increases in total operating revenues, and most of the individual revenue categories that make up total operating revenues, are primarily attributable to the expansion of our franchise operations in 2004
and 2005. The 2004 and 2005 increases in interest income (net), primarily resulted from increased loan origination activities, increases in the amount of loans held in inventory for eventual sale and increases in retained interest from loans sold.
Income before income taxes for 2005 increased at a faster rate than net income because we increased our 2005 income tax liability to reflect an increase in the 2005 estimated effective tax rate from 33% to 35%. The increase in the estimated effective tax rate resulted from a preliminary estimate of 2005 taxes and the 2004 actual tax rate.
Net income and net income per share have increased year over year primarily because we have increased the number of new franchises each year. A significant share of our revenues results from initial franchise fees associated with adding new franchise locations. A significant share of our revenues also results from gains recorded on the sale of loans made to new franchisees. Initial franchise fees and gains on sales of loans typically have larger profit margins than those generated by our other activities.
Customer receivables primarily include amounts owed to Brooke Franchise by our franchisees. Customer receivables increased in 2005 and 2004 primarily from continued expansion of our franchise operations. A loss allowance was established for Brooke Franchise’s credit loss exposure to customer receivables (See Franchise Services Segment, below).
Notes receivables include loans made by Brooke Credit to franchisees and others. Notes receivables balances vary, sometimes significantly from year to year, as a result of our decision to temporarily retain more or fewer loans in our “held for sale” loan inventory based on the funds available to us. During 2004, Brooke Credit used its line of credit to increase its notes receivables balances. No loss allowance has been made for the notes receivables held in Brooke Credit’s loan inventory because we typically hold these assets for less than one year and, therefore, have a short-term exposure to loss, and we have experienced limited credit losses (See Lending Services Segment, below). Interest earned not collected on notes (accrued interest income) increased in 2005 and 2004 primarily because we are holding more loans.
Other receivables, which primarily include the estimated amounts due from franchisees for future policy cancellations, fluctuate from year to year as the result of changes in policy cancellation rate calculations.
At present, our profitability is dependent in part on our ability to continue adding locations to our franchise network. As we grow, we believe that our profitability will become less dependent on the opening of new franchise locations and more dependent on the operation of existing franchise locations. We measure our progress in becoming less dependent upon the opening of these new locations by monitoring the following:
For the years ended December 31, 2005, 2004 and 2003, we incurred income tax expenses of $5,261,000, $3,280,000 and $2,083,000, respectively, resulting in effective tax rates of 35%, 33% and 33%. As of December 31, 2005 and 2004, we had current income tax liabilities of $474,000 and $1,913,000, respectively, and deferred income tax liabilities of $5,141,000 and $481,000, respectively. In 2005 we revised the manner in which we calculate taxes and deferred recognition of revenues, for tax purposes, on loans sold until interest payments are actually received. As a result, a significant deferred tax liability was recorded.
Our three reportable segments are Franchise Services, Lending Services and Brokerage Services. The Franchise Services segment includes the sale of general insurance and related services to customers on a retail
basis through franchisees by Brooke Franchise. The Lending Services Segment includes our lending activities through Brooke Credit. The Brokerage Segment includes the sale of hard-to-place and niche insurance and the brokering of loans to other agencies that sell these kinds of insurance.
Financial Information Financial information for the years ended December 31, 2005, 2004 and 2003, and the percentage change between periods, relating to Brooke Franchise and our Franchise Services Segment is as follows (in thousands, except percentages):
Commission expense increased because insurance commission income increased and franchisees are typically paid a share of insurance commission income. Commission expense represented approximately 80%, 81% and 87%, respectively, of Brooke Franchise’s insurance commission revenue for the years ended December 31, 2005, 2004 and 2003.
Brooke Franchise sometimes retains an additional share of franchisees’ commissions as payment for franchisee optional use of Brooke Franchise’s service or sales centers. However, all such payments are applied to service center/sales center expenses and not applied to commission expense. As of December 31, 2005, Brooke Franchise had a total of 24 service centers/sales centers, of which 3 were opened in 2005 and 13 in 2004.
Amortization expenses decreased in 2005 as the result of an internal audit of the amortization calculations on intangible assets performed during the second quarter of 2005. The net book values of the intangible assets were adjusted accordingly.
Net commission refund expense is our estimate of the amount of Brooke Franchise’s share of retail commission refunds due to policyholders resulting from future policy cancellations. This expense increased $2,000 to $39,000 in 2005 and increased $36,000 to $37,000 in 2004 primarily as a result of Brooke Franchise’s continued expansion of franchise operations. As of December 31, 2005 and 2004, Brooke Franchise recorded corresponding total commission refund liabilities of $716,000 and $521,000, respectively.
Initial Franchise Fees for Basic Services A certain level of basic services is initially provided to all franchisees, whether they acquire an existing business and convert into a Brooke franchise or whether they start up a new Brooke franchise. These basic services include services usually provided by other franchisors, including a business model, use of a registered trade name, access to suppliers and license for an Internet-based management system. The amount of the initial franchise fees typically paid for basic services is currently $135,000. We expect the initial franchise fee rate for basic services to increase as demand for access to our trade name, suppliers and business model increases.
Initial Franchise Fees for Buyers Assistance Plans The amount of the total initial franchise fees for all initial services typically varies based on the level of additional assistance provided by Brooke Franchise, which is largely determined by the size of the acquisition. We typically base our initial franchise fees for buyer assistance plans on the estimated revenues of the acquired business. All initial franchise fees are paid to Brooke Franchise when an acquisition closes. We allocate initial franchise fees collected in excess of the initial franchise fee for basic service to initial franchise fees for buyers assistance plans.
A significant part of Brooke Franchise’s commission growth has come from acquisitions of existing businesses that are subsequently converted into Brooke franchises. Brooke Franchise provides assistance regarding the acquisition and conversion of businesses such as inspection report compilation, operations analysis and marketing plan development. The increase of initial franchise fees for buyers assistance plan services resulted from continued expansion of Brooke Franchise’s franchise operations and the corresponding increase in business acquisitions and franchise conversions by Brooke franchisees.
Buyers assistance plans provide initial conversion assistance for recently acquired businesses and BAP services are, therefore, generally not provided to buyers of businesses that are already franchises. In addition, buyers assistance plans are not typically provided to franchisees selling to other franchisees and are not provided to franchisees purchasing businesses that had previously been purchased by Brooke Franchise in the past 24 months. A total of 87, 115 and 59 of the new franchise locations in 2005, 2004 and 2003, respectively, represent businesses that were converted into Brooke franchises and received assistance through initial buyers assistance plans.
Seller Related Revenues Seller related revenues typically are generated when a business is acquired by Brooke Franchise for sale to a franchisee. Seller related revenues include consulting fees paid directly by sellers, gains on sale of businesses from deferred payments, gains on sale of businesses relating to company-owned stores, and gains on sale of businesses relating to inventory. A primary aspect of Brooke Franchise’s business is the buying and selling of businesses. Therefore, all seller related revenues are considered part of normal business operations and are classified on our income statement as operating income. Seller related revenues decreased $2,490,000, or 24%, to $8,007,000, in 2005 and increased $6,031,000, or 135%, to $10,497,000, in 2004. Seller related revenues decreased in 2005 primarily because the gains recorded on the sale of company-owned stores in 2004 was significantly more than the corresponding gains recorded in 2005. Seller related revenues increased in 2004 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. Brooke Franchise helps sellers prepare their businesses for sale by developing business profiles, tabulating revenues, sharing its document library and general sale preparation. The scope of the seller consulting engagement is largely determined by the size of the business being sold. Seller consulting fees are typically based on the transaction value, are contingent upon closing of the sales transaction, and are paid at closing. Brooke Franchise completes its consulting obligation at closing and is not required to perform any additional tasks for the seller. Therefore, seller consulting fees paid directly by sellers are recognized at closing immediately because Brooke Franchise has no continuing obligation. Consulting fees increased from continued
Gains on Sale of Businesses from Deferred Payments. Our business includes the buying and selling of insurance agencies, financial service firms and funeral homes, and occasionally holding them in inventory. When purchasing an agency, we typically defer a portion of the purchase price, at a low or zero interest rate, to encourage the seller to assist in the transition of the agency to one of our franchisees. We carry our liability to the seller at a discount to the nominal amount we owe, to reflect the below-market interest rate. When we sell an acquired business to a franchisee (typically on the same day it is acquired), we generally sell it for the full nominal price (i.e. before the discount) paid to the seller. When the sale price of the business exceeds the carrying value, the amount in excess of the carrying value is recognized as a gain. Gains on sale resulting primarily from discounted interest rates increased $375,000, or 46%, to $1,185,000 in 2005 and increased $193,000, or 31%, to $810,000 in 2004. Because we expect to purchase and sell more agencies in 2006 than in 2005, we expect the level of income recorded from this type of gain on sale of businesses to increase.
Income Before Income Taxes Brooke Franchise’s income before income taxes decreased $1,908,000, or 20%, to $7,686,000 in 2005 and increased $6,044,000, or 170%, to $9,594,000 in 2004. Income decreased in
Company-Owned Stores This discussion of company-owned stores is separated into four store types: 1) inventoried stores, 2) managed stores, 3) pending stores, and 4) developed stores. Inventoried stores include businesses purchased by Brooke Franchise for resale to franchisees. Managed stores include businesses as to which Brooke Franchise has entered into agreements with franchisees to manage stores as a result of lender collateral preservation, the disability of the franchisee, the death of the franchisee or other circumstances. Pending stores include businesses that franchisees have contracted to sell, but the transactions have not yet closed, and Brooke Franchise is managing the store to reduce the likelihood of asset deterioration prior to closing. Managed and pending stores are not recorded as an asset on Brooke Franchise’s balance sheet. However, because Brooke Franchise is entitled by agreement to the income and responsible for the expenses of the business until the agreement terminates or ownership is transferred, such income and expenses of managed and pending stores are recorded to Brooke Franchise’s income statement and we, therefore, include the business in our discussions of company-owned stores. Brooke Franchise occasionally develops a business location that has not been previously owned by a franchisee. Because the store has been developed by Brooke Franchise instead of purchased from third parties, all income and expenses associated with development and operation are recorded as income and expenses, but an asset is not recorded on the balance sheet. Company-owned stores revenues and expenses for years prior to 2005 are not available.
Inventoried Stores The number of total businesses purchased into inventory in 2005, 2004 and 2003 was 69, 51 and 50, respectively. At December 31, 2005, 2004 and 2003, Brooke Franchise held 4, 2 and 1, respectively, businesses in inventory with respective total balances, at the lower of cost or market, of $5,058,000, $1,022,000 and $367,000. Revenues from the operation of inventoried stores for 2005 totaled $1,158,000. Expenses incurred in the operation of inventoried stores for 2005 totaled $994,000.
Managed Stores At December 31, 2005, the total number of businesses managed under contract, but not owned, by Brooke Franchise was 7. Revenues from the operation of managed stores for 2005 totaled $1,561,000. Operating expenses incurred by managed stores for 2005 totaled $1,327,000. Additionally, owner’s compensation expenses incurred by managed stores for 2005 totaled $582,000.
Pending Stores At December 31, 2005, the total number of businesses under contract for sale and managed by Brooke Franchise pending closing of a sale was 2. Revenues from the operation of pending stores for 2005 totaled $1,747,000. Operating expenses incurred by pending stores for 2005 totaled $1,141,000. Additionally, owner’s compensation expenses incurred by pending stores for 2005 totaled $589,000.
experience revenue decreases during the first months of conversion into a franchise, making reliable comparisons difficult. Twenty-four months after initial conversion of an acquired business, Brooke Franchise considers the franchise “seasoned” and the comparison of current to prior year revenues is a more reliable indicator of franchise success. Because there is no conversion process for startup franchises, the associated revenues are included in same store sales calculations immediately after start up. Combined same store sales of seasoned converted franchises and startup franchises decreased 1% in 2005 and increased 1% and 6% in 2004 and 2003, respectively. Same store sales of seasoned franchises decreased 3% in 2005 and increased 0% and 5% in 2004 and 2003, respectively. All same store sales calculations exclude profit sharing commissions. Brooke Franchise believes that the decrease in overall franchise revenue growth rates primarily results from softer industry pricing and a decline of property and casualty insurance premiums causing a corresponding decline in commissions. Brooke Franchise also believes that insurance premium rates, on a general basis, will not increase in 2006.
The following table summarizes the Allowance for Doubtful Accounts activity for December 31, 2005, 2004 and 2003 (in thousands). Additions to the allowance for doubtful accounts are charged to expense.
Brooke Credit typically sells most of the business loans it originates to funding institutions as participation interests and to accredited investors as asset-backed securities. Prior to either type of sale transaction, Brooke Credit typically holds these loans on its balance sheet and earns interest income from the loans. Once a sale is completed, we continue to earn interest income from any portion of the participation interest or asset-backed security we retain, in which we typically record a gain on the sale of the loan. 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.
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. Payments to these holders are accounted for as participating interest expense, which is netted against interest income in the consolidated statements of operations. Participating interest expense increased primarily as a result of the increase in participation interests that were sold by Brooke Credit. Participation interest expense represented approximately 54%, 54% and 66%, respectively, of Brooke Credit’s interest income for the years ended December 31, 2005, 2004 and 2003.
Gain on Sales of Notes Receivable When the sale of a loan is classified as a true sale pursuant to the criteria established by SFAS 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” gains or losses are recognized, loans are removed from the balance sheet and residual assets are recorded. We estimate the value of the residual assets by estimating the present value of the future cash flows from the interest and servicing spread, reduced by our estimate of credit losses and notes receivable prepayments. The interest and servicing spread is the difference between the rate paid by Brooke Credit to participating lenders and investors and the rate received by Brooke Credit from borrowers. Over time, as we receive cash from the payment of interest and servicing income, we reduce the value of the residual asset by writing down the interest asset and amortizing the servicing asset. Revenues from gain on sales of notes receivables increased in 2005 compared to 2004 primarily because Brooke Credit securitized more notes receivables in 2005. Revenues from gain on sale of notes receivable decreased in 2004 compared to 2003 primarily because Brooke Credit securitized fewer notes receivables in 2004. Fewer notes receivable were securitized in 2004 partially because Brooke Credit retained more notes receivables as secured borrowings.
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 0.25% 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 0.25% 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 2005, 2004 and 2003, the net gains (losses) from loan servicing totaled $753,000, $1,971,000 and $1,029,000, respectively, which consisted of gains from servicing benefits of $788,000, $1,998,000 and $1,077,000, respectively, and losses from servicing liabilities totaled $35,000, $27,000 and $48,000, respectively. The decrease in net gains from loan servicing benefits and servicing losses in 2005 is primarily the result of increased securitization activity and relatively fewer loan participation sales. The increase in 2004 is primarily the result of relatively more loan participation sales and less securitization activity.
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 approximately 3.25% for securitized loan pools. During 2005, 2004 and 2003, the net gains from interest benefits totaled $6,705,000, $477,000 and $3,291,000, respectively, which included gross gains from interest benefits of $8,475,000, $2,255,000, $4,199,000, respectively, and losses from write downs of retained interest asset to fair market value of $1,770,000, $1,778,000, $908,000, respectively. The increase in net gains from interest benefits
Gains (losses) from servicing and interest benefits are typically non-cash gains (losses) as Brooke Credit receives cash equal to the carrying value of the loans sold. A corresponding adjustment has been made on the Statement of Cash Flows to reconcile net income to net cash flows from operating activities. Gain-on-sale accounting requires us to make assumptions regarding prepayment speeds and credit losses for participated loans and asset-backed securities. The performances of these loans are extensively monitored, and adjustments to these assumptions will be made if necessary. Underlying assumptions used in the initial determination of future cash flows on the participation loans and asset-backed securities accounted for as sales include the following:
The most significant impact from the sale of loan participations and asset-backed securities has been the removal of loans from Brooke Credit’s balance sheet that Brooke Credit continues to service. As of December 31, 2005, December 31, 2004 and December 31, 2003, the balances of those off-balance sheet assets totaled $233,473,000, $138,740,000 and $101,922,000, respectively. The increased level of off-balance sheet assets is primarily the result of a larger loan portfolio and the resulting sale of loan participations and asset-backed securities.
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, 2005 were as follows:
* Estimated credit losses from liability on sold recourse loans with balances totaling $3,807,000 as of December 31, 2005. 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. Additionally, Brooke Credit recognizes a non-cash gain from subordinate interests in the securitized loan pools which are not sold to outside investors and are retained by us. Brooke Credit, therefore, retains a credit exposure in each loan pool. Brooke Credit Corporation’s subordinate interest and retained interest benefit results in a non-cash asset, which is included within “Securities” on our balance sheet. As of December 31, 2005, $44,681,000 of the securities resulted from retained interest in securitizations. The fair value of these securities is comprised of the subordinate or equity interest in the securitized loan pools totaling $33,523,000 and the interest-only strip receivable asset, evidencing retained interest benefits, totaling $11,158,000. As of December 31, 2005, Brooke Credit had borrowed $19,715,000 from commercial banks, the proceeds of which were used to fund its equity interest in the securitized loan pools.
Components of the interest receivable asset as of December 31, 2005 were as follows:
Inventoried loans totaled $43,941,000 and $44,644,000 at December 31, 2005 and 2004, respectively, of which $627,000 and $135,000 were delinquent 60 days or more at December 31, 2005 and 2004, respectively.
Insurance Brokerage Revenues Insurance commissions, primarily from policies sold on a non-exclusive wholesale basis through insurance agents, increased in 2005 primarily as the result of increased profit sharing commissions. Insurance commissions increased in 2004 primarily as a result of the acquisition of Texas All Risk General Agency in November 2003. Brokerage insurance commissions are expected to decrease in 2006 due to the sale of Texas All Risk General Agency in November 2005.
Loan Brokerage Revenues Beginning in November 2005, Brooke Brokerage, through its CJD & Associates, L.L.C. wholly owned subsidiary, began using its industry contacts and expertise in insurance brokerage to broker loans for, and consult with, general insurance agencies specializing in hard-to-place insurance sales, captive insurance agencies and funeral homes selling final expense insurance. Brooke Brokerage received consulting fees from several borrowers in 2005 including fees associated with the sale of Texas All Risk General Agency. Consulting fees from borrowers are expected to increase in 2006.
Brooke Brokerage had established DB Indemnity, Ltd, a captive insurance company to insure a portion of Brooke Franchise’s professional liability exposure and to provide financial guaranty insurance for Brooke Credit. Beginning in 2006, the professional liability exposure of Brooke Franchise will be insured through The DB Group, Ltd. In December 2005, Brooke Brokerage sold DB Indemnity, Ltd to Brooke Investments, Inc, a sister company, but the captive insurance company will continue to issue financial guaranty policies to Brooke Credit. The issuance of financial guaranty policies through DB Indemnity, Ltd is important to Brooke Credit’s participating lender investors and the corresponding premiums are paid by Brooke Credit’s borrowers. As of December 31, 2005, DB Indemnity, Ltd had financial guaranty policies in force covering principal loan balances totaling $64,018,000 and a professional liability policy covering Brooke Franchise franchisees with a policy limit of $2,000,000, which only applies after coverage of $5,000,000 provided by unaffiliated insurers is exhausted.
DB Indemnity premiums decreased $24,000, or 2%, to $1,020,000 in 2005 from $1,044,000 in 2004. DB Indemnity’s first year of operation was 2003. DB Indemnity has not incurred any claims or loss expense since beginning operations. As of December 31, 2005, 2004 and 2003, DB Indemnity recorded corresponding total reserves of $734,000, $719,000 and $135,000, respectively.
Income Before Income Taxes Brooke Brokerage’s income before income taxes increased significantly in 2005 primarily as the result of initiating its loan brokerage and consulting activities and the resulting fees generated from these activities.
Our cash and cash equivalents were $12,321,000, $19,761,000 and $13,741,000 as of December 31, 2005, 2004 and 2003, respectively. Our current ratios (current assets to current liabilities) were 2.08, 1.49, and 1.83 at December 31, 2005, 2004 and 2003, respectively. The increase in our current ratio from 2004 to 2005 is primarily the result of an equity offering in 2005 and an increase in securities related to our loan securitizations in 2005, the purchase of which was primarily financed with long-term debt. The decrease in our current ratio from 2003 to 2004 is primarily due to an increase in short-term debt and current maturities of long-term debt from deferred payments to sellers on acquired business inventory. Our current ratio and cash balances will be adversely affected if business inventory increases, seller loan balances are prepaid, or additional notes are retained in our portfolio.
Our cash and cash equivalents decreased a total of $7,440,000 from December 31, 2004 to December 31, 2005. During 2005, net cash of $3,720,000 was used in operating activities. A cash inflow of $14,318,000 resulted from deferred payments to sellers for business inventory while cash of $4,036,000 was used to fund an increase in inventory. Net cash of $11,619,000 was also used to fund a decrease in other liabilities, which resulted primarily from a decrease in line of credit loan balances from loan securitization activity. Net cash of $19,885,000 was used in investing activities primarily as the result of a cash outflow in the amount of $21,778,000 for the purpose of acquiring subordinate investment interests in securitized loan pools. Net cash of $16,165,000 was provided by financing activities primary as the result of a cash inflow of $31,021,000 from issuance of 2,875,000 shares of the Company’s stock in a follow-on stock offering to the public. Offering proceeds of $12,186,000 were used to pay long-term debt and offering proceeds of $4,315,000 were used to repay bonds.
Brooke Corporation As a holding company, Brooke Corporation’s primary sources of revenues are derived from its operating subsidiaries from administrative services fees, income tax sharing arrangements and dividends. We believe that these sources of revenues are sufficient to fund Brooke Corporation’s normal operations and pay its corporate expenses, income taxes and dividends.
Brooke Franchise Our franchise subsidiary typically generates sufficient cash from its operating and investing activities to satisfy its normal capital needs, including the funding of its business inventory and franchise statement balances. However, to generate sufficient cash to meet its capital needs, Brooke Franchise is largely dependent on the recruitment of additional franchisees and on the availability of loans for these new franchisees from Brooke Credit. Cash of $9,446,000 and $14,063,000, respectively, was generated from franchise operating activities in 2005 and 2004. Additional cash of $12,176,000 and $15,847,000, respectively, was generated from the purchase and sale of subsidiaries, business assets and inventory in 2005 and 2004.
increase again in 2006. The capital and loan funding needs of Brooke Credit are largely met through the sources discussed below. However, to fund this anticipated loan growth in 2006, additional Brooke Credit common equity, or alternative types of equity, may also be required to improve capital-to-asset ratios, fund collateral margin requirements of bank lines of credit, fund increases in loan inventory or fund purchases of securities associated with loan securitizations. If additional equity is required, Brooke Credit does not intend to rely on equity investments from Brooke Corporation and will solicit investments from other investors.
Brooke Brokerage Brooke Brokerage used $5,254,000 and generated $1,586,000 in cash from operating activities in 2005 and 2004. During 2006, we expect to invest $10,000,000 in Brooke Brokerage if its regulatory application to become a savings and loan holding company through acquisition of federal savings bank is approved.
The following summarizes our contractual obligations as of December 31, 2005 and the effect those obligations are expected to have on our liquidity and cash flow in future periods (in thousands):
* Includes interest on short-term and long-term borrowings. For additional information on the debt associated with these interest payments see footnotes 4, 5 and 6 to our consolidated financial statements.
Our principal capital commitments consist of bank lines of credit, term loans, 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.
change the estimated commission payout rates based on the actual average commission payout rates. The commission payout rate used in 2005 to estimate franchisees’ share of undistributed commissions was 80% and the actual average 2005 commission payout rate to franchisees (net of profit sharing commissions) was 80%. We believe that these estimates will not change substantially in 2006.
Allowance for Doubtful Accounts Our allowance for doubtful accounts is comprised primarily of allowance for estimated losses related to amounts owed to us by franchisees for short-term credit advances, which are recorded as monthly statement balances, and longer-term credit advances, which are recorded as non-statement balances. Losses from advances to franchisees are estimated by analyzing all advances recorded to franchise statements that had not been repaid within the previous four months; all advances recorded as non-statement balances for producers in the first three months of development; total franchise statement balances; total non-statement balances; historical loss rates; loss rate trends; potential for recoveries; and management’s experience. Loss rates will vary and significant growth in our franchise network could accelerate those variances. The effect of any such variances can be significant. The estimated allowance for doubtful accounts as of December 31, 2005 was $716,000. The estimated allowance was approximately 25% of the actual amount of 2005 losses from advances made to franchisees, approximately 10% of the actual total combined franchise statement and non-statement balances as of December 15, 2005, and approximately 30% of the actual combined advances recorded to franchise statements that had not been repaid during the four-month period ending December 15, 2005 and recorded as non-statement balances for producers in the first three months of development. We believe that this estimate will increase during 2006 primarily as a result of our growing franchise operations and increased emphasis on producer development for startup franchises.
Loan participations and loan securitizations represent the transfer of notes receivable, by sale, to “participating” lenders or special purpose entities. The fair value of retained interests and servicing assets resulting from the transferred loans are recorded in accordance with the criteria established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” We typically estimate fair value based on the present value of future expected cash flows, which requires us to make assumptions about credit losses, prepayment speed and discount rates. Most of our loans are adjustable rate loans on which in 2005 we assumed credit losses of 0.5% each year, prepayment speeds of 10.0% each year and a discount rate of 11.0%. These assumptions are made based on historical comparisons, management’s experience and the trends in actual and forecasted portfolio prepayment speeds, portfolio credit losses, risk free interest rates and market interest rates. During the fourth quarter 2005 the discount rate assumption was changed from 8.5% to 11.0%. Although we regularly analyze the accuracy of our assumptions of prepayment speeds, credit losses and discount rate and make changes when necessary, we believe that additional changes are unlikely in 2006. As of December 31, 2005, we tested retained interests for impairment and the resulting analysis of prepayments speeds
Loan Origination Expenses Brooke Credit typically sells loans soon after origination and retains responsibility for loan servicing. However, most of Brooke Credit’s operating expenses are associated with loan origination. We analyze our lending activities to estimate how much of Brooke Credit’s operating expenses should be allocated to loan origination activities and, therefore, matched, or offset, with the corresponding loan origination fees collected from borrowers at loan closing. The estimated allocations of payroll and operating expenses to loan origination activities are based on management’s observations and experience; job descriptions and other employment records; and payroll records. Although not expected, significant changes in our estimation of expense allocations could significantly impact our results because loan fee amounts are significant to us. We believe that this estimate will increase during 2006 primarily as a result of our growing loan origination activity.
As part of our ongoing operations, we make loans to franchisees and others to fund purchases or startups of insurance agencies or funeral homes or ongoing working capital needs. We engage in the sale of loan
The following table reports for each of the five securitizations in which we have been involved during fiscal years 2003, 2004 and 2005 (1) the amount of loans sold to a qualifying special purpose entity, (2) the amount of asset-backed securities issued as a part of the securitization, (3) the fair value of the difference between loans sold and securities issued to accredited investors and the fair value of the interest receivable retained recorded as a security for the period ended December 31, 2005, (4) the portion of the security comprised of retained interest, and (5) the portion of the security comprised of retained equity in the special purchase entity.
Components of the loan servicing asset, servicing liability, interest receivable asset relating to loan participation sales as of December 31, 2005 were as follows (in thousands):
Retained Securities 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. As such, our retained interest is subject to credit and prepayment risks on the transferred assets. As of December 31, 2005, Brooke Credit had subordinate investment interest in loan pools totaling $44,681,000, part of which is the carrying value of our retained interest in asset-backed securities, and has borrowed $19,715,000 as of December 31, 2005 from commercial banks to fund this investment.
the absence of any material downgrading or withdrawal of ratings given to securities previously issued in our securitizations.
One of our goals is to fund an increasing number of originated loans through our line of credit with DZ Bank, leading up to the time of loan securitizations. To do so, our debt is expected to increase. The increase in our debt may cause our network of participating lenders to become uncomfortable and, as a result, we may not be able to sell participation interests in loans we originate on terms acceptable to us or at all. Such result would have a material adverse effect on our operations and prospects for growth. Accordingly, we are cautiously monitoring our increased debt totals resulting from DZ Bank funding activities and the comfort of the network of participating lenders and will modify our method of funding practices as needed to maintain a significant network of purchasers of loans.
Proposed Accounting Changes In August 2005, the Financial Accounting Standards Board (FASB) issued three exposure drafts which amend Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The final standards are scheduled to be issued during the calendar year 2006.
The first exposure draft seeks to clarify the derecognition requirements for financial assets and the initial measurement of interests related to transferred financial assets that are held by a transferor. Our current off-balance sheet securitizations in our Lending Services segment would be required to be consolidated in our financial statements based on the provisions of the exposure draft. We will continue to monitor the status of the exposure draft and consider what changes, if any, could be made to the structure of the securitizations to continue to derecognize loans transferred to the securitization special purpose entities. At December 31, 2005, the securitization special purpose entities held loans totaling $141 million, which we would be required to consolidate into our financial statements under the provisions of this exposure draft.
The second exposure draft would require servicing rights to be initially valued at fair value. This provision would not have a material impact to our financial statements. In addition, this exposure draft would permit us to choose to continue to amortize servicing rights in proportion to and over the period of estimated net servicing income, as currently required under SFAS 140, or report servicing rights at fair value at each reporting date and report changes in fair value in earnings in the period in which the changes occur. We have not yet determined how we would elect to account for servicing rights under this provision or the potential impact to the financial statements.
The third exposure draft, among other things, would establish a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are free-standing derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. Alternatively, this exposure draft would permit fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that
See footnote 18 to our consolidated financial statements for a discussion of the effects of the adoption of new accounting standards.
See footnote 11 to our consolidated financial statements for information about related party transactions.
Although inflation has not had a material adverse effect on our financial condition or results of operations, increases in the inflation rate are generally associated with increased interest rates. A significant and sustained increase in interest rates could adversely affect our franchisees’ ability to repay the variable rate loans that we have made to them and thereby adversely affect our profitability. Such an interest rate increase could also adversely affect our profitability by increasing our interest expenses and other operating expenses.
A significant change in interest rates or in the willingness to extend credit could have a significant and adverse impact on our ability to make loans and, by extension, to continue expanding our agency network.
A significant change in interest rates could also affect the cash flows associated with our servicing assets and liabilities; our retained interest assets related to our loan participation and securitization sales; and the value of our investment in the subordinate interests in our securitizations. We make certain assumptions about the rate of prepayment by our borrowers and the credit losses of our loan portfolio. In the event of a sudden increase in interest rates, it is reasonable to expect that credit losses would increase, as our borrowers found it increasingly costly to make their interest payments. Our assumptions about the prepayment rates on loans could also be subject to change in the event of a sudden increase or decrease in interest rates.
Our business is also dependent on the cyclical pricing of property and casualty insurance, which may adversely affect our franchisees’ performance and, thus, our financial performance. Our franchisees primarily derive their revenues from commissions paid by insurance companies, which commissions are based largely on the level of premiums charged by such insurance companies. In turn, we earn fees from our franchisees based upon the commissions earned by our franchisees. Because these premium rates are cyclical, our financial
An adverse change in economic activity could reduce the ability of individuals and small businesses-the key customers for our franchisees-to purchase insurance and other financial services. In such event, the revenue growth rate of our franchisees could flatten or decline, in turn reducing our revenues and hurting our franchisees’ ability to make timely interest and principal payments on their loans.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Brooke Corporation at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of the three years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
Brooke Corporation (the “Company”) was incorporated under the laws of the State of Kansas in January 1986. The Company’s registered office is located in Overland Park, Kansas. At December 31, 2005, Brooke Holdings, Inc. owned 46.9% of the Company’s outstanding common stock and a control group consisting of Brooke Holdings, Inc. and certain executive officers of the Company owned 52.6% of the Company’s outstanding common stock. The Company is primarily a holding company that owns directly, or indirectly through a wholly owned subsidiary, 100% of the stock and ownership interests of all of its subsidiaries. The Company’s primary business operations are conducted by its subsidiaries and include franchising, franchise and insurance related lending, insurance brokerage and loan brokerage.
Brooke Credit Corporation, a Kansas corporation, is a licensed finance company that specializes in lending to small businesses that sell insurance, financial and funeral related services. 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 or Brooke Brokerage Corporation. Loans originated by Brooke Credit Corporation are sold on an individual basis to participating lenders or on a pooled basis to investors.
The DB Group, Ltd and DB Indemnity, Ltd subsidiaries were incorporated in the country of Bermuda as captive insurance companies. Separate financial statements are prepared for Bermuda subsidiaries as required by the Bermuda government. The captive insurance company subsidiaries are wholly owned by Brooke Investments, Inc. and profits are not typically distributed as dividends.
DB Indemnity, Ltd was incorporated under the laws of Bermuda and is licensed as a Class 1 insurer under the Insurance Act 1978 of Bermuda and related regulations for the purpose of self-insuring a portion of the professional insurance agents’ liability exposure of Brooke Franchise Corporation, its affiliated companies and its franchisees and for the purpose of self-insuring financial guaranty policies to Brooke Credit Corporation and its participating lenders.
Brooke Agency Services Company LLC is licensed as an insurance agency and was created to serve as the agent of record for property, casualty, life and health insurance offered by 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, Brooke Securitization Company 2004A, LLC, Brooke Capital Company, LLC and Brooke Securitization Company V, LLC are the purchasers of Brooke Credit Corporation loans pursuant to true sales and the issuers of certain floating rate asset-backed notes issued pursuant to various agreements. 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.
The discount, prepayment and credit loss rates used to calculate fair value of securities resulting from asset-backed securitizations
The Company does not accrue interest on loans that are 90 days or more delinquent and payments received on all such loans are applied to principal. Loans and accounts receivables are written off when management determines that collection is unlikely. This determination is made based on management’s experience and evaluation of the debtor’s creditworthiness.
written by the Company. The calculation of insurance company profits is usually made by the insurance company by deducting policyholder claims and insurance company expenses from policy premiums. Although the share of insurance company profits paid to the Company is affected by annual premium growth, the Company does not typically receive contingent commissions based solely on premium volume. Contingent and profit sharing commissions are generally paid based on prior year performance and recognized when received. Premiums due from the insured to the Company are reported as assets of the Company and as corresponding liabilities, net of commissions, to the insurance carriers.
Policy fees. The Company receives fees for the placement and issuance of policies that are in addition to, and separate from, any sales commissions paid by insurance companies. As these policy fees are not refundable and the Company has no continuing obligation, all such revenues are recognized on the effective date of the policies or, in certain cases, the billing date, whichever is later.
Initial franchise fees. The Company receives initial franchise fees for two types of initial franchise services: basic services provided pursuant to a franchise agreement and buyers assistance plan (BAP) services provided pursuant to a consulting agreement. Agreements are typically executed, and initial franchise fees are typically paid, when a franchise is acquired or opened. Initial franchise fees are non-refundable after execution of the franchise or consulting agreement.
Additional payments of the purchase price have been made in the amount of $1,352,000 since the initial purchase. On November 30, 2005, CJD & Associates, L.L.C. sold 100% of the outstanding shares of Texas All Risk General Agency, Inc. and T.A.R. Holding Co., Inc. to an unrelated purchaser. See footnote 12 for additional disclosure regarding this sale.
As a result of the acquisition of CJD & Associates, L.L.C. on July 1, 2002, the Company recorded additional Amortizable Intangible Assets of $65,000 (net of accumulated amortization of $130,000).
Subsequent to the initial recording at fair value, the amortizable intangible asset is evaluated and measured annually for impairment. The impairment testing is performed by two different methods of analysis. The first method is a cash flow analysis to determine if there are sufficient operating cash flows. The second method is a fair market value analysis based primarily on comparative sales data. If analysis indicates that operating cash flows are insufficient or the asset’s fair value is less than its book value, then an impairment has occurred and the Company writes down the asset to the estimated fair value. No impairment was recognized for the years ended December 31, 2005, 2004 or 2003.
The amount of assets included in the “Investment in Businesses” category is the total of purchase prices paid, or market prices if lower, for business assets, primarily renewal rights, that Brooke Franchise Corporation acquires to hold in inventory for sale to its franchisees. Renewal rights associated with businesses that the Company plans to own and operate for less than one year are considered inventory and are not amortized (see footnote 1(g)) because the residual values of those assets are expected to be the same at the time of sale to franchisees as at the time of acquisition by the Company. Typically, the Company acquires and sells the business assets simultaneously. If the assets are not sold simultaneously, then the Company operates the business until sold and records the income and expense associated with the business. The amount of income and expenses associated with inventoried businesses is not considered material by the Company. The number of businesses purchased for this purpose for the years ended December 31, 2005 and 2004 was 68 and 51, respectively. Correspondingly, the number of businesses sold from inventory for the year ended December 31, 2005 and 2004 was 66 and 50, respectively. At December 31, 2005 and 2004, the “Investment in Businesses” inventory consisted of 4 businesses and 2 businesses, respectively, with fair market values totaling $5,058,000 and $1,022,000, respectively.
The acquisition of renewal rights purchased by the Company or through its subsidiaries for businesses the Company plans to own and operate for more than one year are not classified as “Investment in Businesses” (see footnote 1(g)). In footnote 12, we discuss our accounting for businesses which we have acquired with the intent to own and operate for periods greater than one year. Such businesses are part of the Company’s existing operations and are not part of “Investment in Businesses.”
Also included in the Contract database asset are the legal and professional fees associated with development of standardized loan documents. These contracts are available for sale to others that make these types of loans, by first purchasing a license from Brooke Credit Corporation. A complete review and revision is scheduled for all loan documents every five years; therefore, the asset was being amortized over a five-year period and was fully amortized at December 31, 2005.
The holders of the Company’s 2002B convertible preferred stock are entitled to receive a cumulative dividend in cash at the rate of 9% of the liquidation value of such stock per share per annum, if determined by the Board of Directors. The holders of 2002B convertible preferred stock do not have any voting rights and their conversion rights have expired. In the case of liquidation or dissolution of the Company, the holders of the 2002B convertible preferred stock shall be entitled to be paid in full the liquidation value, $32 per share, after payment of full liquidation value to the holders of 2002 convertible preferred stock, 2002A convertible preferred stock, and before the holders of common stock.
The Board of Directors designated 200,000 shares of preferred stock as 2003 convertible preferred stock; however, no shares of the 2003 convertible preferred stock have been issued and the Board of Directors has indicated that no such shares will be issued.
In April 2004, the Company’s shareholders approved the reduction of the common stock’s par value from $1.00 to $.01 per share. The Company’s shareholders also authorized an increase in the number of common shares from 9,500,000 to 99,500,000. The common shareholders shall possess all rights and privileges afforded to capital stock by law, subject to holders of convertible preferred stock.
Basic net income per share is calculated by dividing net income, less preferred stock dividends declared in the period (whether or not paid) and the dividends accumulated for the period on cumulative preferred stock (whether or not earned), by the average number of shares of the Company’s common stock outstanding. Diluted net income per share is calculated by including the probable conversion of preferred stock to common stock, and then dividing net income, less preferred stock dividends declared on non-convertible stock during the period (whether or not paid) and the dividends accumulated for the period on non-convertible cumulative preferred stock (whether or not earned), by the adjusted average number of shares of the Company’s common stock outstanding. Total preferred stock dividends declared during the years ended December 31, 2005, 2004 and 2003 were $194,000, $194,000 and $196,000, respectively.
The prior year comparative average number of shares of common stock has been adjusted to reflect the 2-for-1 stock split in 2004 and the 6-for-1 stock split in 2003.
The consolidated financial statements include the accounts of the Company and its subsidiaries, except for the following qualifying special purpose entities: Brooke Acceptance Company LLC, Brooke Captive Credit Company 2003, LLC, Brooke Capital Company, LLC, Brooke Securitization Company 2004A, LLC and Brooke Securitization Company V, LLC. These qualifying special purpose entities were formed for the sole purpose of acquiring loans in connection with the securitization of agency loans. Each is treated as its own separate and distinct entity. Qualifying special purpose entities are specifically excluded from consolidation under FIN 46.
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, 2005 and 2004 was $72,000 and $59,000, respectively.
The carrying values of securities were $44,682,000 and $17,889,000 at December 31, 2005 and 2004, respectively, and consisted primarily of two types of securities: interest-only strip receivables in loan securitizations and retained interests in loan securitizations. These securities are classified as available for sale under SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” The aggregate carrying values of $44,681,000 and $17,115,000 at December 31, 2005 and 2004, respectively, for the corresponding marketable securities approximates the fair value as calculated by the Company using reasonable assumptions.
The carrying values of the interest-only strip receivable in loan securitizations were $11,158,000 and $3,409,000 at December 31, 2005 and 2004, respectively. The carrying values of retained interests were $33,523,000 and $13,706,000 at December 31, 2005 and 2004, respectively. The amount of unrealized gain on the interest-only strip receivable was $575,000 and $212,000 at December 31, 2005 and 2004, respectively.
Upon the securitization of financial assets, unaffiliated purchasers in the transferred assets obtain full control over the assets and obtain the right to freely pledge or transfer the notes receivable. Servicing associated with the transferred assets is primarily the responsibility of unaffiliated servicing companies, which are compensated directly from cash flows generated from the transferred assets.
Cash flows associated with the Company’s retained interest in the transferred assets are subordinate to cash flow distributions to the trustee over the transferred assets, servicer of the transferred loans and unaffiliated purchasers. Actual prepayments and credit losses will impact the amount and frequency of cash flow distributions to the Company from its retained interest. Although the Company expects to receive a certain level of cash flows over the life of the securitized receivables and the term of the securitization notes, the Company will not receive full return of its retained interest until all obligations with respect to underlying loans are met.
Subsequent to the initial calculation of the fair value of retained interest, the Company utilizes a fair market calculation methodology to determine the ongoing fair market value of the retained interest. Ongoing fair value is calculated using the then current outstanding principal of the transferred notes receivable and the outstanding balances due unaffiliated purchasers, which are reflective of credit losses and prepayments prior to the fair value recalculation. Additionally, the Company completes an ongoing analysis of key assumptions used in the fair market value calculation to ensure that such assumptions used in the calculation are viable, based on current and historical prepayment and credit loss trends within similar asset types. Based upon this analysis and due to the current risk free interest rate and the risk characteristics associated with the loans sold, the discount rate assumption used in the asset valuation was increased from 8.5% to 11.00% in the fourth quarter of 2005. All other assumptions remain the same. Management may make necessary adjustments to key assumptions based on current and historical trends, which may result in an immediate reduction or impairment loss in the fair market value of retained interest. As a result of the change in discount rate, the Company recorded an unrealized loss, net of taxes, of $91,000 on the retained interest for the year ended December 31, 2005. No impairment loss resulted. Accordingly, although the value of the securities will decline as a result of underlying loan repayments, the Company does not anticipate changes in the fair value of securities in the near future based upon changes in assumptions. Summarized in footnote 2 to the Company’s consolidated financial statements is a sensitivity analysis or stress test on retained interests to determine the impact of a 10% and 20% variance in key assumptions currently used by management to calculate the fair value of retained interests.
Footnote 2 also contains a table summarizing the principal balances of loans managed by the Company, which includes the subordinate tranche (equity interest in securities balance) within the securitized notes receivable. Included within the table are delinquency and net credit loss trends of managed receivables at December 31, 2005 and 2004.
following assumptions when calculating the fair value of the stock option: expected stock volatility of 10%; risk-free interest rate of 5%; and dividend rate of 1%. See footnote 13 for additional disclosures.
The transfers that do not meet the criteria established by SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” are classified as secured borrowings and the balances recorded as both a note receivable asset and participation payable liability. At December 31, 2005 and 2004, secured borrowings totaled $10,857,000 and $2,452,000, respectively.
In April 2003, Brooke Credit Corporation sold $15,825,000 of loans to qualifying special purpose entity Brooke Acceptance Company LLC. This sale represents a loan securitization for which an interest receivable was retained. Of the loans sold, $13,350,000 of asset-backed securities were issued to accredited investors by Brooke Acceptance Company LLC. Brooke Credit Corporation received servicing income of $8,000, $11,000 and $11,000, respectively, from the primary servicer for the years ended December 31, 2005, 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 $3,511,000 and $3,502,000, respectively, on December 31, 2005 and 2004. This security is comprised of retained interest totaling $479,000 and retained equity in the special purchase entity totaling $3,032,000.
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 $12,000, $17,000 and $2,000, respectively, from the primary servicer for the years ended December 31, 2005, 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 $6,556,000 and $6,955,000, respectively, on December 31, 2005 and 2004. This security is comprised of retained interest totaling $585,000 and retained equity in the special purchase entity totaling $5,971,000.
In June 2004, Brooke Credit Corporation sold $24,832,000 of loans to qualifying special purpose entity Brooke Securitization Company 2004A, LLC. This sale represents a loan securitization for which an interest receivable was retained. Of the loans sold, $20,000,000 of asset-backed securities were issued to accredited investors by Brooke Securitization Company 2004A, LLC. Brooke Credit Corporation received servicing income of $10,000 and $6,000 from the primary servicer for the years ending December 31, 2005 and 2004, respectively. 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 a balance of $4,721,000 and $6,658,000, respectively, on December 31, 2005 and 2004. This security is comprised of retained interest totaling $1,182,000 and retained equity in the special purchase entity totaling $3,539,000.
In March 2005, the Company sold $40,993,000 of loans to qualifying special purpose entity Brooke Capital Company, LLC. This sale represents a loan securitization in which an interest receivable was retained. Of the loans sold, $32,000,000 of asset-backed securities were issued to accredited investors by Brooke Capital Company, LLC. Brooke Credit Corporation received servicing income of $32,000 from the primary servicer for the year ended December 31, 2005. The fair value of the difference between loans sold and securities issued to accredited investors and the fair value of interest receivables retained were recorded on the Company’s books as a security with a balance of $11,692,000 at December 31, 2005. This security is comprised of retained interest totaling $3,407,000 and retained equity in the special purpose entity totaling $8,285,000.
The fair value of retained interest is calculated by estimating the net present value of interest income on loans sold using the discount rate and prepayment speeds noted in the following table. The fair value of the retained interest is also reduced by the amount of estimated credit losses on loans sold with recourse and loans sold in securitizations, which are calculated using the estimated credit loss percentage noted in the following table. At December 31, 2005 and 2004, the fair value of retained interest recorded by the Company was $12,570,000 and $5,893,000, respectively. Of the totals at December 31, 2005, $1,412,000 was listed as interest-only strip receivable on the Company’s balance sheet and $11,158,000 in retained interest carried in the Company’s securities. Of the totals at December 31, 2004, $2,484,000 was listed as interest-only strip receivable on the Company’s balance sheet and $3,409,000 in retained interest carried in the Company’s securities.
The predominant risk characteristics of the underlying loans related to 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 have been 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. However, for presentation purposes and due to the immateriality of the fixed rate stratum, they have been combined in the tables hereafter. The fixed rate stratum represents less than 1.00% of the retained interest and servicing assets. In addition, beginning in 2005, the Company no longer originates fixed rate loans, and, therefore, there are no new assets resulting from fixed 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.
At December 31, 2005, key economic assumptions and the sensitivity of the current fair value of residual cash flows to immediate 10 percent and 20 percent adverse changes in those assumptions are as follows:
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 $233,473,000. 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.
The following table presents quantitative information about delinquencies, net credit losses and components of loan participations sold with recourse, unsold, or inventoried, loans and the equity interest carried in securities balance at and for the years ended December 31, 2005 and 2004:
interest in the insurance policy renewal rights purchased by the Company. Sellers typically agree that their security interests are subordinate to Brooke Credit’s security interests in the renewal rights of the agency, which also collateralize the loans made by Brooke Credit to franchisees. The renewal rights associated with the collateral interests of seller notes payable had estimated annual commissions of $38,491,000 and $35,192,000 at December 31, 2005 and 2004, respectively.
None of the Amortizable Intangible Assets described in footnote 1(g) and none of the Acquisitions and Divestitures described in footnote 12 was financed with seller note payables at December 31, 2005. Three notes payable to banks for Company debt require the Company to maintain minimum financial ratios or net worth and restrict dividend payments from Brooke Credit Corporation to the Company.
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
For the year ended December 31, 2005, income of $1,122,000 was earned in Bermuda and is excluded from the U.S. federal tax. Under current Bermuda law, DB Indemnity, Ltd and The DB Group, Ltd are not required to pay any taxes in Bermuda on either income or capital gains. They have received an undertaking from the Minister of Finance in Bermuda that in the event of any such taxes being imposed they will be exempted from taxation until March 28, 2016.
The Company sells participation interests in loans to numerous banks and finance companies. At December 31, 2005, the Company had sold participation interests in loans totaling $38,745,000 to one financial institution. This represents 35% of the participation interests sold at December 31, 2005, excluding loans sold for securitization.
The Company’s three reportable segments as of and for the years ended December 31, 2005 and 2004 consisted of its Franchise Services Business, Brokerage Business and its Lending Services Business.
The Franchise Services Business segment includes the sale of insurance, financial, funeral and credit services on a retail basis through franchisees. The Brokerage Business segment includes the sale of hard-to-place and niche insurance policies on a wholesale basis, the brokerage of loans for general insurance agencies, captive insurance agencies, funeral homes and other small businesses, and the management of offshore insurance companies. The Lending Services Business segment includes the solicitation, underwriting, origination, sale and servicing of loans. The results of each segment are separately audited and the segments’ accounting policies are the same as those described in the summary of significant accounting policies. The Company assesses administrative fees to each business segment for legal, corporate and administrative services. Administrative fees for Franchise Services, Lending Services and Brokerage Business for the year ended December 31, 2005 totaled $5,100,000, $1,800,000 and $120,000, respectively, for the year ended December 31, 2004 totaled $5,100,000, $900,000 and $60,000, respectively, and for the year ended December 31, 2003 totaled $5,100,000, $1,200,000 and $600,000, respectively. Administrative fees are reported as an expense for the individual business segment and reported as “other operating expenses” in the reconciliation of the segment totals to the related consolidated totals. Unallocated corporate-level expenses are reported in the reconciliation of the segment totals to the related consolidated totals as “other operating expenses.”
Brooke Holdings, Inc., Robert D. Orr, Leland G. Orr, Anita F. Larson, Shawn T. Lowry, Michael S. Lowry and Kyle L. Garst have agreed to vote their shares of the Company’s common stock together and, as a group, they beneficially owned 6,568,897 shares, or 52.6%, of the Company’s common stock at December 31, 2005.
Shawn T. Lowry, President of Brooke Franchise Corporation, 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, 2005, all but $25,000 of the entire loan principal balance of $582,000 was sold to unaffiliated lenders. The Company’s exposure to loss on this loan totals $313,000, of which $288,000 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 7.50% 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, 2005, all but $300 of the entire loan principal balance of $341,000 was sold to unaffiliated lenders. The Company’s exposure to loss on this loan totals $235,000, of which $235,000 is the recourse obligation by Brooke Credit Corporation on a loan participation balance.
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.
In November 2003, CJD & Associates, L.L.C. acquired 100% of the outstanding shares of Texas All Risk General Agency, Inc. and T.A.R. Holding Co., Inc. for an initial purchase price of $1,000,000. All of the initial purchase price was allocated to Amortizable Intangible Assets as disclosed in footnote 1(g). The sellers were entitled to an increase of the initial purchase price equal to 25% of Texas All Risk’s monthly net revenues during
The Company’s net income and net income per common share would have been reduced to the pro forma amounts indicated below if compensation cost for the Company’s stock option plan had been determined based on the fair value at the grant date for awards in accordance with the provisions of SFAS 123R, “Share-Based Payment.” The earnings per share has been adjusted to reflect the 2-for-1 stock split in 2004 and the 6-for-1 stock split in 2003.
The Company has granted stock options to officers, certain key employees, and directors for the purchase of its common stock under a shareholder-approved plan. Pursuant to resolutions dated February 18, 2003 and April 22, 2004, the Compensation Committee of the Board of Directors adjusted the number of shares authorized for issuance under the 2001 Compensatory Stock Option Plan pursuant to the anti-dilution provisions of the Plan. Accordingly, at December 31, 2005, the Brooke Corporation 2001 Compensatory Stock Option Plan authorizes the issuance of up to 1,080,000 shares of the Company’s common stock for use in paying incentive compensation awards in the form of stock options. Unless otherwise required by law, the options are granted at fair market value at the date of grant and, except for stock options awarded to selected officers, directors and employees, generally have become partially exercisable immediately. The options expire one to ten years from the date of
grant. At December 31, 2005, there were 430,960 additional shares available for granting stock options under the stock plan.
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, 2005, the Company was required to maintain a statutory capital and surplus of $120,000. Actual statutory capital and surplus was $2,147,000 and $1,053,000 at December 31, 2005, and 2004, 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 were available for payment of dividends to shareholders.
DB Indemnity, 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 qualify as relevant assets under the statute. The relevant liabilities are total general business insurance reserves and total other liabilities, less sundry liabilities. DB Indemnity, Ltd was required to maintain relevant assets of at least $564,000 and $553,000 at December 31, 2005, and 2004, respectively. At December 31, 2005 and 2004, relevant assets were $2,900,000 and $1,790,000, respectively. The minimum liquidity ratio was, therefore, met.
In July 2002, the Company entered into an agreement to purchase CJD & Associates, L.L.C. The sellers are entitled to an increase of the initial purchase price equal to 30% of CJD & Associates’ monthly net revenues during the contingency period of September 1, 2003 to September 1, 2007. Additional payments of the purchase price have been made in the amount of $1,702,000 since the initial purchase. Based on historical trends, the Company estimates payments to the sellers of $816,000 and $626,000 in the fiscal years 2006 and 2007, respectively.
The earnings per share is based on the weighted average number of shares outstanding at the end of each quarter. In August 2005 the Company had a secondary offering that issued an additional 2,875,000 shares of common stock. This affected the weighted average shares outstanding for the year which affects the annual earnings per share reported on the consolidated statement of operations.