1999 marked a year in which we achieved solid financial results as we continued to grow internally and through acquisitions. We reported net income of $4.9 million, or $0.50 per diluted share, for the fourth quarter, and net income of $8.8 million, or $0.95 per diluted share, for the year ended December 31, 1999. In 1998, we reported net income of $2.2 million, or $0.27 per diluted share, for the fourth quarter and a loss of $411,000, or $0.08 per diluted share for the twelve month period ended December 31, 1998.
On September 1, 1999, we acquired substantially all the assets and assumed certain liabilities of The Wamberg Organization, and stock of Wamberg Financial Corporation. The sole shareholder of both of these companies was W. T. Wamberg, our Chairman and Chief Executive Officer. We acquired all of the remaining renewal commission not previously acquired, and some liabilities, principally operating expenses and employee benefits. In addition, we acquired intellectual property, customer lists, and all rights under existing contracts, leases and agreements as well as an airplane leased to the Wamberg Organization by Wamberg Financial Corporation.
- a cash payment of $12.4 million of which $360,000 is held in escrow;
- the assumption of a $3.8 million note payable for the purchase of a corporate aircraft; and
The total initial cost of acquiring the Wamberg Companies is $24.9 million which includes the $6.9 million unamortized balance of the January purchase. In addition, cash payments of $11.9 million will be made if The Wamberg Organization attains certain operating income targets in years 1999 through 2002. These payments are conditional solely on achieving the earnings objectives and no other condition, such as the continued employment of Mr. Wamberg, has been imposed. As of December 31, 1999, the financial objectives for that year had been met and a cash payment of $1.5 million will be made to W.T. Wamberg in the first quarter of 2000 and will be recorded as additional purchase price. The acquisition is being accounted for as a purchase and the entire excess purchase price paid has been allocated to the net present value of future
revenue to be received until September 1, 2018. This is being amortized on the basis of the lapsing annual net present value of the remaining years revenue.
Both The Wamberg Organization and Wamberg Financial Corporation were S corporations and did not pay federal income taxes directly.
During 1999, the former NICB shareholders achieved the revenue and income goals set forth in the agreement for 1999 and an additional 96,113 shares CBH common were issued to them on January 26, 2000. The value of the shares was $1.4 million and will be accounted for as additional goodwill amortized over twenty-four years.
The assets acquired included cash, receivables, equipment, intellectual property, and client lists. The liabilities assumed include commissions, employee benefits and operating expenses. The $17.8 million cash portion of the purchase price was funded by a borrowing under our credit facility. The promissory note is payable in thirty-two equal quarterly installments of principal and interest at 10% per annum starting April 5, 2000 and it is guaranteed personally by W. T. Wamberg, our Chairman and Chief Executive Officer. MCG is a 168 employee executive benefit consulting organization servicing the healthcare industry and is headquartered in Minneapolis, Minnesota.
MCG was an S corporation and, accordingly, did not pay federal income taxes.
The total purchase price of the assets, excluding assumed liabilities and acquisition expenses is expected to be approximately $50 million consisting of:
This acquisition is expected to be funded by borrowing under CBI's bank line of credit.
The transaction is subject to a number of conditions including an on-going review of the target's financial and business affairs, execution of definitive purchase agreements, approval of both companies' boards of directors and the consent of our lenders, among other things.
We also appointed a representative of Conning, Steven F. Piaker, Senior Vice President, to our board of directors. We further agreed that, when Mr. Piaker's term expires, we would use our best efforts to elect a Conning representative to our board of directors. Proceeds of the $17 million sale of our common stock were used to reduce outstanding debt and for acquisitions.
During 1999, one of the carriers we use, General American Life Insurance Company experienced financial difficulties as a result of being unable to meet withdrawal requests under certain guaranteed investment contracts General American had issued. General American represented approximately 6.0% of total revenue in 1998 and 4.8% of total revenue in 1999. Upon learning of these matters, we ceased selling programs financed by insurance policies underwritten by General American. Since that time, General American's life insurance business has been sold to MetLife, its financial ratings upgraded and we expect to continue to use General American and MetLife as carriers.
- fees paid by clients in connection with program design and administrative services; and
- Renewal Commission Revenue. Renewal revenue is recognized on the date that the renewal premium is due or paid to the insurance company. Renewal revenue in future periods, which is not recorded on our balance sheet, is estimated to be approximately $246 million over the next five years. However, renewal revenue can be affected by policy surrenders or exchanges, material contract changes, asset growth and case mortality rates. Over the last five years, we have experienced a persistency rate of approximately 95% of the accrued inforce insurance underlying our programs. We can give no assurances that our persistency rate will remain at this level. As we continue to diversify and acquire companies specializing in different market segments, our persistency rates can begin to vary significantly. While we intend to do all we can to retain our clients, service their accounts and sustain our persistency, there can be no assurance our persistency rates will remain at this level.
- introduction of new or enhanced programs and services by us or our competitors;
Revenue growth from existing business units was mixed for the year ended December 31, 1999. Overall, revenue for the periods can be summarized as follows:
For 1999, acquisitions contributed 16.6% of revenue compared to 26.9% for 1998. By definition, we consider any revenue source appearing in the first full twelve months of operating results as being from acquisitions. After that, they become part of existing business.
During 1999, a significant percentage of our first-year revenue was generated from the large-bank market. In this market, we were able to restructure certain commission arrangements on existing products with our insurance carriers in order to receive a higher percentage of new-business revenue in the first year for our independent producers and ourselves while retaining favorable product performance for our clients. The result of this restructuring is that we received $5.9 million more of gross revenue in 1999 than we would have if this restructuring had not taken place. In addition, several large-bank cases were sold using a separate-account product, which typically generates a higher percentage of first-year commission than our historical general-account products used in the large-bank market.
All of our first-year revenue is and always has been subject to charge-back, which gives the insurance company the ability to recover commissions paid in the event a policy prematurely terminates. Our charge-back schedules differ by product, and typically apply to first-year commission only. A typical charge-back schedule, based on a percent of first year commission, is as follows:
As a condition to certain restructured contracts discussed above, the carriers imposed a higher charge-back schedule, which varies by product and is typically as follows:
This revised charge-back schedule relates primarily to certain sales in our large-bank market. Historically, commission charge-backs are rare, and we have never experienced a charge-back for policies placed in the large-bank market.
The following table represents the gross renewal revenue associated with our inforce business-owned life insurance policies as of December 31, 1999. This projected gross revenue is not adjusted for mortality, lapse, or other factors that may impair realization. We cannot assure you that commissions under these policies will be received. These projected gross revenues are based on the beliefs and assumptions of management and are not necessarily indicative of the revenue that may actually be achieved in the future.
While increases in commission expense are closely correlated with increases in gross revenue, an important operating measurement is gross profit. This is the amount of revenue we keep after paying commissions to our sales force.
Our gross profit increased 136.1% for the year as compared to 1998. Several factors contributed to this improvement:
- the acquisitions of The Wamberg Organization and NICB -- the effect of which is to eliminate a commission expense that was previously being paid to certain sales representatives of these organizations on both first year and renewal revenue;
- the acquisitions of MCG/HealthCare which generates its revenue through in-house sales staff who are paid a lower commission percentage than our traditional independent representatives; and
Note -- prior to 1998, corporate overhead was included in the Clark/Bardes Division.
(2) prior to our acquiring NICB, it functioned as an independent producer for BCS. With the acquisition, commission previously paid to NICB by BCS has been replaced, in part, by salaries to the former owners;
(4) with the acquisition of MCG (now HCS), all of HCS' sales force is company personnel thus, HCS does not rely on any independent producers.
An important factor to consider, however, is that the rate of increase in general and administrative expenses remains lower than the rate of increase in gross profit. By way of comparison for the periods:
Operating income increased substantially in 1999 over the full year 1998. The increase in expense is more than offset by the combined benefit of;
Since September 1997, we have completed four major and three smaller acquisitions for a total cost of over $100 million. These companies have a relatively small amount of tangible assets such as accounts receivable and equipment with the result that most, and in some cases all, of the purchase price is allocated to intangible assets:
Non-recurring operating expense: In 1998, we recognized a $4.8 million expense for the increased market value of certain put warrants. Other than our employee stock option plans, we do not have any other convertible securities outstanding.
- we purchased a stream of renewals from the Wamberg Organization in January 1, 1999, for $7.5 million
- we sold 1,000,000 shares of our common stock to Conning for $16.9 million, net, and applied the proceeds to outstanding bank debt
Federal and state income tax expense was 40.8% of income before taxes for the year ended December 31, 1999. This compares to a 40% statutory combined federal and state income tax rate. Like most corporations, we have a certain amount of expenses that are not deductible for federal income tax purposes. They are closely controlled and do not exceed the amounts management deems prudent for such outlays.
Total Revenue. Total revenue increased to $74.8 million for the year ended December 31, 1998 as compared to $49.5 million for the year ended December 31, 1997, representing an increase of 51.2%. The results for the year ended December 31, 1998 reflects contributions of $45.4 million from the core benefits business, including Schoenke, and $29.4 million from the BCS community bank business. Results for the year ended December 31, 1997 reflect contributions of $41.0 million from the core benefits business and $8.5 million from BCS community bank business. The breakout of first-year and renewal revenue is as follows:
Commission and Fee Expense. Commission and fee expense increased to $46.1 million for the year ended December 31, 1998 compared to $32.4 million for the year ended December 31, 1997, representing an increase of 42.1%. Commission and fee expense as a percentage of total revenue decreased to 61.6% for the year ended December 31, 1998 compared to 65.6% for the year ended December 31, 1997. This reduction in commission and fee expense as a percentage of total revenue was due to acquisitions and a favorable product mix from business on which a smaller than usual percentage of revenue was distributed to producers. Clark/Bardes considers present levels of commission and fee expense as a percentage of total revenue to be sustainable.
General and Administrative Expense. General and administrative expense increased to $19.6 million for the year ended December 31, 1998 compared to $11.5 million for the year ended December 31, 1997, representing an increase of 70.5%. General and administrative expense as a percent of total revenue was 26.2% for the year ended December 31, 1998 compared to 23.3% for the year ended December 31, 1997. The increase in general and administrative expense as a percentage of total revenue reflects additional staffing in 1998 to keep up with Clark/Bardes' revenue growth, as well as additional corporate overhead costs associated with becoming a public company.
Amortization. Amortization expense was $1.2 million for the year ended December 31, 1998, reflecting the full year amortization of intangible assets capitalized as a result of the BCS acquisition, four months of amortization expense for the Schoenke acquisition and two months of amortization expense for the Wiedemann acquisition. Amortization expense was $295,000 for the year ended December 31, 1997, reflecting the four months of amortization expense for the BCS acquisition.
Non-recurring Expenses. A non-recurring expense of $4.8 million was incurred for a market value adjustment for Clark/Bardes warrants with put rights which were subsequently extinguished.
Income from Operations. Income from operations was $7.8 million for the year ended December 31, 1998 ($3.0 million including the non-recurring item) compared to $5.2 million for the year ended December 31, 1997, representing an increase of 49.7%. The increase represents a full year of income from BCS as compared to four months of income for the year ended December 31, 1997. The Schoenke acquisition also contributed to income from operations for the for the year ended December 31, 1998. Operating Margin (excluding the non-recurring item) was 10.4% for the year ended December 31, 1998 and 10.5% for the year ended December 31, 1997.
Income Before Taxes. Income before taxes was $406,000 for the year ended December 31, 1998, compared to $4.3 million for the year ended December 31, 1997.
Income Tax Expense. On July 31, 1998, Clark/Bardes changed its tax status from an S corporation to a C corporation, which changed Clark/Bardes' treatment for Federal income tax purposes. Clark/Bardes recorded $817,000 of income tax expense for the year ended December 31, 1998, as compared to $60,000 of state income tax expense for the year ended December 31, 1997.
In addition to our recognized balance sheet assets and liabilities, we have an on going renewal revenue stream, that over the next ten years is estimated to be $437 million. Discounting these renewals to net present value of the estimated realizable amounts, adjusted for a 95% persistency rate, at the U.S. Treasury thirty year bond rate yield was as follows for the last three years:
We expect acquisitions to continue and be financed primarily from available credit lines and possible additional equity. However, we can offer no assurances such will be the case.
In December 1999, we restructured our $65.0 million credit agreement entered into in January 1999 with Bank One, into a $100.0 million facility. The loans are at a floating rate based on the London InterBank Offered Rate or prime rate at due dates. The loan matures on December 31, 2004, with interest and principal payable quarterly starting March 31, 2000. The credit agreement contains restrictive covenants which, among other things, require mandatory prepayments under certain conditions, financial reporting and compliance certificates, maintenance of financial ratios, restrictions on guarantees and additional indebtedness, limitations on mergers and acquisitions, prohibition of cash dividends, limitation on investments, loans and advances, and certain change in control provisions.
We are obligated to pay a commitment fee based on the daily average of undrawn funds under the credit agreement. The fee is a minimum of .25% and a maximum of .50% based on the ratio of consolidated indebtedness to income before interest, taxes, depreciation and amortization on a rolling quarterly basis. A ratio of one to one produces the lowest fee and three to one, or more, produces the highest.
In an effort to reduce interest costs, management has directed that all cash beyond reasonably foreseeable needs be used to pay down debt. In June, we sold 1,000,000 shares of common stock to Conning Insurance Capital Limited for $16.9 million in a private placement. Approximately $12 million was used to pay the debt on our acquisition credit facility.
Depending upon adherence to the criteria in our loan agreements at the time of draw down, we have $67.0 million available under our credit lines at December 31, 1999.
Interest on borrowings under our line of credit is based on one of two factors, at our option, at the time the funds are borrowed:
- U.S. prime rate, published in the Wall Street Journal, which will float as adjusted from time to time, for as long as this segment of borrowing is outstanding; or,
- London InterBank offered rate, which is based on the published rate at the time of the borrowing and will remain fixed at that rate for as long as this segment, or any part, of the borrowing is outstanding.
- the tax-deferred nature of the policies provides an attractive return.
Recent amendments to the federal tax laws have reduced the advantages of purchasing certain business-owned life insurance programs. With some exceptions, amendments adopted in 1996 eliminated the ability to deduct interest on loans against the cash value of life insurance policies. In 1997, legislation enacted an interest disallowance on all business-owned life insurance except for policies placed on employees, officers, directors and 20-percent owners. The effect of the 1997 legislation was to reduce interest deductions on general indebtedness.
Although we believe that the proposal does not have widespread support in Congress, we cannot predict the effect that any amendments will have on our Clark/Bardes or Bank Compensation Strategies divisions. We cannot be sure if this or any other adverse tax proposal will be enacted.
State governments extensively regulate our life insurance activities. We sell our insurance products in all 50 states through licensed insurance producers. States have broad powers over licensing, payments of commissions, business practices, policy forms and premium rates. Insurance laws related to licensing, marketing activities and the receipt of commissions vary from state to state. While we have not encountered regulatory problems in the past, we cannot assure you that we and the producers through whom we sell, will always be in compliance with all applicable regulatory requirements of each state.
While the federal government does not directly regulate the marketing of most insurance products, some products, such as variable life insurance, must be registered under the federal securities laws. As a result, our producers selling these products must be registered representatives of a broker-dealer registered with the National Association of Securities Dealers. While we have not had any regulatory problems in the past related to these products, we cannot be sure that we or our producers will not have regulatory problems in the future.
General economic conditions and market factors, such as changes in interest rates and stock prices, affect our commission and fee income and the extent to which clients keep a policy inforce year after year. Interest rate fluctuations can have a significant effect on the sale and profitability of many employee benefit programs whether they are financed by life insurance or other financial instruments. For example, if interest rates rise, competing products could become more attractive to potential purchasers of the programs we market. Further, a prolonged decrease in stock prices can have a significant effect on the sale and profitability of our clients' programs that are linked to stock market indices. We cannot be sure that we will be able to compete with alternative products if these market forces make our clients' programs unattractive.
Our business is highly competitive. We compete with consulting firms, insurance agents, brokers, third party administrators, producer groups and insurance companies. A number of our competitors offer attractive alternative programs. The direct competitors of our Clark/Bardes division include:
During 1999, we derived approximately 75% of our total revenue from the marketing activities of eleven of our producers' offices, including The Wamberg Organization. Before our acquisition of The Wamberg Organization, it was our largest independent producer organization and accounted for approximately 17.5% of our total revenue in 1998 and 15.2% of our total revenue for the eight month period ended August 31, 1999. The offices operated by Steven Cochlan, Malcolm Briggs and George Blaha collectively accounted for approximately 21.5% of our total revenue in 1998 and 22.3% of our total revenue for 1999. We enter agency agreements with our producers in which they agree not to compete with us for a period of time and after their relationship with us terminates. Generally, we can terminate the producer agreements or the producers can terminate the agreements with either 90 or 180 days' written notice depending on the individual agreement. From time to time, we or our producers have terminated relationships. We cannot be sure if a producer relationship will be terminated in the future. We cannot be sure that a court will enforce the non-competition provisions in the agreements.
LACK OF POLICY PERSISTENCY CAN ADVERSELY IMPACT OUR RENEWAL COMMISSIONS AND FEES.
We derive a substantial portion of our revenue from business-owned life insurance and other financial instruments that underlie many of our clients' compensation and benefit programs that are maintained year after year. High persistency rates are especially important to our Clark/Bardes division and Bank Compensation Strategies divisions since we derive a substantial portion of our revenue from these two divisions in the form of renewal commissions and fees. If the business purchaser chooses to let a policy lapse, we will stop receiving any renewal commissions and fees. In the past, we have had high persistency rates, but we cannot assure you that we will continue to have them in the future.
Since September 1997, we have completed seven acquisitions. At any point in time, we may also be considering several other potential acquisitions. Future acquisitions may require substantial expenditures that will need to be financed through cash from operations, bank debt as well as future debt and/or equity offerings. We cannot assure you that funds will be available through the capital markets and, if so, on terms acceptable to us.
- the diversion of our management's time and attention to the negotiation of the acquisition and to the assimilation of the businesses acquired;
- the possible need to modify financial and other systems and add management resources;
An acquisition may not produce the revenue and profits we expect. Thus, an acquisition that fails to meet our expectations could have a material adverse effect on our business, financial condition and operating results.
These amounts represent the excess of the purchase price over the value of the net tangible assets we acquired. The amounts allocated to inforce revenue are determined using the discounted cash flow of inforce revenue adjusted for expected persistency, mortality and associated costs. The balance of the excess purchase price over the net tangible assets is allocated to goodwill. The inforce revenue is amortized over a period of anticipated benefit, which is normally thirty years. Many factors outside our control determine the persistency of our inforce business and we cannot be sure that the values we allocated will ultimately be realized. Non-competition agreements represent the negotiated value of such agreements with the former owners of acquired businesses and are amortized over their contractual terms.
Many of these factors are beyond our control. The sales cycles of our programs and services usually last between twelve to eighteen months, with first year revenue often coming from a few large cases and subject to a number of factors beyond our control. Our revenue is thus difficult to forecast, and we believe that comparing our consecutive quarterly results of operations is not necessarily meaningful, nor does it indicate what results we will achieve for any subsequent period. In our business, past operating results are not reliable indicators of future performance.
W.T. Wamberg, our Chairman and Chief Executive Officer, owns 19.7% of our outstanding common stock. As a result, Mr. Wamberg is able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying, preventing or deterring a change in control of Clark/ Bardes Holdings that may otherwise be beneficial to you.
- a board of directors classified into three classes of directors with the directors of each class having staggered, three-year terms;
- our board's authority to issue shares of preferred stock without shareholder approval; and
- provisions of Delaware law that restrict many business combinations and provide that directors serving on staggered boards of directors, such as ours, may be removed only for cause.