Corporate Systems owns three buildings located at its principal place of business in Amarillo, Texas. The two original buildings have a total of 48,037 square feet. In 1995, Corporate Systems completed construction of a new building of 26,000 square feet, which is used as office space for its customer service division.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS
The principal business of the Partnership is to provide risk information services for the property and casualty insurance industry. These services consist generally of claims administration products including data conversion, data intake, data processing, and reporting.
The Partnership's ability to generate operating revenues is dependent on the volume and timing of the signing of sales contract agreements and service deliveries during the year, which are difficult to forecast. Additionally, certain business and credit concentrations exist that could have a significant impact on the Partnership's operating revenues should adverse conditions occur. The Partnership had revenues from five customers in fiscal 1996 and 1995 totaling $21.64 million and $21.56 million, respectively. Such revenues from significant customers represent individually over 5 percent of total operating revenues and in the aggregate approximately 52 percent and 47 percent of total operating revenues during the fiscal years ended in 1996 and 1995, respectively. For the fiscal year ended in 1996, material customers representing over 10 percent of total operating revenues are American International Group, The Travelers Insurance Company and ITT Hartford and for the fiscal year ended 1995, such were The Travelers Insurance Company and ITT Hartford. At December 31, 1996 and 1995, the Partnership also had $3.51 million and $4.56 million, respectively, of unsecured trade accounts receivable due from customers that operate primarily in the insurance industry.
Risk management claims administration services decreased $1.04 million (4 percent) from fiscal 1995 to 1996. The main components of risk management claims administration services revenue are medical claims management processing fees, claims administration service fees, teleclaim fees, and risk information reporting service fees. Medical claims management processing fees decreased $.97 million in 1996 compared to fiscal 1995. This decrease is
Computer access and equipment rental fees declined $.51 million (14 percent) due to continued competitive considerations and certain contract price concessions given to customers, as well as customers purchasing stand-along systems and terminating existing service agreements with the Partnership.
Other operating income increased $.09 million (5 percent) due to an increase in revenue from reimbursed time ($.04 million) and software support from the Partnership's Prism products and special service fees ($.16 million) for fiscal 1996 over fiscal 1995.
Within the components of operating expenses there was a decrease in cost of services of $5.67 million (16 percent) and an increase in selling, general, and administrative expense of $1.71 million (29 percent) in fiscal 1996 when compared to fiscal 1995.
Cost of services includes new product development, which is defined as research and development, product development performed under contracts for others, and other development efforts. Net research and development expenditures for the fiscal years 1996 and 1995, were $2.45 million and $4.08 million, respectively. The net new product development expense totaled $2.82 million and $4.44 million for the fiscal years 1996 and 1995, respectively. New product development expense is in support of the Partnership's new and existing product development initiatives. New product development costs are expensed as incurred and are reflected as components of costs of services in the financial statements. The following table sets forth the amounts related to new product development included in the financial statements under the following captions:
YEAR YEAR ENDED ENDED DECEMBER 31, DECEMBER 31, 1996 1995 ------------ ------------
OPERATING REVENUES Research and development $ - $1,500,000 Product development performed under contract for others 448,896 1,767,441 ---------- ---------- SPECIAL PROJECT FEES 448,896 3,267,441 ---------- ---------- OPERATING EXPENSES Research and development 2,451,375 5,581,390 Product development performed under contract for others 545,876 1,841,332 Other development costs 273,108 285,480 ---------- ---------- COST OF SERVICES 3,270,360 7,708,202 ---------- ---------- NET NEW PRODUCT DEVELOPMENT $2,821,464 $4,440,761 ---------- ---------- ---------- ----------
When the effects of new product development are removed from cost of services, cost of services decreased $1.24 million (4 percent). Permanent employees were hired in fiscal 1996, which decreased temporary salaries by $.63 million over fiscal 1995. Substantially all other expense categories decreased during fiscal 1996 as compared to fiscal 1995, which includes depreciation expense ($.25 million) due to fully depreciated assets and other miscellaneous expense ($.40 million).
Operating revenues for fiscal 1995 were $46.09 million compared to fiscal 1994 operating revenues of $39.75 million, an increase of $6.35 million (16 percent).
The most significant components of the Partnership's operating revenue growth during fiscal 1995 were increases in risk management claims administration services of $2.19 million (9 percent), installations and programming of $.56 million (31 percent), special project fees of $3.55 million (41 percent) and other operating revenues of $.56 million (44 percent).
The increase installations and programming revenue of $.56 million in 1995 over fiscal 1994 mainly consists of license and set up fees generated from a new produce, CS KnowlEDGE, in the amount of $.23 million and an increase in programming fees of $.20 million.
The increase in special project fees is partly due to an increase of $.22 million over the same period in 1994 due to the full ramp up in 1995 of a special operations customer obtained in 1994. Special operations customers have a full time dedicated customer service staff, and this revenue is expected to be ongoing in future years. Also included in special project fees are revenues that are one time in nature and are expected to fluctuate from year to year. From time to time, the Partnership may be requested to assist a current customer or may be contracted by a noncustomer to
Offsetting these increases in revenue was a decrease in computer access and equipment rental fees of $.52 million (13 percent) due to competitive considerations and certain contract price concessions given to customers, as well as customers purchasing stand-alone systems and terminating existing service agreements with the Partnership.
OPERATING EXPENSES Research and development 5,581,390 2,334,613 Product development performed under contract for others 1,841,332 1,616,884 Other development costs 285,480 230,516 ------------ ------------ COST OF SERVICES 7,708,202 4,182,013 ------------ ------------ NET NEW PRODUCT DEVELOPMENT $ 4,440,761 $ 4,182,013 ------------ ------------ ------------ ------------
Excluding the increases in new product development costs, cost of services increased $2.84 million (11 percent) in 1995 over 1994. This increase is primarily due to increases in the volume of services provided to customers that required the Partnership to employ additional people, increasing salary and benefit expense by $.86 million (7 percent), contract temporary workers increasing expense by $.48 million (120 percent), and entering into various new computer and equipment contracts increasing cost by $1.94 million (31 percent). The new computer and equipment contracts were necessary to allow the Partnership to keep pace with changing technology and business growth.
Selling, general, and administrative expenses increased $.46 million (8 percent) in 1995 over 1994. This increase is mainly attributable to increases in salaries and wages of $.23 million and deferred compensation of $.38 million in 1995 over 1994. An overall decrease of $.15 million was realized in the other components of general and administrative expense that includes depreciation, materials and supplies, travel, and other expenses.
Partnership net earnings for fiscal 1995 have decreased from fiscal 1994 by $1.06 million ($.19 per unit). The revenue increase of $6.35 million was reduced primarily due to planned increases in product development ($3.53 million), upgrades in technology tools used by employees ($1.9 million), and recognition of the cumulative effect of the change in accounting post retirement benefits ($.59 million).
Cash and cash equivalents increased from December 31, 1995, to December 31, 1996, by approximately $1.44 million. The current ratio increased from 1.28 at December 31, 1995, to 1.60 at December 31, 1996, primarily due to decreases in current liabilities.
Net cash provided by operating activities was $6.84 million for the year ended December 31, 1996. In addition to earnings, $43.98 million in cash was provided by collections of trade accounts receivable, which was offset by payment of $37.14 million in cash for accounts payable and accrued expenses.
During the year ended December 31, 1996, the Partnership expended $1.04 million for property, plant, and equipment. Additionally, the Partnership paid $4.49 million in distributions to Partners. These transactions were financed with internally generated funds.
During the year ended December 31, 1996 and 1995, net research and development costs were approximately $2.45 million and $4.08 million, respectively. Due to the nature of the Partnership's business, research and development costs may increase in the foreseeable future. Research and development costs have historically been funded from internally generated funds. In the future, it is expected that these costs will be funded from internally generated funds and possibly through borrowing and/or outside capital.
As more fully discussed in note 1 to the 1996 Consolidated Financial Statements, effective February 1, 1997, the Partnership reorganized from a partnership to corporate form and the Partnership was renamed as Corporate Systems, Inc. As a result of such conversion, the Company will be subject to Federal income taxes, and accordingly, the level of dividends paid to shareholders is expected to decrease. Additionally, the Company established a leveraged employee stock ownership plan (ESOP) through the purchase of existing shares and additional shares issued by the Company. Such purchases were financed by the issuance of bank debt. The Company will cease to make contributions to the existing employee profit sharing plan to service the debt associated with the ESOP.
Consolidated Balance Sheets as of December 31, 1996 and 1995. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Consolidated Statements of Changes in Partners' Equity for each of the years in the three-year period ended December 31, 1996 . . . . . . . . . . . . . . . . . . . . . . . . . 23
Consolidated Cash Flows for each of the years in the three-year period ended December 31, 1996. . . . . . . . . . 24
In our opinion, the balance sheet referred to above presents fairly, in all material respects, the financial position of Corporate Systems Holding, Inc. as of December 31, 1996, in conformity with generally accepted accounting principles.
We have audited the accompanying consolidated balance sheets of Corporate Systems, Ltd. (a Texas limited partnership) and subsidiary as of December 31, 1996 and 1995, and the related consolidated statements of income, changes in partners' equity, and cash flows for each of the years in the three-year period ended December 31, 1996. These consolidated financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITY - During 1995, distributions to partners totaling $940,202 were declared and recorded as a liability. This amount was paid in 1996.
The principal business of Corporate Systems, Ltd. (the Partnership), now known as Corporate Systems, Inc. (see below), is to provide risk information services for the property and casualty insurance industry. These services consist generally of claims administration products including data conversion, data intake, data processing, and reporting. The Partnership's products include a claims administration system, workers' compensation services, computer outsourcing services, software development project management services, a disability claims administration system, and risk information reporting.
The general partner of the Partnership was CSC General Partner, Inc. The general partner was responsible for management of the operations of the Partnership. The general partner received no management fees for its services but was reimbursed for all expenses incurred in performing services for the Partnership. Such reimbursed expenses were not significant during 1996, 1995 and 1994.
Effective February 1, 1997, the Partnership reorganized from a partnership to corporate form and the Partnership was renamed as Corporate Systems, Inc. (the Company). The pro forma consolidated balance sheet as of December 31, 1996 gives effect to certain transactions which occurred upon the effective date of the reorganization. The transactions reflected in the pro forma adjustments include the following:
To reflect initial capitalization through the issuance of 5,922,814 shares of common stock, $.001 par value, in respect of the outstanding units of the Partnership $ 9,215,096 To reflect sale of shares to ESOP 2,800,000 To reflect unearned ESOP shares (2,800,000) To reflect initial application of SFAS No. 109 which resulted in a net deferred tax asset 1,536,000 To record the initial impact of the establishment of the leveraged ESOP which will be funded by the issuance of bank debt (4,738,248) ----------- $ 6,012,848 ----------- -----------
The pro forma unaudited net earnings per common share of $0.47 for the year ended December 31, 1996 is calculated as if the conversion to corporate form had been consummated on January 1, 1996 and considers all significant adjustments to the consolidated statement of income necessary to appropriately reflect the corporate form of business and the above described ESOP transactions. Such adjustments include the recognition of income tax expense and interest expense on ESOP debt and a reduction in cost of services due to the discontinuance of contributions to the profit sharing plan.
The Partnership maintains an allowance for doubtful accounts based on management's estimate of the collectibility of all trade accounts receivable. The Partnership's trade accounts receivable are generally unsecured.
Prepaid airline passes allow certain employees to travel for a specified amount of air miles per year. The passes are amortized as they are used and the amount expected to be used during the next fiscal year is included in current assets.
Property, plant and equipment are stated at cost. Leased computer equipment under capital leases is stated at the lower of the present value of minimum lease payments or the fair value of the equipment at the inception of the lease. Office buildings are depreciated over their estimated useful lives on the straight-line basis. Computer equipment and furniture and fixtures are depreciated using accelerated and straight-line methods over their estimated useful lives. Assets recorded under capital leases are amortized using the straight-line method over the shorter of the lease term or estimated useful life of the asset.
The Partnership removes fully depreciated plant and equipment, including computer software, from the respective asset and accumulated depreciation accounts. In 1996, 1995 and 1994, the Partnership removed approximately $1,125,000, $2,080,000 and $1,123,000, respectively, of fully depreciated assets.
During 1995, the Partnership capitalized approximately $78,000 in interest costs incurred on debt obtained to finance the construction of an additional office building. The Partnership did not capitalize any interest costs in 1996 or 1994.
is recognized. The adoption of Statement 121 had no effect on the Partnership's consolidated financial position or results of operations.
The Partnership sponsors a defined benefit health care plan for substantially all retirees and employees. Prior to January 1, 1995, the Partnership's policy had been to recognize expenses as claims were paid. Effective January 1, 1995, the Partnership adopted SFAS No. 106, EMPLOYERS' ACCOUNTING FOR POSTRETIREMENT BENEFITS OTHER THAN PENSIONS (Statement 106). Statement 106 requires accrual of postretirement benefits other than pensions, primarily medical and dental benefits provided to retired employees, during the years an employee provides services. The cumulative effect of this change in accounting for such postretirement benefits of $590,000 was reported in the 1995 consolidated statement of income.
Revenue from risk management claims administration services consists of fees charged for the processing of various risk management reports and related services and reimbursed costs associated with printing and shipping such reports. Another revenue component of the risk management claims administration services is the medical cost management fee income which involves entering customer medical claims into the system and performing an analysis of the cost on the claims. Installations and programming revenue consists primarily of licensing fees, file construction and custom programming services. Revenues from computer access and equipment rental fees represent amounts charged to customers for dedicated telephone lines and "dial-up" access fees, and amounts related to leasing certain computer equipment. Special project fees represent revenues from agreements with several large customers to provide risk management services. Significant terms of these special project agreements generally include management fees based on a specified amount or number of claims on file, and reimbursement of direct and indirect operating costs. Also, the agreements have initial terms and renewal options and are subject to termination (generally 180 day notice) by the other party. Also included in special project fees are revenues that are one-time in nature as a result of requests to assist a customer or noncustomer in the development of a set of software programs designed specifically for that entity and within the scope of the Partnership's expertise. Other operating revenues primarily result from software sales and support, consulting and certain other reimbursed costs. Consulting fees include amounts charged for training customer personnel.
Revenues from custom programming, software sales requiring significant modifications or customization and other consulting fees are generally recognized using percentage of completion contract accounting. As contracts progress, changes from the original contract such as contract specifications, completion dates, and final contract settlements may result in changes to revenues and profit. These changes are recognized in the period that the revisions occur.
Costs of internally developed software, primarily programmers' salaries, are charged to expense as incurred. Production costs incurred after technological feasibility has been established are not considered significant.
Under provisions of the Internal Revenue Code, the income or loss of a partnership is includable in the federal income tax returns of the individual partners. Accordingly, federal income taxes related to the Partnership have not been provided in the consolidated financial statements.
Additionally, the Partnership has a software development project with one customer. The arrangement requires the customer to reimburse the Partnership for certain expenses, primarily programmers' salaries, incurred on the project. During 1996, 1995 and 1994, revenues totaling approximately $449,000 $1,767,000 and $1,907,000, respectively, were recognized as a result of such reimbursements.
The Partnership self-insures group health care for employees up to $50,000 in claims per employee each year. The Partnership's provision for such claims includes the estimate of the ultimate costs for both reported claims and claims incurred but not reported. Claims expense was approximately $922,000 $840,000 and $1,154,000 in 1996, 1995 and 1994, respectively.
SFAS No. 107, DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS, requires that the Partnership disclose estimated fair values for its financial instruments. Fair value estimates at December 31, 1996 and 1995, are set forth below for the Partnership's financial instruments.
The following is a summary of activity in the allowance for doubtful accounts for the years ended December 31, 1996, 1995 and 1994:
1996 1995 1994 -------- --------- -------- Balance at beginning of year $501,111 $ 904,366 $276,608 Provisions charged (credited) to expense (93,871) (478,075) 664,982 Charge-offs (66,709) (360) (94,978) Recoveries 79,436 75,180 57,754 -------- --------- -------- Balance at end of year $419,967 $ 501,111 $904,366 -------- --------- -------- -------- --------- --------
During 1995, the Partnership terminated an operating lease on certain computer equipment prior to the expiration of such lease. Such early termination resulted in the Partnership recognizing a loss of approximately $670,000, which represented the Partnership's remaining obligation on the lease at the date of termination. Additionally, the Partnership entered into a new lease for similar computer equipment and received an incentive from the new lessor totaling $615,000. Such incentive has been reflected as a liability in the accompanying consolidated balance sheets at December 31, 1996 and 1995 and is being amortized over the three year lease term which began in January 1996. Although a loss was recognized in 1995 as a result of this transaction, the Partnership's management believes the economic benefits that will be realized in subsequent years under the new lease due to reduced obligations will exceed such loss realized in 1995.
The following is a schedule by year of future minimum lease payments under noncancelable operating leases (with initial or remaining lease terms in excess of one year) and the present value of the future minimum capital lease payments as of December 31, 1996:
During November 1994, the Partnership obtained a secured $3,145,000 interim construction loan commitment from a bank to acquire, construct and renovate certain facilities. At December 31, 1996 and 1995, $2,668,088 had been advanced under the interim construction loan. The interim loan agreement, which was renewed and extended several times, required monthly payments of interest at the bank's prime rate of 8.25% at December 31, 1996, and was due March 31, 1997. Additionally, the Partnership was required to maintain a compensating balance on deposit at the bank equal to 20% of the outstanding interim construction loan balance.
During 1995, the Partnership adopted an incentive award plan that provides certain employees with cash equivalent options to purchase limited partnership units valued at $5 per unit. Under this plan, a total of 93,096 unit options were granted. Of this total, 50% became vested and 46,548 units were exercised during 1996 with the remainder vesting in 1997. Such options for units were converted to options for common stock as a result of the conversion described in note 1. The Partnership expensed and paid out approximately $332,000 in 1996 under the incentive award plan. Also during 1995, the Partnership expensed and paid out approximately $301,000 under a similar incentive plan. Under this plan, 42,140 options for units were granted and exercised. The per unit weighted-average fair value of the unit options granted during 1996 and 1995 is not significant due to the lack of volatility in the fair value of units and the relatively short period between grant dates and exercise dates.
As discussed in note 1, the Partnership adopted Statement 106, effective January 1, 1995. The Partnership recognized the entire transition obligation of approximately $590,000 at the date of adoption. Net periodic pension cost consisting of the portion of expected postretirement benefit obligation attributable to employee service during the period and interest costs associated with the unfunded accumulated obligation for future benefits was approximately $115,000 and $98,000 for the years ended December 31, 1996 and 1995, respectively. The effect of adopting Statement 106 on net earnings and the net periodic postretirement benefit cost for the year ended December 31, 1995, was a decrease of approximately $670,000 and $80,000, respectively. Postretirement benefits costs for 1994 have not been restated.
1996 1995 -------- -------- Accumulated postretirement benefit obligation at January 1: Actives eligible to retire $139,513 $115,191 Retired participants 176,899 260,801 Actives not yet eligible to retire 353,452 214,433 -------- -------- Accrued postretirement benefit costs 669,864 590,425
The discount rate used in determining the accumulated postretirement benefit obligation was 7.5% for 1996 and 1995. The assumed health care cost trend rate was 9% and 10% for 1996 and 1995, respectively, graded down to 4.5% after ten years for 1996 and 1995.
1996 1995 1994 ----------- ----------- ----------- Customer "A" $ 6,185,268 $ 5,854,233 $ 5,536,087 Customer "B" 5,820,795 5,670,300 6,925,341 Customer "C" 3,531,959 4,139,768 3,697,641 Customer "D" 4,247,647 3,824,381 - Customer "E" - 2,070,013 2,316,742 Customer "F" 1,855,918 - - ----------- ----------- ----------- $21,641,587 $21,558,695 $18,475,811 ----------- ----------- ----------- ----------- ----------- -----------
At December 31, 1996 and 1995, the Partnership had approximately $3,506,000 and $4,560,000, respectively, of unsecured trade accounts receivable due from customers which operate in the insurance industry.
The Partnership is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Partnership's consolidated financial position or liquidity.