(a) We adopted SFAS No. 142 on January 1, 2002. Under SFAS No. 142, goodwill and intangible assets deemed to have indefinite lives are no longer amortized but are reviewed annually (or more frequently if impairment indicators arise) for impairment. Separable intangible assets that are not deemed to have indefinite lives will continue to be amortized over their useful lives (but with no maximum life). Goodwill amortization was $4.4 million and $5.5 million in 2000 and 2001, respectively. In accordance with SFAS No. 142, we recognized an impairment loss on goodwill and identifiable intangible assets not subject to amortization of $0.8 million in 2002, $5.7 million in 2003 and $2.4 million in 2004. Prior to the adoption of SFAS No. 142, we accounted for long-lived assets in accordance with SFAS No. 121. For the years ended December 31, 2000 and 2001, we recorded an impairment loss on goodwill of $1.1 million and $2.1 million, respectively.
We are a leading independent distributor of financial services products primarily to high net worth individuals and growing entrepreneurial companies. Founded in 1998, and commencing operations on January 1, 1999, we have grown internally and through acquisitions and, as of December 31, 2004, operate a national distribution network with over 1,700 producers in 41 states and Puerto Rico operating through 144 owned firms and over 200 affiliated third-party distributors. We acquired 26, 24 and 19 firms in 2002, 2003 and 2004, respectively. Our operating results have improved from a net loss of $(10.5) million in 1999 to net income of $40.1 million in 2004. As a result of new acquisitions and the growth of previously acquired firms, we have grown from a base of no revenue at the beginning of 1999 to $639.5 million of revenue in 2004.
acquisition price, we first estimate the annual operating cash flow of the business to be acquired based on current levels of revenue and expense. For this purpose, we define operating cash flow as cash revenue of the business less cash and non-cash expenses, other than amortization, depreciation and compensation to the business’s owners or individuals who subsequently become principals. We refer to this estimated annual operating cash flow as “target earnings.” Our acquisition price is a multiple (generally in a range of five to six times) of a portion of the target earnings, which we refer to as “base earnings.” Base earnings average 47% of target earnings for all firms owned at December 31, 2004. In determining base earnings, our general rule is not to exceed an amount equal to the recurring revenue of the business. By recurring revenue, we mean revenue from sales previously made (such as renewal commissions on insurance products, commissions and administrative fees for ongoing benefit plans and mutual fund trail commissions) and fees for assets under management.
Additional purchase consideration is often paid to the former owners based on satisfying specified internal growth thresholds over the three-year period following the acquisition.
Substantially all of our acquisitions have been paid for with a combination of cash and our common stock, valued at its then fair market value. We require our principals to take typically at least 30% of the total acquisition price in our common stock; however, through December 31, 2004, principals have taken on average approximately 45% of the total acquisition price in our common stock. The following table shows acquisition activity in the following periods:
Although Management believes that we will continue to have opportunities to complete a similar number of acquisitions as we have had in the past three years, there can be no assurance that we will be successful in identifying and completing acquisitions. See “Risk Factors-Risks Relating to Our Company-We may be unsuccessful in acquiring suitable acquisition candidates, which could adversely affect our growth.” Any change in our financial condition or in the environment of the markets in which we operate could impact our ability to source and complete acquisitions.
Corporate and executive benefits commissions and fees. Our firms earn commissions on the sale of insurance policies written for benefit programs. The commissions are paid each year as long as the client continues to use the product and maintain its broker of record relationship with us. Our firms also earn fees for the development and implementation of corporate and executive benefit programs as well as fees for the duration that these programs are administered. Asset-based fees are also earned for administrative services or consulting related to certain benefits plans.
Financial planning and investment advisory fees and securities commissions. Our firms earn commissions related to the sale of securities and certain investment-related insurance products as well as fees for offering financial advice and related services. These fees are based on a percentage of assets under management and are generally paid quarterly. In a few cases, incentive fees are earned based on the performance of the assets under management. Some of our firms charge flat fees for the development of a financial plan or a flat fee annually for advising clients on asset allocation.
Our firms also earn additional compensation in the form of incentive revenue, from manufacturers of financial services products, based on the volume, persistency and profitability of business generated by us from these three sources. These forms of payments are earned both with respect to sales by our owned firms and sales by our network of over 200 affiliated third-party distributors.
Some of our firms offer property and casualty insurance brokerage and advisory services. We believe these services complement the corporate and executive benefits services provided to our clients. Commissions and fees are earned in connection with these services.
Commissions and fees. Commissions and fees are typically paid to non-principal producers, who are producers that are employed by or affiliated with our firms but are not principals. When business is generated solely by a principal, no commission expense is incurred because principals are only paid from a share of the cash flow of the acquired firm through management fees. However, when income is generated by a non-principal producer, the producer is generally paid a portion of the commission income, which is reflected as commission expense of the acquired firm. The use of non-principal producers affords principals the opportunity to expand the reach of the business of a firm beyond clients or customers with whom they have direct contact. In addition, NFPSI pays commissions to our affiliated third-party distributors who transact business through NFPSI.
if a firm produces earnings below target earnings in a given year, our share of the firm’s total earnings would be higher for that year. If a firm produces earnings at or above target earnings, our share of the firm’s total earnings would be equal to the percentage of the earnings capitalized by us in the initial transaction, less any additional management fees earned under ongoing incentive plans.
Stock- based compensation. Stock-based compensation expense consists primarily of expenses related to stock option grants under two incentive programs offered to the principals and certain employees of our earlier acquisitions. As an inducement to the sellers of the first 27 firms we acquired, the first incentive program allowed principals and certain employees to earn options at a fixed exercise price of $10.00 per share. The incentive program under which these stock options were granted expired, and therefore the stock-based compensation expense related to this program has ended. The second program, offered to the sellers of the next 40 firms we acquired, allows principals and certain employees to earn options with a strike price equal to the price of our common stock at the time the options were earned. The second incentive program expired at the end of 2003.
Impairment of goodwill and intangible assets. The firms we acquire may not continue to positively perform after the acquisition for various reasons, including legislative or regulatory changes that affect the products in which a firm specializes, the loss of key clients after the acquisition closed, general economic factors that impact
In addition to internal growth in the revenue of our firms, we monitor acquired firm revenue, commission and fee expense and operating expense from new acquisitions as compared with existing firms. For this purpose, a firm is considered to be a new acquisition for the twelve months following the acquisition. After the first twelve
months, a firm is considered to be an existing firm. Within any reported period, a firm may be considered to be a new acquisition for part of the period and an existing firm for the remainder of the period. Additionally, NFPSI and NFPISI are considered to be existing firms. Sub-acquisitions that do not separately report their results are considered to be part of the firm making the acquisition, and the results of firms disposed of are included. The results of operations discussions set forth below include analysis of the relevant line items on this basis.
Management fees. Management fees increased $50.7 million, or 53.7%, to $145.1 million in 2004 compared with $94.4 million in 2003. The increase results from higher earnings at our acquired firms generated primarily through new acquisitions and internal growth of existing firms. Management fees represented 50.8% of gross margin before management fees in 2004 compared with 46.6% in 2003. A higher percentage of our firms operated at or above target earnings in 2004 compared with 2003. This resulted in a greater proportion of management fees being accrued than in the prior period. In addition, management fees included an accrual of $9.3 million for ongoing incentive plans in 2004 compared with $2.4 million in 2003, primarily reflecting growth at firms that we have owned for at least three years, and that are ending their incentive cycle. Offsetting the increase were higher earnings at NFPISI and NFPSI, for which no management fee expense is realized. Management fees as a percentage of revenue increased to 22.7% in 2004 from 20.3% in 2003.
Gross margin. Gross margin increased $32.3 million, or 29.9%, to $140.4 million in 2004 compared with $108.1 million in 2003. This increase was largely due to the rate of growth in revenue exceeding the growth in commissions and fees expense and operating expenses as described above.
General and administrative. General and administrative expenses increased $9.2 million, or 35.1%, to $35.4 million in 2004 compared with $26.2 million in 2003. The increase was primarily due to cost associated with the implementation of Sarbanes-Oxley and other corporate initiatives. In 2004, expenses associated with Sarbanes-Oxley compliance totaled approximately $3.8 million. In addition, the Company incurred one-time expenses of $1.0 million related to a reserve for notes receivable related primarily to two previously unwound firms and severance. As a percentage of revenue, general and administrative expense declined to 5.5% in 2004 compared with 5.7% in 2003, as we continued to benefit from the absorption of corporate expenses over an expanding revenue base.
related to options expected to be issued under the option incentive programs (see “Business-Acquisition Strategy-Option incentive programs”). One program expired during the second half of 2002 and the other program expired in the fourth quarter of 2003. In conjunction with the ending of these programs, we reduced accruals for options which were not issued by $2.1 million during 2003. The reduction of these accruals offset option expense of $1.8 million recorded in connection with the option incentive programs and $0.5 million of option compensation expense for the stock-based employee compensation plans. As a percentage of revenue, option compensation expense was 0.2% in 2004 compared with less than 0.1% in 2003.
(Gain) loss on sale of subsidiaries. Loss on sale of subsidiaries decreased $1.9 million to $(0.1) million in 2004 compared with $1.8 million in 2003. The gain on sale resulted from the disposal of one subsidiary in 2004 and the loss on sale resulted from the disposal of three subsidiaries in 2003.
Interest and other income. Interest and other income increased $0.6 million, or 37.5%, to $2.2 million in 2004 compared with $1.6 million in 2003.
Income tax expense. Income tax expense increased $8.7 million, or 37.3%, to $32.0 million in 2004 compared with $23.3 million in 2003. The increase is a direct result of an 54.1% increase in pretax income for the year ended December 31, 2004 of $72.1 million compared with $46.8 million for the year ended December 31, 2003, offset by a decrease in our effective tax rate to 44.4% from 49.8%. The effective tax rate differs from the provision calculated at the federal statutory rate primarily because of certain expenses that are not deductible for tax purposes, as well as the effects of state and local taxes. The effective tax rate declined in 2004 as a direct result of the proportional increase in pretax income relative to nondeductible expenses, as well as benefits obtained through state tax planning initiatives commenced during the year.
Commissions and fees. Commissions and fees expense increased $19.7 million, or 21.4%, to $111.6 million in 2003 compared with $91.9 million in 2002. The increase was principally due to business generated by firms
which were acquired in 2002 and in 2003. As a percentage of revenue, commissions and fees expense decreased to 24.0% in 2003 from 26.4% in 2002. The decline as a percentage of revenue was attributable to lower commission expense as a percentage of revenue at newly acquired firms as well as a reduction in the commission payout rate at our broker-dealer, NFPSI. Commissions and fees expense from new acquisitions were approximately $5.4 million in 2003. Commissions and fees expense from existing firms were approximately $106.2 million in 2003 compared with $91.9 million in 2002.
Operating expenses. Operating expenses increased $35.0 million, or 30.4%, to $150.3 million in 2003 compared with $115.3 million in 2002. The increase was principally due to business generated by firms which were acquired during 2002 and 2003 and internal growth at our existing firms. As a percentage of revenue, operating expenses declined to 32.4% in 2003 from 33.1% in 2002 as the rate of expense growth was slightly below the rate of revenue growth. Operating expenses from new acquisitions were approximately $19.5 million in 2003. Operating expenses from existing firms were approximately $130.8 million in 2003 compared with $115.3 million in 2002.
Management fees. Management fees increased $28.8 million, or 43.9%, to $94.4 million in 2003 compared with $65.6 million in 2002. The increase results from higher earnings at our acquired firms generated primarily through new acquisitions and internal growth of existing firms. Management fees represented 46.6% of gross margin before management fees in 2003 compared with 46.5% in 2002. A higher percentage of our firms operated at or above target earnings in 2003 compared with 2002. This resulted in a greater proportion of management fees being accrued than in the prior period. In addition, management fees included an accrual of $2.4 million for ongoing incentive plans in 2003 compared with $0.8 million in 2002, reflecting growth at firms that we have owned for at least three years. Offsetting the increase were higher earnings at NFPISI and NFPSI, for which no management fee expense is realized. Management fees as a percentage of revenue increased to 20.3% in 2003 from 18.8% in 2002.
General and administrative. General and administrative expenses increased $5.5 million, or 26.6%, to $26.2 million in 2003 compared with $20.7 million in 2002. The increase reflects additional expenses associated with operating as a public company, including increased directors and officers liability insurance premiums, costs associated with stockholder services, as well as higher accrued incentive compensation. In 2003 we accrued $1.8 million for a production bonus related to the acquisition of an insurance marketing platform completed at the beginning of 2000. The production bonus was accrued based upon the achievement of specific milestones over a thirty-nine month period. During 2002 we reversed approximately $0.7 million of acquisition bonuses that were previously accrued as certain contingencies required for the payment of the bonuses and were not met As a percentage of revenue, general and administrative expense declined to 5.7% in 2003 compared with 6.0% in 2002, as we continue to benefit from the absorption of corporate expenses over an expanding revenue base.
Stock-based compensation. Stock-based compensation expense decreased $9.7 million to $0.2 million in 2003 compared with $9.9 million in 2002. In prior years, we accrued stock-based compensation expense related to options expected to be issued under the option incentive programs (see “Business-Acquisition Strategy-Option incentive programs”). One program expired during the second half of 2002 and the other program expired in the fourth quarter of 2003. In conjunction with the ending of these programs, we reduced accruals for options which were not issued by $2.1 million during 2003. The reduction of these accruals offset stock based compensation expense of $1.8 million recorded in connection with the option incentive programs and $0.5 million of stock-based compensation expense for the stock-based employee compensation plans. As a percentage of revenue, stock-based compensation expense was less than 0.1% in 2003 compared with 2.8% in 2002.
Depreciation. Depreciation expense increased $1.6 million, or 51.6%, to $4.7 million in 2003 compared with $3.1 million in 2002. The increase in depreciation resulted from an increase in the number of owned firms and a higher level of capital expenditures as some firms moved into newer or larger facilities, purchased office furniture and made investments in new technology. As a percentage of revenue, depreciation expense increased to 1.0% in 2003 from 0.9% in 2002.
Interest and other income. Interest and other income decreased $0.3 million, or 15.8%, to $1.6 million in 2003 compared with $1.9 million in 2002.
As of December 31, 2004, we had cash and cash equivalents of $83.1 million, an increase of $11.9 million from the balance as of December 31, 2003 of $71.2 million. As of December 31, 2003, we had cash and cash equivalents of $71.2 million, an increase of $39.4 million from the balance as of December 31, 2002 of $31.8 million. The increase in cash and cash equivalents during 2004 was due to cash provided by operations, and cash proceeds from the exercise of stock options, offset by payments for acquired firms, net of cash, and continent consideration, and cash dividends paid on common stock. The increase in cash and cash equivalents during 2003 was due to net cash proceeds of $86.4 million provided by the sale of 4.3 million shares of common stock through our initial public offering in September 2003 and cash provided by operations, offset by $39.5 million in repayments of borrowings under our credit facility. The decrease in cash and cash equivalents during 2002 resulted from investments in acquisitions and capital spending which were partially offset by the increase in cash provided by operations and additional borrowings under the credit facility.
During 2004, cash provided by operating activities was $86.1 million resulting primarily from an increase in net income and an increase in premiums payable to insurance carriers, due to principals and/or certain entities they own and accrued liabilities. The increase was partially offset by an increase in cash, cash equivalents and securities purchased under resale agreements in premium trust accounts, commissions, fees and premiums receivable, net, and other current assets. During 2003, cash provided by operating activities was $50.3 million, resulting primarily from an increase in net income and an increase in premiums payable to insurance carriers, accrued liabilities and due to principals and/or certain entities they own, and partially offset by an increase in cash, cash equivalents and securities purchased under resale agreements in premium trust accounts, and commissions, fees and premium receivable, net. During 2002, $24.3 million of cash was provided by operating activities, primarily as a result of an increase in net income, partially offset by an increase in notes receivable, net of deposits, and an increase in commissions, fees and premiums receivable.
During 2004, 2003 and 2002, cash used in investing activities was $70.9 million, $59.2 million and $33.0 million, respectively, in each case for the acquisition of firms and property and equipment. During 2004, 2003 and 2002, we used $60.2 million, $52.3 million and $29.8 million, respectively, for payments for acquired firms, net of cash acquired, and contingent consideration. In each period, payments for acquired firms represented the largest use of cash in investing activities.
During 2004, 2003 and 2002, cash (used in) provided by financing activities was $(3.4) million, $48.3 million and $5.1 million, respectively. In 2004, cash used in financing activities was primarily the result of $13.3 million of common stock dividends paid offset by $8.0 million of cash proceeds, net of tax benefits, from the exercise of stock options. In 2003 cash provided by financing activities was primarily the result of the sale of 4.3 million shares of our common stock in our initial public offering in September 2003 and was partially offset by cash used in the repayment of borrowings under our credit facility. In 2002, cash provided by financing activities was primarily the result of borrowings under our credit facility.
The credit facility contains various customary restrictive covenants prohibiting us and our subsidiaries, subject to various exceptions, among other things, from (i) incurring additional indebtedness or guarantees, (ii) creating liens or other encumbrances on our property or granting negative pledges, (iii) entering into a merger or similar transaction, (iv) selling or transferring any of our property except in the ordinary course of business, (v) making dividend and other restricted payments and (vi) making investments. In addition to the foregoing, the credit facility contains financial covenants requiring us to maintain a minimum interest coverage ratio and a minimum amount of Adjusted EBITDA (as defined in the credit agreement) and a maximum consolidated leverage ratio. At December 31, 2004 and 2003, we were in compliance with all covenants under the credit facility.
We encourage succession planning in the management of our firms. See “Business-Operations- Succession Planning.” We have financed several purchases of interests in entities owned by principals or applicable management agreements to facilitate succession. This financing is secured by management fees and, in many cases, is secured by other assets.
In the ordinary course of business, we are involved in lawsuits and other claims. We consider these lawsuits and claims to be without merit and are defending them vigorously. Management believes, based upon consultation with legal counsel, that the resolution of these lawsuits or claims will not have a material adverse impact on our consolidated financial position. In addition, the sellers of our firms typically indemnify us for loss or liability resulting from acts or omissions occurring prior to the acquisition, whether or not the sellers were aware of these acts or omissions. Several of the existing lawsuits and claims have triggered these indemnity obligations.
Some of our firms have received subpoenas and other informational requests from governmental authorities, including the New York Attorney General’s Office, seeking information regarding compensation arrangements and related matters. These appear to be similar to those received by other insurance intermediaries in their respective states. Given the current regulatory environment and the number of our firms operating in local markets throughout the country, it is possible that additional subpoenas or other inquiries will be received. We have and will continue to cooperate fully with all governmental agencies. In addition, we are conducting a voluntary internal review of the policies and practices of our insurance operations under the supervision of outside counsel. The review includes an examination of the Company’s client disclosure practices, bidding procedures and contingent compensation arrangements. Our internal review has and will continue to result in significant legal and other costs.
At the time of NFP’s founding, it established an acquisition bonus program (“first bonus program”) under which certain founding officers and directors were eligible to receive a payment equal to $1.25 million in cash or
common stock of NFP, at their election, for each $5 million of average base earnings of the applicable acquired firms over a three-year period. This acquisition bonus program period commenced with eligible acquisitions effective January 1, 1999 through and including those eligible acquisitions closed by December 31, 2000. Accordingly, the three-year measurement periods ended between December 31, 2001 and December 31, 2003. The bonuses related to this program were accrued at the close of each eligible acquisition in an amount equal to 25% of the base earnings of the acquired firm and the amounts in the bonus pool were adjusted over the appropriate three-year measurement period based on the actual earnings of the applicable firms. For the year ended December 31, 2002, we reduced previous accruals by $(1.3) million. There were no adjustments made during 2003.
At December 31, 2004, future minimum rentals for operating leases (which are subject to escalation clauses) primarily consisted of real estate and equipment leases that had initial or uncancelable lease terms in excess of one year and were payable as follows:
Our $90 million credit facility provides for the issuance of letters of credit on our behalf, provided that, after giving effect to the letters of credit, our available borrowing amount is greater than zero. The maximum amount issuable under letters of credit that is permitted by our credit facility is $10 million. As of December 31, 2004 and 2003, we were contingently obligated for letters of credit in the amount of $1.8 million and $2.5 million, respectively.
In order to better determine the economic value of the businesses we have acquired, we incorporated contingent consideration, or earnout, provisions into the structure of our acquisitions since the beginning of 2001. These arrangements generally provide for the payment of additional consideration to the sellers upon the firm’s satisfaction of certain compounded growth rate thresholds over the three-year period following the closing of the acquisition. In some cases, contingent consideration may be payable after shorter periods. As of December 31, 2004, 57 acquisitions include contingent consideration features.
The table below shows our contractual obligations as of December 31, 2004:
We had no off-balance sheet arrangements as of December 31, 2004 and 2003.
Insurance and annuity commissions paid by insurance companies are based on a percentage of the premium that the insurance company charges to the policyholder. First-year commissions are calculated as a percentage of the first twelve months’ premium on the policy and earned in the year that the policy is originated. In many cases, our firms receive renewal commissions for a period following the first year, if the policy remains in force. Our firms also earn commissions on the sale of insurance policies written for benefit programs. The commissions are paid each year as long as the client continues to use the product and maintain its broker of record relationship with us. Our firms also earn fees for the development and implementation of corporate and executive benefit programs as well as fees for the duration that these programs are administered. Asset-based fees are also earned for administrative services or consulting related to certain benefits plans. Insurance commissions are recognized as revenue, when the following three criteria are met (1) the policy application is substantially complete, (2) the
Our firms earn commissions related to the sale of securities and certain investment-related insurance products. Our firms also earn fees for offering financial advice and related services. These fees are based on a percentage of assets under management and are generally paid quarterly. In certain cases, incentive fees are earned based on the performance of the assets under management. Some of our firms charge flat fees for the development of a financial plan or a flat fee annually for advising clients on asset allocation. Any investment advisory or related fees collected in advance are deferred and recognized as income on a straight-line basis over the period earned. Transaction-based fees, including performance fees, are recognized when all contractual obligations have been satisfied. Securities and mutual fund commission income and related expenses are recorded on a trade date basis.
We account for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes,” which requires the recognition of tax benefits or expenses on the temporary differences between the financial reporting
In December 2004 the FASB issued SFAS No. 123 (revised) (“SFAS No. 123R”), “Share-Based Payment”. SFAS No. 123R eliminates the intrinsic value method under APB 25 as an alternative method of accounting for stock-based awards. SFAS No. 123R also revises the value-based method of accounting for share-based payment liabilities, forfeitures and modifications of stock-based awards and clarifies SFAS No. 123’s guidance in several areas, including measuring fair value, classifying an award as equity or as a liability and attributing compensation cost to reporting periods. In addition, SFAS No. 123R amends SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid, which is included within operating cash flows. SFAS No. 123R is effective for public companies at the beginning of the first interim or annual period beginning after June 15, 2005. Thus, we are required to adopt SFAS No. 123R for the interim period beginning July 1, 2005 and may elect to use either a modified version of prospective application or a modified version of retrospective application.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” SFAS No. 148 amends FASB Statement No. 123 to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of FASB Statement No. 123 to require prominent disclosures in both annual and interim financial statements. Effective January 1, 2003, we adopted the fair value recognition provisions of FASB Statement No. 123 in accordance with SFAS No. 148 and adopted the “prospective” method for transition.
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others,” an interpretation of FASB Statement Nos. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. FASB Interpretation No. 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. FASB Interpretation No. 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of FASB Interpretation No. 45 are applicable to guarantees issued or modified after December 31, 2002 and did not have a material effect on our financial statements. The disclosure requirements were effective for financial statements of interim and annual periods ending after December 15, 2002.