CMI leases 28,000 square feet of office space in Cincinnati, Ohio, 22,000 square feet of office space in Richmond, Virginia, and 17,000 square feet of office space in Cleveland, Ohio. These facilities serve as regional offices. The Cincinnati, Richmond and Cleveland leases expire in December 2007, November 2008 and April 2008, respectively. Both the Cleveland and Cincinnati leases contain two renewal options of five years each.
Primrose leases a 13,000 square foot facility in Acworth, Georgia as its corporate headquarters. The initial lease is for a term of five years and expires in June 2008. The lease contains two renewal options of five years each, and provides Primrose an option to purchase the building during a limited time period as specified in the lease. Primrose also leases an 8,000 square foot building, also located in Acworth, Georgia, for its company-owned and operated educational childcare facility. The initial lease term is 10 years and expires in January 2013. The lease contains two renewal options of 10 years each and also provides Primrose an option to purchase the building during a limited time period as specified in the lease.
Security Capital operates as a holding company that actively participates in the management of its subsidiaries, but also gives each subsidiary a certain degree of operating autonomy, with its own chief executive officer and senior management. The Company itself is managed by Capital Partners pursuant to an Advisory Services Agreement. Capital Partners controls approximately 80% of the Company’s shares, held principally by CPI. Mr. Brian Fitzgerald controls Capital Partners and serves as our Chairman of the Board of Directors, President and Chief Executive Officer.
In July 2004, Mr. Fitzgerald and the representative of the Company’s controlling stockholder, Capital Partners, submitted an offer to the Special Committee for the public shares they did not control (the “Capital Partners Offer”). The Special Committee subsequently received other offers for the entire Company, including an offer in September 2004 from a group that included certain current and former members of the management of CMI, the main operating subsidiary of WC (the “CMI Management Offer”). Both the Capital Partners Offer and the CMI Management Offer were subsequently increased.
The Special Committee’s ability to move forward with the process of exploring strategic alternatives and providing a liquidity event for public stockholders was hampered by a number of unforeseen events. Most notably, the Company’s management, beginning in July 2004, had to perform various supplemental procedures (the “Supplemental Procedures”), and the Audit Committee of the Company’s Board of Directors, beginning in November 2004, oversaw an internal independent investigation (the “Investigation”), into certain related-party transactions and conflicts of interest involving certain members of CMI’s management team. The Investigation was completed in March 2005, and the results indicated that, while there were certain unauthorized and undisclosed transactional, operational, and financial relationships between various entities owned, operated and controlled by certain members of CMI’s management and CMI and its subsidiaries, there were no instances of fraud or financial impropriety that would indicate the Company’s historical financial statements were misstated. The total cost of the Investigation, including the Supplemental Procedures, was approximately $3,000, of which $900 was recorded in 2004 and the remaining costs were recorded in 2005.
The Investigation caused a delay in the filing of our quarterly report on Form 10-Q for the quarter ended September 30, 2004 until March 11, 2005. The Investigation and the Restatement also caused the completion of the Company’s year-end audit to be significantly delayed due to the additional audit procedures that were performed. Our 2004 Form 10-K was not filed until June 28, 2005. Additionally, the late filing of our 2004 Form 10-K resulted in the late filing of our Form 10-Q for the periods ended March 31, 2005 (the “First Quarter 10-Q”) and June 30, 2005 (the “Second Quarter 10-Q” and, collectively with the First Quarter 10-Q, the “2005 Form 10-Qs”), which were not filed until September 1, 2005 and September 16, 2005, respectively.
We continue to seek to sell the WC business and the balance of the Company. The Company is considering offers for its interest in WC and the balance of the Company. The Company currently expects to enter into a definitive agreement during the second quarter of 2006 to sell WC and the balance of the Company.
Revenues for the Employer Cost Containment and Health Services segment are derived from third-party
Revenues from the Educational Services segment are composed of royalties, franchise fees, assignment and real estate services fees, transfer fees, forfeiture fees and tuition fees. Royalties are received from franchisees based on a percentage of a school’s monthly revenue. Royalty revenue is recorded in the month earned and typically collected in the subsequent month. Franchise fees are received from a franchisee upon the signing of a franchise agreement. These fees are initially deferred and recognized as revenue when the school receives its certificate of occupancy. Assignment and real estate services include site identification and evaluation, preparation for the construction of the franchisee’s Primrose school and consulting services provided to the franchisee during the construction of the school related to architectural and engineering design. Additionally, assignment and real estate services may include coordination with third-party professional service providers to (i) prepare environmental and soil studies; (ii) prepare the applications for all required building and zoning permits and assist with any follow-up procedures necessary to obtain all required permits; (iii) obtain a title commitment for the land site; and (iv) ensure that the franchisee’s lender has all relevant documentation necessary for the franchisee to purchase the land for its Primrose school. Third party fees are not included in our revenues. A majority of the assignment and real estate services fees is received from a franchisee upon the signing of a franchise agreement, and the remaining fee is received upon the closing of the purchase of the property by the franchisee (the “Closing”). All fees for assignment and real estate services received prior to the Closing are initially deferred. A portion of the assignment and real estate services fees is recognized at the time of the Closing, and the remaining portion is recognized when the school receives its certificate of occupancy.
Our receivables are composed primarily of amounts due for contract services provided by WC and royalty payments due to Primrose from franchisees. Primrose also incurs third-party professional services costs on behalf of franchisees for assignment and real estate services. These costs are recorded as recoverable costs and are collected from the franchisee upon the Closing. We establish an allowance for doubtful accounts and for potentially uncollectible recoverable costs based on a review of the current status of the receivable, customer or franchisee credit evaluations, collection history and other pertinent information. Receivables are generally not collateralized.
projections, reference to relevant market data, replacement cost analysis and independent third-party valuations. Determining the estimated useful life of intangible assets is dependent upon an evaluation of numerous factors, such as the competitive environment, our market share and our ability to maintain that market share in the future, any legal, regulatory or contractual provisions that limit, or could limit, the assets’ life and the expected macroeconomic environment and its impact on the industries in which we operate. Intangible assets are amortized over their estimated useful life. Accordingly, differences in the estimated useful life of intangible assets and the actual useful life can have a significant effect on our financial statements. Our intangible assets are being amortized over a weighted average useful life of 12.4 years. If the weighted average useful life was one year less (11.4 years), amortization expense would have been higher by approximately $180.
The excess of the fair value of assets acquired and liabilities assumed over the acquisition cost is allocated to goodwill. Goodwill is not amortized; however, it is subject to annual impairment testing. To test goodwill for impairment, the carrying amount of the net assets of each “reporting unit” is compared to the fair value of the reporting unit. If the fair value of the reporting unit is greater than the carrying amount, no additional testing is required. However, if the fair value of the reporting unit is less than its carrying amount, then the fair value of the reporting unit is allocated to the assets and liabilities of the reporting unit, including an amount for any “implied” goodwill. If implied goodwill exceeds the net carrying amount of goodwill, no impairment loss is recorded. Otherwise, an impairment loss is recognized for the difference.
At December 31, 2004 and 2003, we determined the fair value of each reporting unit using a discounted cash flow approach. This approach requires management to make assumptions and estimates of future cash flows of the reporting unit, the appropriate discount rate and a terminal value of the reporting unit. The discount rate used for each reporting unit was determined by assessing the appropriate risk level of the cash flows of the respective reporting unit and adjusting the risk-free rate by a factor dependent upon this risk assessment. The terminal period cash flow of the respective reporting units was based upon assigning a multiple of earnings before income taxes, depreciation and amortization (“EBITDA”) consistent with companies of similar size and industry in which each of the units operates. The results of our approach indicated that the fair value of the Company’s reporting units exceeded their carrying value. Accordingly, no impairment charges were recognized in 2004 and 2003.
We review long-lived assets, including intangible assets, for impairment in accordance with the provisions of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”). SFAS 144 requires companies to test long-lived assets when events or circumstances lead management to believe that the carrying value of an asset may not be recoverable. Recoverability is assessed based on the carrying value of an asset and its fair value, which is generally determined by the sum of the estimated undiscounted cash flows expected to result from the use and eventual disposal of the asset in question. If the fair value of the asset is less than its carrying value, an impairment loss is recognized based on the excess of the carrying amount of the asset over its fair value. Based on our review and analysis conducted during the applicable periods, we have not recognized any impairment losses on long-lived assets, including identified intangible assets, during each of the three years ended December 31, 2005, 2004 and 2003.
We adopted the provisions of SFAS 123R using the modified prospective application. Under the modified prospective application, the provisions of SFAS 123R are applied to new awards and awards modified, repurchased or cancelled after the effective date. Additionally, compensation cost for the unvested portion of awards outstanding as of
the effective date is recognized as the requisite service is rendered. Share-based compensation expense for the unvested portion of awards outstanding as of the effective date was $180 in 2005, and is expected to be $208 in 2006, $60 in 2007 and 2008, $53 in 2009 and $26 in 2010.
Under SFAS 123R, share-based awards result in a cost measured at fair value on the awards’ grant dates. Determining the fair value of an award requires management to make estimates regarding the number of awards expected to vest, the length of time the awards will be held, the appropriate risk-free interest rate, the dividend yield and the expected volatility of the underlying security. The fair value of the estimated number of awards expected to vest is recognized through earnings over the requisite service period, which is generally the vesting period. At December 31, 2005, share-based awards are limited to stock options granted to employees and non-employee directors.
The expected life is the length of time the option holder is expected to hold the options. It is a significant assumption as it determines the period for which the risk-free interest rate, volatility and dividend yield must be applied. The risk-free interest rate is based on the expected U.S. Treasury rate over the expected life. Volatility reflects the movement in our stock price over the most recent historical period equivalent to the expected life. The dividend yield represents the dividend the Company expects to pay over the expected life. In 2005, the Company granted options to purchase 64,510 shares of the Company’s common stock. The fair value of the options aggregated $264 ($4.09 per share) using a Black-Scholes option pricing model and the following assumptions:
Income taxes are accounted for in accordance with Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, whereby deferred taxes are recognized based on the temporary differences between the financial reporting basis and the tax basis of the assets and liabilities, using presently enacted rates. Certain judgment is required in determining our annual effective tax rate and in evaluating our tax positions. While we believe that our tax return positions are fully supportable, we expect that certain positions could be challenged and that we may not be able to successfully defend our positions. Accordingly, we establish certain reserves, including interest, for these items. We adjust these reserves in light of changing facts and circumstances. Our effective tax rate for 2005 was 30.7% compared to 47.1% in 2004. In 2005, our tax provision included the reversal of $1,684 of previously recorded tax reserves that management believed were no longer necessary in light of current facts and circumstances.
Certain items are included in our tax return at different times than they are reflected in our financial statements. As a result, our effective tax rate reflected in our financial statements is different that that reported in our tax return. Some of the differences are permanent, such as expenses that are not tax deductible, and some of the differences are temporary, and will reverse over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction in our tax return in future years for which we have already recorded the benefit in our statement of income. We establish valuation allowances when we believe expected future taxable income will not be sufficient to realize the deferred tax asset.
In 2005, income available to common stockholders and earnings per share also experienced significant increases over 2004 due to the revenue growth referred to above, plus the actions taken in 2004 to dispose of our discontinued operations, repay outstanding debt and redeem our outstanding Preferred Stock. Income available to common stockholders and diluted earnings per share in 2005 were $9,435 and $1.34, respectively, compared to income available to common stockholders and diluted earnings per share in 2004 of $1,958 and $0.26, respectively. For the year ended December 31, 2004, income available to common stockholders and earnings per share were reduced by a loss from discontinued operations of $1,230 and Preferred Stock accretion of $1,275. Due to the sale of substantially all the assets of Pumpkin, the resolution of all outstanding claims against the Company with respect to the Possible Dreams bankruptcy, and the redemption of all outstanding Preferred Stock during 2004, we no longer reported results from discontinued operations or recognized Preferred Stock accretion in 2005. Finally, during 2004, we incurred $2,423 of interest expense on a $30,000 fixed rate note (the “Note”). The Note was repaid in September 2004, resulting in lower interest costs in 2005.
Revenues from the Employer Cost Containment and Health Services segment for the year ended December 31, 2005 increased $19,451, or 16% to $140,786 compared to $121,335 for 2004. The increase was driven by the acquisition of Caronia in March 2005, which accounted for $10,941 of revenue in 2005, the full-year contribution of the strong customer growth in the second half of 2004 and additional customer growth during 2005.
inclusion of Octagon for 12 months in 2004 compared to only three months in 2003 resulted in additional revenues of $33,918.
Revenues from the Educational Services segment for the year ended December 31, 2005 increased $2,920, or 25% to $14,525 compared to $11,605 for 2004. Royalty revenues for 2005 increased $1,713, or 18% compared to 2004 due to a 10% increase in same school revenue, a full year contribution from schools opened in 2004 and the opening of 24 additional schools during 2005. The opening of 24 schools in 2005 compared to seven in 2004 also resulted in an increase of $1,042, or almost 300% in franchise fees and assignment and real estate services fees. At December 31, 2005, there were 149 schools opened compared to 125 schools at December 31, 2004.
SG&A expenses in the Employer Cost Containment and Health Services segment increased $16,955, or 16% to $120,961 for the year ended December 31, 2005 compared to $104,006 for 2004. Compensation and benefits expense increased $11,600 due to the acquisition of Caronia, which accounted for $5,580 of the increase, an increase in personnel necessary to support the customer growth in 2004 and 2005 and a one-time special compensation charge in 2005 of $910 resulting from the cash settlement of vested options held by certain WC employees. Legal and accounting fees were higher in 2005 due to the cost of the Investigation ($2,100 incurred in 2005 compared to $900 in 2004), consulting fees of $350 were incurred relating to an internal control documentation and improvement project and costs of approximately $1,000 were incurred for the integration of Caronia’s information systems with our systems.
SG&A expenses in the Employer Cost Containment and Health Services segment increased $32,297, or 45% to $104,006 for the year ended December 31, 2004 compared to $71,709 for 2003. SG&A increased $30,405 as Octagon was included for 12 months in 2004 compared to only the last three months in 2003 following its acquisition. Also, for the year ended December 31, 2004, SG&A expense included $900 for the Supplemental Procedures and the Investigation and $892 of higher audit fees resulting from the Supplemental Procedures and the Investigation.
SG&A expenses at our corporate headquarters increased $1,516, or 120% to $2,779 for the year ended December 31, 2004 compared to $1,263 for 2003. This increase was mainly due to an increase in audit fees, legal fees, and the costs of the Special Committee. Audit fees for corporate increased $850 due to an increase in the hourly billing rates of our accountants, additional work incurred for the Investigation and the Restatement, and other factors associated with the planning and execution of year-end audit procedures. Legal fees were $383 higher than in 2003 mainly due to services pertaining to the review of strategic alternatives, the redemption of the Preferred Stock, the sale of Pumpkin, the settlement of the Possible Dreams bankruptcy and public filing requirements resulting from the offers to purchase the Company, the Supplemental Procedures and the Investigation and the late filing of our quarterly and annual reports. The costs of the Special Committee in 2004 were $580 and included costs of an investment banking firm, independent legal counsel and fees paid to the Special Committee members.
Our controlling stockholder, Capital Partners, provides certain management and advisory services related to investments, general administration, corporate development, strategic planning, stockholder relations, financial matters and general business policy for which we paid an annual fee of $1,550 for the years ended December 31, 2005 and 2004 and $1,400 for the year ended December 31, 2003.
On December 23, 2005, we entered into the Second Amended and Restated Advisory Services Agreement (the “Amended Advisory Services Agreement”) with Capital Partners, effective January 1, 2006. Under the Amended Advisory Services Agreement, Capital Partners will provide services similar to those provided under prior Advisory Services Agreements, and we will pay Capital Partners an annual fee of $1,550. The fee is payable quarterly at the beginning of the quarter. Under the terms of the Amended Advisory Services Agreement, if the Company is sold prior to June 30, 2006, Capital Partners will continue to provide services under the agreement for a period of six months following the effective date of a sale. In addition, under the Amended Advisory Services Agreement, Capital Partners will provide advisory services to the Company in connection with managing the formal sale process, including in the areas of planning such sale process, selecting and evaluating potential buyers, negotiating directly or indirectly with potential buyers and consummating a sale of the Company, or if applicable, the sale of Primrose and the sale of the balance of the Company in two separate transactions. In exchange for such services, the Company will pay to Capital Partners a sale bonus of $2,000 (the “Incentive Sale Bonus”). The Incentive Sale Bonus will be increased or decreased depending on the ultimate aggregate sale proceeds obtained (the “Adjustment Amount”). In the event a sale of Primrose occurs in a separate transaction, no amount will be due. Rather, the Incentive Sale Bonus, including the Adjustment Amount, will be earned and payable upon the sale of the balance of the Company.
D&A for the Employer Cost Containment and Health Services segment increased $1,186, or 37% to $4,400 for the year ended December 31, 2005 as compared to $3,214 for 2004. This increase was primarily due to depreciation and amortization of $781 on fixed assets and intangible assets acquired as part of the Caronia acquisition and additional amortization of $138 due to a decrease in the estimated useful life of an intangible asset (customer list) in 2005.
D&A for the Employer Cost Containment and Health Services segment increased $1,321, or 70% to $3,214 for the year ended December 31, 2004 as compared to $1,893 for 2003. This increase was primarily due to a full year of depreciation and amortization of fixed and intangible assets acquired as part of the Octagon acquisition.
Other expense in 2005 included certain costs to resolve various matters with the Former Executives of WC. In March 2006, we entered into the Agreement with the Former Executives. See Item 3. “Legal Proceedings.” The total cost of the Agreement was $935 and was reflected in the 2005 financial statements as follows: $428 was recorded as other expense; $190 was recorded as SG&A; and $317 was capitalized as intangible asset and will be amortized over the three-year life of the covenants not to compete. The cost of the Agreement does not including potential contingent payments aggregating $846 that the Former Executives are eligible to receive upon a change of control of the Company or WC. Other expense in 2003 included the loss from the sale of marketable securities acquired in the Octagon acquisition of $251 partially offset by a gain of $107 from the sale of assets.
Income tax expense was $4,770, $5,245, and $4,617 for the years ended December 31, 2005, 2004 and 2003, respectively, representing an overall effective tax rate on continuing operations of 30.7%, 47.1%, and 42.1%, respectively. The decrease in our effective tax rate in 2005 resulted from the reversal of $1,684 of certain tax reserves that management believed were no longer necessary. Excluding the effect of this reversal, our effective tax rate for 2005 was 41.5%.
During 2005, we spent $23,704 to acquire Caronia, pay for capital expenditures and acquire shares of WC from the minority stockholders of WC. To fund these expenditures, cash of $11,816 was generated from operating activities and cash of $11,740 was raised through financing activities. Further discussion of the components of our cash flow for each of the last three years follows.
We have revised our 2004 and 2003 consolidated statements of cash flows as a result of recent guidance provided
Cash used in investing activities was $23,704 in 2005 compared to net cash used in investing activities of $3,021 in 2004. In 2005, cash used in investing activities included $15,432 to acquire Caronia and pay transaction costs, $4,931 for capital expenditures and $3,341 to acquire 979.88 shares of WC from the minority stockholders of WC (see below). Cash used in investing activities in 2004 included $3,841 for capital expenditures and $1,801 for the acquisition of KRAMMCO and ICS. These uses were partially offset by net cash received from the sale of substantially all the assets of Pumpkin. The increase in capital expenditures in 2005 compared to 2004 is due to expenditures for information technology and software upgrades in our Employer Cost Containment and Health Services segment. We estimate that expenditures for information technology and software upgrades in our Employer Cost Containment and Health Services segment in 2006 will be approximately $4,000 - $4,500. We currently have no commitments for capital expenditures.
Cash used in investing activities in 2003 was primarily for capital expenditures of $1,589 and the acquisition of Octagon for $14,893, net of proceeds from the sale of investments acquired. Capital expenditures in 2004 increased compared to 2003 primarily due to facilities expansion at Octagon in 2004.
In 2005, we raised $11,740 of net cash from the issuance of long-term debt and other sources. In connection with the Caronia acquisition, WC entered into a Second Amended and Restated Loan Agreement (the “Credit Agreement”) that provided WC with a $40,500 (net cash of $40,359 after financing costs of $141) five-year, fully-amortizing term loan (the “WC Term Loan”) and the WC Revolver. The proceeds of the WC Term Loan were used to fund the Caronia acquisition and repay the $24,929 balance then outstanding under the WC Holdings Senior Term Loan (the “Prior WC Term Loan”). The WC Term Loan bears interest at LIBOR plus 2.5% or Prime, at the Company’s option, and borrowings under the WC Revolver bear interest at LIBOR plus 2.0% or Prime minus 0.5%, at the Company’s option. The WC Term Loan requires monthly principal payments of $675. During 2005, total principal repayments under the WC Term Loan were $6,075.
On September 16, 2005, the Company acquired 979.88 shares of WC stock directly from the minority stockholders of WC for total cash consideration of $3,341. The funds to acquire these shares were obtained from the Dividend. Also on September 16, 2005, certain option holders of WC exercised options to purchase shares of WC for aggregate cash consideration of $283. As a result of the exercise of these options, an additional 408.41 shares of WC were issued to minority stockholders. Prior to September 16, 2005, the minority stockholders of WC had an aggregate ownership interest of 20%. After the net effect of the Company’s acquisition of 979.88 shares from the minority stockholders and the issuance of 408.41 additional shares to the minority stockholders, the aggregate ownership interest of the minority was reduced to 15.6%.
The Credit Agreement also requires that an additional principal payment (the “Accelerated Payment”) be made based on the annual earnings, as defined, of WC. The Accelerated Payment based on the 2005 earnings of WC is $1,574 and is due on April 30, 2006.
The obligation for the advisory fee due to Capital Partners under the Amended Advisory Services Agreement is
Consolidated Statements of Income for the years ended December 31, 2005, 2004 and 2003
We have audited the consolidated balance sheet of Security Capital Corporation and subsidiaries as of December 31, 2005, and the related consolidated statements of income, stockholders’ equity, and cash flows for the year then ended. Our audit also included the financial statement schedule of Security Capital Corporation, listed in the Index at Item 15(a). These financial statements and the financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We have audited the accompanying consolidated balance sheet of Security Capital Corporation and subsidiaries (the “Company”) as of December 31, 2004, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the two years in the period ended December 31, 2004. Our audits also included the related financial statement schedule (for the 2004 and 2003 information) listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Security Capital Corporation and subsidiaries at December 31, 2004, and the consolidated results of their operations and their cash flows for each of the two years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule (for the 2004 and 2003 information), when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
In recent years, the Company has sought to strengthen these two valuable businesses, while at the same time shedding unneeded and unprofitable businesses. Discontinued operations in 2004 and 2003 consisted of the Company’s Seasonal Products segment. This segment consisted of our 100% ownership interest in Pumpkin Masters Holdings, Inc. (“Pumpkin”) and our 75% ownership interest in P.D. Holdings, Inc. (“Possible Dreams”). In October 2004, we consummated the sale of substantially all of the assets of Pumpkin, and in November 2004, we entered into an agreement with the bankruptcy Trustee for Possible Dreams to resolve all outstanding claims against the Company.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. Significant estimates include an allowance for doubtful accounts and uncollectible recoverable costs, the amount of employee related health care costs incurred but not reported, reserves for potential loss contingencies, our ability to utilize future tax benefits, the estimates and assumptions inherent in our goodwill impairment testing procedures, the allocation of the purchase price to the fair value of assets acquired and liabilities assumed, the determination of the economic lives of intangible assets, and the estimates inherent in the determination of the fair value of share-based awards.
Revenues from the Educational Services segment are composed of royalties, franchise fees, assignment and real estate services fees, transfer fees, forfeiture fees and tuition fees. Royalties are received from franchisees based on a percentage of a school’s monthly revenue. Royalty revenue is recorded in the month earned and typically collected in the subsequent month. Franchise fees are received from a franchisee upon the signing of a franchise agreement. These fees are initially deferred and recognized as revenue when the school receives its certificate of occupancy. Assignment and real estate services include site identification and evaluation, preparation for the construction of the franchisee’s Primrose school and consulting services provided to the franchisee during the construction of the school related to architectural and engineering design. Additionally, assignment and real estate services may include coordination with third-party professional service providers to (i) prepare environmental and soil studies; (ii) prepare the applications for all required building and zoning permits and assist with any follow-up procedures necessary to obtain all required permits; (iii) obtain a title commitment for the land site; and (iv) ensure that the franchisee’s lender has all relevant documentation necessary for the franchisee to purchase the land for its Primrose school. Third-party fees are not included in our revenues. A majority of the assignment and real estate services fees is received from a franchisee upon the signing of a franchise agreement, and the remaining fee is received upon the closing of the purchase of the property by the franchisee (the “Closing”). All fees for assignment and real estate services received prior to the Closing are initially deferred. A portion of the assignment and real estate services fees is recognized at the time of the Closing, and the remaining portion is recognized when the school receives its certificate of occupancy.
Transfer fees are received and earned upon the sale of an existing franchise to another franchisee. Forfeiture fees include fees applicable to the termination of franchise agreements or the expiration of option agreements. Tuition fees are earned at the company-owned school and are generally billed weekly for services to be provided in the following week. Primrose will occasionally provide existing franchisees an option to purchase a franchise in a designated geographical area for a stated period of time (typically six to 12 months) for which Primrose receives a fee. This fee is initially deferred when received. When the option is exercised, the option fee is credited against the amount of the franchise fee and recognized as revenue when the school receives its certificate of occupancy. If the option expires, the fee is recognized as a forfeiture fee.
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. All cash equivalents are carried at cost, which approximates fair value. At times, cash and cash equivalents may
Acquisitions are accounted for under the “purchase method,” whereby acquired tangible and intangible assets and assumed liabilities are recorded at fair value. The determination of fair value of tangible and intangible assets and their respective useful lives requires management to make certain estimates, judgments and assumptions. We determine fair value
At December 31, 2004 and 2003, we determined the fair value of each reporting unit using a discounted cash flow approach. This approach required management to make assumptions and estimates of future cash flows of the reporting unit, the appropriate discount rate and a terminal value of the reporting unit. The discount rate used for each reporting unit was determined by assessing the appropriate risk level of the cash flows of the respective reporting unit and adjusting the risk-free rate by a factor dependent upon this risk assessment. The terminal period cash flow of the respective reporting units was based upon assigning a multiple of earnings before income taxes, depreciation and amortization (“EBITDA”) consistent with companies of similar size and industry in which each of the units operates. The results of our approach indicated that the fair value of the Company’s reporting units exceeded their carrying value. Accordingly, no impairment charges were recognized in 2004 and 2003.
Effective July 1, 2005 (the “Effective Date”), the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), to account for share-based awards. SFAS 123R is a revision to Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). We adopted the provisions of SFAS 123R using the modified prospective application. Under the modified prospective application, the provisions of SFAS 123R are applied to new awards and awards modified, repurchased or cancelled after the Effective Date. Additionally, compensation cost for the unvested portion of awards outstanding as of the Effective Date is recognized as the requisite service is rendered after the Effective Date. Share-based compensation expense recognized in 2005 was $180 ($172 after taxes and minority interest), and is reflected as selling, general and administrative expense in the 2005 consolidated statement of income.
Basic earnings per common share (“EPS”) are derived by dividing income available to common stockholders by the weighted average shares outstanding. Diluted EPS assumes the dilution from the potential exercise of employee stock options in Company stock and in stock of subsidiary companies. The assumed exercise of stock options of subsidiary companies has the effect of reducing our earnings (“diluted earnings”) since our overall ownership interest in the subsidiary companies, and thus our share of the net income of the subsidiaries, would be reduced. Diluted EPS are derived by dividing the applicable diluted earnings by the weighted average shares outstanding plus the dilutive effect of common stock equivalents. See Note 14 for a detailed computation of EPS.
The cost to acquire Caronia was allocated to the tangible and intangible assets acquired and liabilities assumed based on their respective fair values, and any excess was allocated to goodwill. The purchase price allocation was as follows:
In October 2003, WC, through its subsidiary, CMI, acquired all of the outstanding shares of Octagon for $30,000, plus $914 of transaction costs. Octagon, based in Oakland, California, provides workers’ compensation and professional liability claims administration and consulting services primarily in the western United States, including California. The purchase price allocation was as follows:
The following unaudited selected financial data presents the pro forma combined results of the Company and Octagon for the year ended December 31, 2003 as if the Octagon acquisition had taken place on January 1, 2003. The pro forma amounts give effect to the amortization of intangibles, increased interest expense and the related income tax and minority interest effects. This pro forma information does not necessarily reflect the results of operations as they would have been if the business had been managed by the Company during that period and is not indicative of results that may be obtained in the future. The results of Octagon were reflected in our consolidated statements of income as of the acquisition date.
The changes in the carrying amount of goodwill at December 31, 2004 and 2005 were as follows:
The Company’s intangible assets consist primarily of franchise agreements, customer lists, proprietary curriculum, trademarks and non-compete agreements with former executives of WC. Amortization expense is provided over the estimated useful life of the asset using the straight-line method. Estimated useful lives are 21 years for franchise agreements, five to seven years for customer lists, ten years for proprietary curriculum, 15 years for trademarks and three years for non-compete agreements. The weighted average amortization period of intangible assets as of December 31, 2005 and 2004 was 12.4 years and 13.7 years, respectively. The gross carrying value and accumulated amortization for intangible assets at December 31, 2005 and 2004 were as follows:
Amortization expense for the years ended December 31, 2005, 2004 and 2003 was $2,548, $1,774 and $811, respectively. The estimated future amortization expense for the above intangible assets is as follows:
Possible Dreams was a 75%-owned subsidiary that formerly operated as a designer, importer and distributor of giftware and collectible figurines. In October 2003, Possible Dreams filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. In November 2004, we settled all outstanding claims against the Company with the bankruptcy Trustee for $442. An after-tax gain of $1,516 was recognized from the settlement and included in the loss from discontinued operations reported in the consolidated statement of income for the year ended December 31, 2004.
Revenues from discontinued operations were $10,500 and $21,600 for the years ended December 31, 2004 and 2003, respectively.
On March 31, 2005, WC entered into a Second Amended and Restated Loan Agreement (the “Credit Agreement”). The Credit Agreement provided WC with a $40,500 five-year, fully-amortizing term loan (the “WC Term Loan”) and an $8,000 revolving line of credit (the “WC Revolver”). The WC Term Loan bears interest at LIBOR plus 2.5% or Prime, at the Company’s option, and borrowings under the WC Revolver bear interest at LIBOR plus 2.0% or Prime minus 0.5%, at the Company’s option. The WC Term Loan requires monthly principal payments of $675. The WC Term Loan also requires that an additional principal payment (the “Accelerated Payment”) be made based on the annual earnings, as defined, of WC. The Accelerated Payment based on the 2005 earnings of WC is $1,574 and is due on April 30, 2006. The proceeds of the WC Term Loan were used to fund the Caronia acquisition and repay then outstanding debt under the WC Holdings Senior Term Loan (the “Prior WC Term Loan”).
Borrowings under the Prior WC Term Loan bore interest at Prime minus 0.5% or one-month LIBOR plus 1.75%, at the Company’s option. WC also maintained an $8,000 revolving line of credit (the “Prior WC Revolver”). Borrowings under the Prior WC Revolver bore interest at LIBOR plus 1.75%. The Prior WC Revolver was replaced by the WC Revolver.
In January 2004, the Company issued a $30,000 Senior Subordinated Promissory Note (the “Note”), due September 30, 2008 The initial interest rate on the Note was 10% per annum, but was scheduled to increase to 16% on September 30, 2004. Because of the availability of less expensive financing alternatives, the Note was prepaid without penalty prior to September 30, 2004.
At December 31, 2005 and 2004, there were no amounts outstanding under the WC Revolver, the Prior WC
The WC Term Loan, the Primrose Term Loan, the WC Revolver and the Primrose Revolver each contains restrictive covenants that prohibit or limit certain actions, including specified levels of capital expenditures, investments and incurrence of additional debt, and require the maintenance of a minimum fixed charge ratio. Borrowings are secured by a pledge of substantially all assets at the subsidiary level, as well as a pledge of the shares of subsidiary stock owned by the Company. The Credit Agreement also contains provisions that require WC to provide monthly financial statements and audited annual financial statements to the lender. Management believes that the Company is currently in compliance with all of these requirements.
Scheduled maturities at December 31, 2005 of long-term debt for the next five years were as follows:
The outstanding interest rate swap exposes us to credit risk in the event that the counterparty to the agreement does not or cannot meet its obligation. The notional amount is used to measure interest to be paid or received and does not represent the amount of exposure to credit loss. The loss would be limited to the amount that would have been received, if any, over the remaining life of the swap agreement. The counterparty to the swap is a major financial
institution, which we expect to fully perform under the terms thereof.
The difference between the carrying value of the Preferred Stock and the redemption value was accreted using the interest method over the remaining estimated period to redemption. Preferred Stock accretion of $1,275 and $457 was recognized in 2004 and 2003, respectively. Additional accretion was recorded in 2004 to accrete the carrying value of the Preferred Stock to its redemption value.
The authorized common stock of the Company consists of Common Stock and Class A Common Stock. The Class A Common Stock shares are identical in rights to the Common Stock shares, except that, with certain exceptions, transfer of shares of the Class A Common stock is prohibited to a person who is, or would thereby become, a holder of 4.75% or more of the fair market value of the Common Stock and the Class A Common Stock. The Company has not paid any dividends to common stockholders during the last five years. Certain financing arrangements limit the ability of our subsidiaries to pay dividends to Security Capital, thus limiting our ability to pay dividends to our stockholders.
Prior to September 16, 2005, the minority stockholders of WC had an aggregate ownership interest of 20%. On September 16, 2005, we acquired 979.88 shares of WC stock directly from the minority stockholders of WC for total cash consideration of $3,341. Also on September 16, 2005, certain option holders of WC exercised options to purchase shares of WC. As a result of the exercise of these options, an additional 408.41 shares of WC were issued to WC minority stockholders for aggregate cash consideration of $283. The resulting net decrease of 571.47 shares of WC held by the minority stockholders of WC reduced their ownership interest from an aggregate 20% to 15.6%. Also on September 16, 2005, WC settled for cash options to purchase 277 shares of WC for an aggregate of $720.
We maintain a stockholder-approved stock incentive plan (the “Incentive Plan”), whereby up to 966,346 shares of our Class A Common Stock may be granted to certain employees and non-employee directors. Eligible employees and non-employee directors may receive stock options, stock appreciation rights, limited stock appreciation rights in tandem with stock options, restricted stock, deferred stock and stock granted as a bonus or in lieu of other awards (collectively, “Awards”). Awards are currently limited to stock options granted to employees and non-employee directors. The Board of Directors administers the Incentive Plan and has full authority to, among other things, select participants to whom Awards will be granted, determine the type and number of Awards to be granted, the exercise price of the Awards and all other relevant provisions, including, but not limited to forfeiture, vesting, restrictions on exercises, and transferability of the Awards. Stock options are typically granted at the fair market value of our Class A
Common Stock on the date of the grant, vest ratably over a three- to five-year period and expire 10 years from the date of grant. The Company will generally issue new shares to satisfy a stock option exercise. At December 31, 2005, the Company had 58,836 shares of Class A Common Stock reserved for future Awards.
A summary of stock option activity for the years ended December 31, 2005, 2004 and 2003 is as follows:
At December 31, 2005, the intrinsic value (based on the stock price of $14.50) of options outstanding and exercisable was $3,197 and $2,698, respectively. The intrinsic value of stock options exercised during 2005 was $722.
Information regarding unvested stock options at December 31, 2005 and 2004 is as follow:
We also grant stock options to certain key employees of WC to purchase shares of WC. The options are granted at the fair market value of a share of WC stock, as determined by the Company’s Board. The options vest over three to eight years; however, for certain options, vesting is accelerated if certain performance objectives are obtained. All options expire 10 years from the grant date.
A summary of stock option activity for WC stock options and Primrose stock options for the years ended December 31, 2005, 2004 and 2003 is as follows:
Accounting Standards No. 123, Accounting for Stock-Based Compensation, as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transitions and Disclosure, an amendment to FASB Statement No. 123 (“SFAS 148”). The following table is presented in accordance with SFAS 148 and illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123R for all periods presented.
In 2004, we established a deferred compensation plan for key employees of Octagon (the “Octagon Plan”). An Administrative Committee has been appointed to administer the Octagon Plan and has the authority to, among other things, determine those employees who will participate in the Octagon Plan, approve the performance goals that each participant will be measured against, determine whether those goals were achieved and the amount to be awarded to each participant. The amount each participant can be awarded is based on a percentage of their eligible compensation (as defined), but the total amount awarded to all participants cannot exceed 10% of Octagon earnings before interest, taxes, depreciation and amortization. The amounts awarded to participants vest 50% after five years and 100% after 10 years. The Octagon Plan is not required to be funded. For the years ended December 31, 2005 and 2004, we recognized expense of $300 and $322, respectively, related to the Octagon Plan.
The provision (benefit) for income taxes from continuing operations was as follows:
The Company’s net deferred tax asset was composed of the following:
While we believe that our tax return positions are fully supportable, we expect that certain positions could be challenged and that we may not be able to successfully defend our positions. Accordingly, we establish certain reserves, including interest, for these items. We review the adequacy of these reserves periodically and make adjustments when deemed necessary. During 2005, we reversed $1,684 of such reserves as we deemed them to be no longer necessary. Remaining tax reserves at December 31, 2005 aggregated $4,948.
The following table shows the calculation of basic and diluted EPS:
Stock options to acquire 24,000, 318,000, and 324,000 shares of Class A Common Stock in 2005, 2004 and 2003, respectively, were excluded from the computation of diluted EPS because the effect of their assumed conversion was antidilutive. For the years ended December 31, 2004 and 2003, 500,000 shares of Preferred Stock, which were convertible into 500,000 shares of Class A Common Stock, were also excluded because the effect of their assumed conversion was antidilutive.
The Advisory Services Agreement with Capital Partners also provides for the payment of investment banking fees to Capital Partners for acquisition opportunities presented to the Company at usual and customary rates for transactions of similar size and complexity. Capital Partners is under no obligation to present to the Company any or all acquisition candidates of which it becomes aware. Furthermore, the Company is under no obligation to utilize Capital Partners for investment banking services. The payment of an investment banking fee to Capital Partners requires the approval of the Audit Committee, the Compensation Committee and the full Board of Directors. We paid Capital Partners an investment banking fee in 2005 of $240 in connection with the Caronia acquisition and an investment banking fee in 2003 of $150 in connection with the Octagon acquisition. The investment banking fees were capitalized as part of the acquisition costs of these acquisitions.
In November 2005, Mr. Robert Bossart, former Chief Executive Officer of WC and CMI, and Mr. Paul Miller, former Chief Financial Officer and General Counsel of WC and CMI (collectively, the “Former Executives”), filed a complaint against WC, CMI and certain of its subsidiaries (collectively, the “CMI Companies”). The complaint alleged that the Former Executives were wrongfully terminated by the CMI Companies. Each of the Former Executives filed a single claim for breach of his employment contract, seeking monetary damages. This matter was settled subsequent to December 31, 2005. See Note 17.
In connection with a written offer made by Brian Fitzgerald, our Chairman of the Board, President and Chief Executive Officer, and, through Capital Partners, the controlling person of our majority stockholder, CP Acquisitions, L.P. No. 1 (“CPI”), to acquire by merger all of the outstanding Class A Common Stock and Common Stock of Security Capital, other than shares held by Mr. Fitzgerald, Capital Partners, CPI and certain other persons (the “Offer”), three complaints were filed in the Court of Chancery of the State of Delaware in and for New Castle County (the “Court”), naming the Company, each then-member of our Board of Directors and CPI as defendants. Each of the complaints alleged that the defendants breached their fiduciary duties to the putative class and that the Offer was unfair, inadequate and not the result of arm’s-length negotiations. Each complaint sought an injunction against the proposed merger or, if the merger was consummated, the rescission of the merger, as well as money damages, attorneys’ fees, expenses and other relief. These complaints were subsequently consolidated into one class action. On November 1, 2005, the plaintiffs voluntarily dismissed the consolidated class action without prejudice.
We lease office space and certain equipment under non-cancelable operating lease agreements that expire at various dates through 2017. Certain leases include renewal provisions and require us to pay for certain operating and maintenance costs. Future minimum operating lease payments at December 31, 2005 for each of the following years are as follows:
Net rent expense for the years ended December 31, 2005, 2004 and 2003 was as follows:
On February 10, 2006, the Company signed a definitive agreement for the sale of Primrose to an affiliate of American Capital Strategies, Ltd. for an aggregate purchase price of $85,000, subject to adjustment. After adjustment for transaction costs and certain items specified in the agreement, the net purchase price is anticipated to be approximately $82,800. The Company expects to net, after taxes, approximately $58,200 for its 91.5% fully diluted interest in Primrose. The sale is subject to customary closing conditions and is anticipated to close by March 31, 2006. The net book value of the Primrose business was $22,777 at December 31, 2005.
On March 9, 2006, the Company and its WC business entered into a Settlement Agreement and Release with two former executives of the WC business (the “Agreement”). Pursuant to the Agreement, the former executives agreed to three-year covenants not to complete and non-solicitation agreements, the Company and the former executives agreed to be bound by a “drag/tag” arrangement with respect to the shares of WC held by the former executives in the event of a change of control of the Company or WC, the former executives agreed to dismiss their wrongful termination suit with prejudice, and the parties entered into mutual releases and non-disparagement agreements. Under the Agreement, the Company agreed to pay the former executives an aggregate of $1,781, with $846 of that amount payable upon a change of control of the Company or WC. The Company accrued $935 at December 31, 2005, representing the amount payable at the time of the signing of the Agreement and the amounts to be paid on the first and second anniversary date of the signing of the Agreement. The $846 payable upon a change in control of the Company or WC was not accrued at December 31, 2005.
(3) The third and fourth quarter of 2004 included expenses of the Special Committee of $312 and $215, respectively. The fourth quarter of 2004 also included expenses of $900 related to the supplemental procedures and internal investigation.
We have also reclassified certain amounts to now report income from our subsidiaries for amounts due under a tax-sharing agreement. These amounts were previously netted against income tax benefit or expense. Certain other prior year amounts have been reclassified to conform to the 2005 presentation.
On September 16, 2005, the Company acquired 979.88 shares of WC common stock directly from the minority stockholders of WC for total cash consideration of $3,341. Also on September 16, 2005, certain option holders of WC exercised options to purchase shares of WC. As a result of the exercise of these options, an additional 408.41 shares of WC common stock were issued to WC minority stockholders. The resulting net increase of 571.47 shares of WC held by the Company relative to the minority stockholders of WC, increased the Company’s ownership interest in WC from 80% to 84.4%.
During 2004 and 2003, the Company had issued and outstanding 500,000 shares of Redeemable Convertible Preferred Stock (the “Preferred Stock”), with a stated redemption value of $10 per share. The Preferred Stock was convertible into Class A Common Stock on a 1:1 basis. The Preferred Stock was redeemable at the option of the stockholder upon the occurrence of certain events or on April 6, 2006. On November 10, 2004, all outstanding shares of Preferred Stock were redeemed for $5,000, or $10 per share.
The Company had 2,500,000 shares of authorized preferred shares, $0.01 par value, available for issuance at December 31, 2005.
During the fourth quarter of 2003, we committed to a plan to sell the operations of Pumpkin Masters Holdings, Inc. (“Pumpkin”) and, in October 2004, we sold substantially all of the assets of Pumpkin for $8,741, which includes an additional working capital payment of $1,741. A loss of $3,928 was recognized on the sale and is reflected in equity in income of subsidiaries in the condensed statements of income.
During 2006, an additional 378,000 shares of Class A Common Stock of the Company were issued as a result of stock option exercises. Cash of $3,318 was received from the stock option exercises.