Certain statements contained in this document, including Management’s Discussion and Analysis of Financial Condition and Results of Operations, that are not historical facts, constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results or performance of Regan Holding Corp. and its businesses to be materially different from that expressed or implied by such forward-looking statements. These risks, uncertainties and factors include, among other things, the following: general market conditions and the changing interest rate environment; the interruption, deterioration, or termination of our relationships with the insurance carriers who provide our products or the agents who market and sell them; the ability to develop and market new products to keep up with the evolving industry in which we operate; increased governmental regulation, especially regulations affecting insurance, reinsurance, and holding companies; the ability to attract and retain talented and productive personnel; the ability to effectively fund our working capital requirements; the risk of substantial litigation or insurance claims; and other factors referred to under Item 1A. Risk Factors.
Legacy Marketing also has administrative agreements with each of the insurance carriers listed above. Under the terms of the administrative agreements, Legacy Marketing provides clerical, administrative and accounting services with respect to the insurance policies. For providing these services, the insurance carriers pay Legacy Marketing administrative fees.
Through our wholly-owned broker-dealer subsidiary, Legacy Financial, we sell variable annuity and life insurance products, mutual funds, and debt and equity securities. Sales of investment products are conducted through Legacy Financial’s network of independent registered representatives.
Lynda Regan, Chief Executive Officer, and R. Preston Pitts, President, Chief Operating Officer and Chief Financial Officer of Regan Holding, are the primary owners of PD Holdings. In connection with the sale, we also entered into a service agreement with PD Holdings whereby subsidiaries of Regan Holding will provide certain administrative services to PD Holdings for a fee equal to the cost of the services provided.
The Term Loan is primarily secured by our bank and securities accounts, equipment and investment property, and Legacy Marketing’s obligations are currently guaranteed by Regan Holding, Legacy Advisory Services, Inc., Imagent Online LLC and certain shareholders of Regan Holding. In addition, Legacy Marketing is required to comply with other financial and non-financial covenants specified in the Agreement. In the event of default under the Agreement, the entire balance of the Term Loan would become immediately payable unless Legacy Marketing obtains a waiver from the Lender.
The administrative agreement between IL Annuity and Legacy Marketing expired on April 30, 2006. In the twelve months ended December 31, 2006 and 2005, Legacy Marketing received approximately $600,000 and $1.7 million in gross revenue under the administrative agreement. The expiration of the administrative agreement does not affect the commissions earned by Legacy Marketing on additional premium received or assets under management with respect to the underlying IL Annuity insurance contracts.
In recent years, the U.S. insurance regulatory framework has come under increased scrutiny. Some state legislatures have considered laws that may alter or increase state regulation of insurance, reinsurance, and holding companies. Moreover, the National Association of Insurance Commissioners and state insurance regulators regularly re-examine existing laws and regulations, often focusing on modifications to holding company regulations, interpretations of existing laws, and the development of new laws. Changes in these laws and regulations or their interpretation could have a material adverse effect on our financial condition or results of operations. In addition, the U.S. Congress and insurance regulatory groups have recently held hearings on, and the U.S. Congress has in the past considered statutes that would impose certain national uniform standards and repeal the McCarran-Ferguson antitrust exemption for the business of insurance. The U.S. Congress could adopt laws or regulations that could have a material adverse effect on our financial condition or results of operations.
There are no significant management judgments associated with reporting these revenues. When a policyholder remits a premium payment with an accurate and completed application for an insurance policy, the policy is considered inforce and Legacy Marketing recognizes marketing allowances and commission income. Legacy Marketing’s carriers grant policyholders a contractual right to terminate the insurance contract ten to thirty days after a policy is placed inforce. This return period varies depending on the carrier, the type of policy and the jurisdiction in which the policy is sold. Legacy Marketing gathers historical product return data that does not vary significantly from quarter to quarter, and has historically been predictive of future events. Returns are estimated using this data and have been reflected in the Consolidated Financial Statements. Legacy Marketing recognizes administrative fees on a per transaction basis as services are performed, with the amount of the fee depending on the type of policy and type of service.
We capitalize external consulting fees, and salaries and benefits for employees who are directly associated with the development of software for internal use, when both of the following occur:
We had a consolidated net loss from continuing operations of $6.2 million in 2006, compared to a consolidated net loss from continuing operations of $12.3 million in 2005. The $6.1 million decrease in losses was primarily due to lower net losses incurred by Legacy Marketing and $2.7 million non-recurring tax recovery. We had a consolidated net loss of $6.3 million in 2006, compared to a consolidated net loss of $13.7 million in 2005. The $7.4 million decrease in losses was primarily due to lower net losses incurred by Legacy Marketing, $2.7 million non-recurring tax recovery and lower losses from discontinued operations.
We had a consolidated net loss from continuing operations of $12.3 million in 2005, compared to a consolidated net loss from continuing operations of $6.7 million in 2004. The $5.6 million increase in losses was primarily due to higher net losses incurred by Legacy Marketing and Imagent Online.
Legacy Marketing’s revenue increased $1.3 million (5%) in 2006 compared to 2005 primarily due to increased marketing allowances and commissions of $1.7 million and other revenue of $884,000, partially offset by a decline in administrative fees of $1.2 million. Marketing allowances and commissions increased $1.7 million (11%) primarily due to
the sales of fixed annuity products issued by Washington National. We began marketing Washington National products in March 2006. The increase in sales due to the introduction of a new product with Washington National was partially offset by a decline in sales of fixed annuity products issued by Investors Insurance. This decrease occurred primarily because we discontinued selling fixed annuity products issued by Investors Insurance in certain states during the third quarter of 2005 due to changes in regulatory requirements of those jurisdictions related to minimum guaranteed rates.
Legacy Marketing’s operating expenses decreased $3.7 million (10%) in 2006 compared to 2005 primarily due to a $2.9 million impairment charge for internal use software recorded in 2005. Excluding the $2.9 million impairment charge for internal use software, Legacy Marketing’s expenses decreased $800,000 (2%) in 2006 compared to 2005 primarily due to decreased selling, general and administrative expenses and other expenses. Selling, general and administrative expenses decreased $508,000 (2%) primarily due to decreased compensation and benefits, partially offset by higher sales promotion and support costs. Compensation and benefits decreased primarily due to decreased employee headcount, and sales promotion and support increased in 2006 primarily as the result of increased sales incentive costs. We had a benefit from income taxes of approximately $2.7 million in 2006 resulting from a settlement of prior years’ tax matters. In addition, Legacy Marketing has established a valuation allowance related primarily to its federal and state deferred tax assets, which increased $3.0 million in 2006.
Legacy Marketing’s revenue decreased $9.2 million (27%) in 2005 compared to 2004 primarily due to decreased marketing allowances and commissions and administrative fees. Marketing allowances and commissions decreased $7.2 million (32%) primarily due to decreased sales of fixed annuity products issued by Legacy Marketing’s carriers.
Legacy Marketing experienced a decrease in sales of fixed annuity products issued by Investors Insurance in 2005 compared to 2004. We believe the decrease was primarily attributable to a downgrade in the A.M. Best credit rating of Investors Insurance from an A- rating to a B++ rating in September 2003. As a result, sales of fixed annuity products issued by Investors Insurance declined throughout 2004. In addition, we discontinued selling fixed annuity products issued by Investors Insurance in certain states during 2005 due to changes in regulatory requirements related to minimum guaranteed rates, which contributed to the decrease in sales of fixed annuity products in the second half of 2005. Revenues from the sales and administration of Investors Insurance products decreased $4.5 million in 2005 compared to 2004 and accounted for 20% and 27% of our total consolidated revenue for the years ended December 31, 2005 and 2004.
Legacy Marketing’s fixed annuity product sales were also negatively affected by Transamerica and Legacy Marketing deciding to discontinue the marketing of Transamerica products that were marketed exclusively by Legacy Marketing, effective May 3, 2004. Revenues derived from sales and administration of Transamerica products decreased $4.0 million in 2005 compared to 2004 and accounted for 18% and 24% of our total consolidated revenue for the years ended December 31, 2005 and 2004. Legacy Marketing continues to administer the discontinued products and to accept additional premium payments, subject to applicable additional deposit rules for these products.
Legacy Marketing’s fixed annuity product sales were positively impacted in 2005, as compared to 2004, by revenue derived from sales and administration of products issued by Americom. In June 2004, Legacy Marketing entered into marketing and administrative services agreements with Americom and began marketing and administering Americom products in November 2004. Revenue derived from sales and administration of Americom products was $3.2 million in 2005 and accounted for approximately 11% of our total consolidated revenue for the year ended December 31, 2005.
In January 2006, we decided to discontinue the operations of Values Financial Network (“VFN”). We incurred insignificant costs in connection with exiting the operations.
We had net losses from our discontinued segment of $1.4 million in 2005 compared to a net loss of $751,000 in 2004. The increase in net loss was primarily due to an increase in the valuation allowance against VFN’s deferred tax assets of $1.0 million and a valuation allowance of $201,000 recorded for a long-lived asset. These expenses were partially offset by decreased goodwill impairment losses of $679,000 resulting from a goodwill impairment charge in 2004 and a decrease in compensation and benefits and professional fees in 2005.
On January 25, 2007, prospectdigital sold certain of its assets, which primarily included fixed assets and other miscellaneous operating assets, to PD Holdings. In addition, PD Holdings agreed to assume certain liabilities of prospectdigital. The action was taken in a continuing effort to reduce operating expenses as prospectdigital continued to sustain losses through the date of sale.
Imagent Online had a net loss of $1.3 million in 2006 compared to a net loss of $961,000 in 2005. Losses have increased in 2006 primarily due to an increase in valuation allowance against Imagent Online’s deferred tax assets. Imagent Online’s pre-tax losses decreased in 2006 primarily due to reduced depreciation expense. Depreciation expense was higher in 2005 primarily due to accelerating depreciation on certain capitalized software, which was replaced by a new version.
Our cash provided by or used in operating activities generally follows the trend in our revenue and operating results. Our cash used in operating activities was $4.5 million, $5.6 million and $4.4 million in 2006, 2005 and 2004. Our cash used in operating activities in 2006 was primarily the result of our net loss and non-cash charges such as gains on trading securities, partially offset by depreciation and amortization, a decrease in prepaid expenses and by proceeds from the sales of trading securities.
Our cash used in operating activities during 2005 was primarily the result of our net loss and an increase in deposits and other assets resulting from the prepayment of rent and a lease deposit in connection with the sale/leaseback of our Petaluma office buildings. These amounts were partially offset by non-cash charges, including depreciation and amortization and losses on write-off of fixed assets. In addition, our income tax receivable declined due to an income tax refund received in 2005.
In April 2004, we completed construction of our office building in Rome, Georgia, financing it with a $2.9 million variable interest rate note indexed to 30-day LIBOR plus 1.9%. The note is payable over ten years in monthly installments of principal, amortized on the basis of a 20-year term, and interest. At the end of the ten years, we must pay the balance of the principal due on the note. The outstanding balance of the note as of December 31, 2006, was $2.7 million. To manage interest expense, we entered into an interest rate swap agreement with a notional amount equal to the principal balance of the note, which modifies its interest expense from a variable rate to a fixed rate. The April 2004 swap agreement involves the exchange of interest obligations from April 2004 through April 2014 whereby we pay a fixed rate of 6.8% in exchange for a variable rate indexed to 30-day LIBOR plus 1.9%.
We lease office and warehouse premises and certain office equipment under non-cancelable operating leases. As of December 31, 2006, our total contractual cash obligations, including the building financing and the loan with Washington National discussed above, were as follows:
Pursuant to the terms of our Amended and Restated Shareholder's Agreement with Lynda L. Regan, Chief Executive Officer of the Company and Chairman of our Board of Directors, upon the death of Ms. Regan, we would have the option (but not the obligation) to purchase from Ms. Regan’s estate all shares of common stock that were owned by Ms. Regan at the time of her death, or were transferred by her to one or more trusts prior to her death. In addition, upon the death of Ms. Regan, her heirs would have the option (but not the obligation) to sell their inherited shares to us. The purchase price to be paid by us shall be equal to 125% of the fair market value of the shares. As of December 31, 2006, we believe that 125% of the fair market value of the shares owned by Ms. Regan was equal to $900,000. We have purchased life insurance coverage for the purpose of funding this potential obligation upon Ms. Regan’s death.
We used $4.5 million, $5.6 million and $4.4 million of cash in operations in 2006, 2005 and 2004, respectively. We also incurred consolidated net losses of $6.3 million, $13.7 million and $7.5 million in 2006, 2005 and 2004, respectively. If our consolidated net losses continue, a cash shortfall could occur. To address this issue, during 2006, we lowered our cost structure by reducing our employee headcount. In January 2007, we exited the prospectdigital business and disposed of its assets. This action eliminated approximately $1.2 million of annual cash use. In addition, we intend to continue lowering costs by refining our business model to focus on higher value added activities. This will include multiple initiatives to increase efficiencies. Certain activities may be eliminated completely; other activities may be restructured. We are currently restructuring a portion of our debt, which we anticipate will enable us to defer our obligation to begin making scheduled principal payments until March 2008 and improve our liquidity by allowing us to leverage certain assets the use of which is currently restricted by the debt agreement. We are also in negotiations to sell certain assets, which sales, if successful, will result in additional cash inflows. In the event that a cash shortfall does occur, we believe that adequate financing could be obtained to meet our cash flow needs. However, there can be no assurances that such financing would be available on favorable terms.
To the Board of Directors and Shareholders of Regan Holding Corp.:
In our opinion, the consolidated statement of operations, shareholders' equity and cash flows for the year ended December 31, 2004, before the effects of the adjustments to retrospectively reflect the discontinued operations described in Note 15, present fairly, in all material respects, the results of operations and cash flows of Regan Holding Corp. and its subsidiaries for the year ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America (the 2004 financial statements before the effects of the adjustments discussed in Note 15 are not presented herein). In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) for the year ended December 31, 2004 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements before the effects of the adjustments described above. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit, before the effects of the adjustments described above, of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
Legacy Marketing also has administrative agreements with the carriers. The administrative agreement with IL Annuity expired on April 30, 2006. Pursuant to the administrative agreements, Legacy Marketing provides clerical, administrative, and accounting services with respect to the policies. These services include billing, collecting and remitting premium for the policies. For providing these services, the carriers pay Legacy Marketing administrative fees.
The Company’s investments are classified as available-for-sale or trading securities and are carried at fair value. For available-for-sale securities, unrealized gains and losses, net of the related tax effect, are reported as a separate component of shareholders’ equity. For trading securities, unrealized gains and losses are reported in Selling, general and administrative expenses.
In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is currently evaluating the effect, if any, that implementation of SFAS No. 157 will have on its results of operations and financial condition.
In September 2006, the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements in Current Year Financial Statements” (“SAB 108”) which provides guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The Company has determined that the guidance in SAB 108 does not have a material impact on its financial position or results of operations.
On November 18, 2005, the Company sold its office buildings in Petaluma, California for a purchase price of $12.8 million. In connection with the sale, the Company disposed of the following fixed assets:
exchange for annual option fees. The Company had the right to exercise the option at any time on or prior to June 30, 2005, or terminate the Option Agreement in accordance with its terms before such date if the A.M. Best rating of Investors Insurance declined below a specified level. The A.M. Best rating of Investors Insurance fell below the specified level. On June 22, 2005, the Company terminated the Option Agreement. SCOR repaid the option fees paid by the Company pursuant to the Option Agreement, including interest, totaling approximately $3.3 million.
As of December 31, 2004, the Company had an outstanding mortgage due of $7.1 million on its office buildings in Petaluma, California. The note bore interest at 6.95% and was originally due by August 1, 2012. On November 18, 2005, in connection with the sale of its office buildings in Petaluma, California, the Company repaid the outstanding mortgage due on the buildings.
The Company’s future annual principal payments on the Term Loan and the mortgage are as follows:
The Company sponsors a qualified defined contribution 401(k) plan, which is available to all employees. The 401(k) plan allows employees to defer, on a pre-tax basis, up to 15% of their annual compensation as contributions to the 401(k) plan, subject to a maximum of $15,000. The Company typically matches 50% of each employee’s contributions up to 6% of their annual compensation, subject to a maximum of $7,500. The Company’s matching contributions were $249,000, $115,000, and $311,000 for the years ended December 31, 2006, 2005, and 2004.
achievement of predetermined monthly sales targets. The Company recorded expense of $1.9 million during the year ended December 31, 2006 related to these programs, of which $332,000 was paid as of December 31, 2006. The Company recorded expense of $910,000 during the year ended December 31, 2005, related to this program, of which $425,000 was paid as of December 31, 2005. The amount expensed in 2004 was $392,000. The amounts expensed are included in selling, general and administrative expenses.
The Company leases office and warehouse premises and certain office equipment under non-cancelable operating leases. Related rent expense of $1.3 million, $298,000, and $329,000 is included in occupancy costs for the years ended December 31, 2006, 2005, and 2004. Total rentals for leases of equipment included in equipment expense were $747,000, $727,000, and $674,000 for the years ended December 31, 2006, 2005, and 2004.
Between 1990 and 1992, the Company issued Series A and Series B redeemable common stock to certain shareholders. The Company is obligated to repurchase the redeemable common stock at the current fair market value. Because there is no active trading market for the Company’s stock that would establish market value, the Company’s Board of Directors approved a redemption value for Series A redeemable common stock of $0.06 per share and $0.69 per share, and a redemption value for Series B redeemable common stock of $0.05 and $0.57 per share, as of December 31, 2006 and 2005, based on an independent appraisal of the stock value obtained by management.
Under the prospective application method, the Company is required to record compensation expense prospectively for all employee stock options awarded during the reporting period based upon the fair-value-based method prescribed by SFAS No. 123R. The Company estimates the fair value of each stock option award on the date of grant using the Black-Scholes stock option valuation model. The estimated fair value of employee stock option awards is amortized over the award’s vesting period on a straight-line basis. Compensation expense related to stock options awarded in 2006 was immaterial.
The following table summarizes information about stock options outstanding at December 31, 2006 under both plans:
The provision for (benefit from) federal and state income taxes consist of amounts currently payable (receivable) and amounts deferred, which for the periods indicated, are shown below:
As of December 31, 2006, the Company had federal and primary state net operating loss carryforwards of $17.1 million and $34.7 million. On December 31, 2024, 2025 and 2026, $251,000, $4.8 million and $12.1 million of the federal net operating losses will expire. On December 31, 2012, $4.9 million of the state net operating losses will begin to expire. The Company also has federal and state alternative minimum tax credit carryforwards of $192,000 and $275,000. These credits do not have an expiration date. Federal and state tax valuation allowances have been established for all of the federal and state net operating loss carryforwards and the federal and state tax credit carryforwards.
We had net losses from our discontinued segment of $9,000 in 2006, $1.4 million in 2005 and a net loss of $751,000 in 2004.
Cash provided by or used in operating activities generally follows the trend in the Company’s revenue and operating results. Cash used in operating activities was $4.5 million, $5.6 million and $4.4 million in 2006, 2005 and 2004, respectively. The Company also incurred consolidated net losses of $6.3 million, $13.7 million and $7.5 million in 2006, 2005 and 2004, respectively. If the Company’s consolidated net losses continue, a cash shortfall could occur. To address this issue, during 2006, the Company lowered its cost structure by reducing its employee headcount. In January 2007, the Company exited the prospectdigital business and disposed of its assets. This action eliminated approximately $1.2 million of annual cash use. In addition, the Company intends to continue lowering costs by refining its business model to focus on higher value added activities. This will include multiple initiatives to increase efficiencies. Certain activities may be eliminated completely; other activities may be restructured. The Company is currently restructuring a portion of its debt, which it anticipates will enable it to defer its obligation to begin making scheduled principal payments until March 2008 and improve its liquidity by allowing it to leverage certain assets the use of which is currently restricted by the debt agreement. The Company is also in negotiations to sell certain assets, which sales, if successful, will result in additional cash inflows. In the event that a cash shortfall does occur, the Company believes that adequate financing could be obtained to meet its cash flow needs. However, there can be no assurances that such financing would be available on favorable terms.
On November 18, 2005, the Company sold its office buildings in Petaluma, California for $12.8 million. The Company and the third party buyer (the “Buyer”) further agreed to enter into a ten year lease agreement, concurrently with the sale of the buildings, whereby the Company is leasing back (i) 71,612 square feet for a period not to exceed eighteen months and (ii) between 35,612 and 51,612 square feet for the remainder of the lease term. The monthly base rent is $1.29 per square foot and will increase annually by three percent during the term of the lease, in addition to monthly taxes and operating expenses. Pursuant to the terms of the lease, the Company paid the Buyer a security deposit of $1.0 million and advance rent of $980,000. The advance rent was utilized to pay the monthly base rent, monthly taxes and operating expenses during the first nine months of the lease term. The security deposit will be reduced if the Company meets certain profitability criteria as specified in the Agreement.
On January 25, 2007, prospectdigital LLC ("prospectdigital"), an indirect wholly owned subsidiary of the Company, sold certain of its assets, which primarily included fixed assets and other miscellaneous operating assets, to PD Holdings LLC ("PD Holdings"). In addition, PD Holdings agreed to assume certain liabilities of prospectdigital. The action was taken in a continuing effort to reduce the Company’s operating expenses, as prospectdigital continued to sustain losses through the date of sale.
Lynda Regan, Chief Executive Officer, and R. Preston Pitts, President, Chief Operating Officer and Chief Financial Officer of the Company, are the primary owners of PD Holdings. In connection with the sale, the Company also entered into a service agreement with PD Holdings, whereby subsidiaries of the Company will provide certain administrative services to PD Holdings, for a fee equal to the cost of the services provided.