The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Securities and Exchange Commission ("SEC") has defined a company's most critical accounting policies as those that are most important to the portrayal of its financial condition and the results of operations, and which require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the following critical accounting policies and judgments. Although we believe that our estimates and assumptions are reasonable, they are based upon information available when they are made. Actual results may differ significantly from these estimates under different assumptions and conditions.
Renewal Commission Revenue and Related Fees. Renewal commission revenue is the commission we earn on the policies underlying the benefit programs we have sold in prior years. Renewal revenue is recognized on the date that the renewal premium is due or paid by the client to the insurance company depending on the type of policy.
We record revenue on a gross basis when we are the primary obligor in the arrangement or when we bear the credit risk in the arrangement. We record revenue on a net basis when another party is the primary obligor in the arrangement or when another party bears the credit risk.
We have intangible assets representing the excess of the costs of acquired businesses over the fair values of the tangible net assets associated with an acquisition. Intangible assets consist of the net present value of future cash flows from policies in-force at the acquisition date, non-compete agreements with the former owners, other identifiable intangibles and goodwill. Non-compete agreements are amortized over the period of the agreements and other identifiable intangibles are amortized over their useful lives.
The net present value of in-force revenue is typically amortized between 20 and 30 years (the expected average policy duration). The determination of the amortization schedule involves making certain assumptions related to persistency, expenses, and discount rates that are used in the calculation of the carrying value of in-force revenue. If any of these assumptions change or actual experience differs materially from the assumptions used, it could affect the carrying value of the in-force revenue.
In assessing the recoverability of goodwill and the net present value of future cash flows from policies in-force, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, we may be required to record impairment charges not previously recorded.
We account for stock-based compensation to employees using the intrinsic value method prescribed in Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees. Under APB 25, compensation cost for stock options is measured as the excess, if any, of the quoted market price of our stock at the date of grant over the amount an employee must pay to acquire the stock. Common stock options issued to employees to date did not result in compensation expense because the exercise price of the option equaled the market price of the underlying stock on the date of grant.
Employees are eligible for bonuses based upon us achieving certain pre-determined targets. The bonus expense is accrued ratably over the year based upon our estimate of meeting these targets. This bonus accrual is reviewed and adjusted periodically.
Our revenue for the year ended December 31, 2002 was $278.6 million compared to $236.9 for the year ended December 31, 2001, an increase of 17.6%. Our net income for 2002 (after cumulative effect of change in accounting principle of $523,000, net of tax, from the adoption of SFAS No. 142) was $17.3 million compared to $16.0 million for the year ended December 31, 2001, an increase of 8.2% over 2001. Diluted earnings per share for 2002 was $0.99 compared to $1.18 for 2001. The diluted weighted average number of shares outstanding increased to 17.5 million for the year ended December 31, 2002 compared to 13.6 million for the year ended December 31, 2001.
Commission expense. Commission and fee expense was $90.0 million, or 32.2% of total revenue for the year ended December 31, 2002, versus $84.0 million, or 35.5% of total revenue for the year ended December 31, 2001. This reduction in the percentage of commission expense as a percentage of revenue reflects an increased proportion of revenue from fee-based consulting activity in 2002 as well as an increase in the percentage of revenue generated from employee consultants. We expect our recent acquisition of LongMiller to result in a significantly greater percentage of commission expense as a percentage of revenue in the future. Fee-based consulting activity accounted for 11.6% of December 31, 2002 revenue compared to 8.3% of December 31, 2001 revenue. Included in commission expense is $474,000 of non-cash expense recognized in 2002 from performance-based stock options issued to non-employee producers. Such expenses may be incurred in the future if certain non-employee producers achieve specified targets.
General and administrative expense. General and administrative expense for the year ended December 31, 2002 was $140.6 million or 50.5% of total revenue compared to $102.9 million or 43.4% of total revenue for the year ended December 31, 2001. The increase is attributed to the expanded staffing of sales consultants and support services company-wide and expenses associated with recent acquisitions. General and administrative expenses also include $13.3 million of general and administrative expense, which includes approximately $825,000 of severance costs associated with not pursuing the International Employment Solutions practice, for Human Capital Practice since May 2002. In addition, general and administrative expense includes $550,000 of severance costs related to reorganization initiatives in the Healthcare Group that occurred in second quarter 2002.
Amortization. Amortization expense for the year ended December 31, 2002 was $9.2 million compared to $11.6 million in the prior year period. The reduction in amortization expense resulted from the January 2002 adoption of SFAS No. 142, which eliminated the amortization of goodwill, offset by amortization related to identifiable intangibles through acquisitions in 2002. For the year ended December 31, 2001, amortization expense included $4.0 million pre-tax attributed to goodwill amortization. The acquisition of LongMiller is expected to add approximately $13.0 million of amortization expense in 2003 as a result of a full year's of amortization of the net present value of in-force revenue. We acquired approximately $400 million of in-force revenue with our November 2002 acquisition of LongMiller and the 2002 results include one month of amortization related to this intangible asset.
Revenue. For the year ended December 31, 2001, our total revenue was $236.9 million, an increase of 58.4% over $149.6 million for the year ended December 31, 2000. This increase was attributable primarily to a full year's results for Compensation Resource Group (full twelve months compared to four months in 2000) and Pearl Meyer (full twelve months compared to six months in 2000), and the addition of Rich Florin/Solutions Inc. (f.d.b.a. Executive Alliance) in March 2001. In addition, we had strong sales results in the corporate and community banking markets in 2001.
General and administrative expense. General and administrative expense was $102.9 million or 43.4% of revenue in 2001 compared to $68.2 million or 45.6% of revenue in 2000. The increase can be primarily attributed to the full year results of Compensation Resource Group, Pearl Meyer and the five acquisitions completed in 2001. General and administrative expense as a percentage of revenue has declined from 45.6% to 43.4% due to integration activities and spreading of fixed costs over a larger revenue base.
During 2001, general and administrative expense for the corporate headquarters was $11.7 million as compared to $9.1 million in 2000. This increase over prior year can be attributed primarily to expenses related to the start up of the reinsurance business and larger bonuses in 2001 as a result of our performance.
Amortization. Amortization was $11.6 million in 2001 or 62.0% higher than $7.1 million incurred in 2000. This is a result of a full year's amortization cost for Compensation Resource Group and Pearl Meyer. Approximately $4.0 million of the amortization in 2001 related to goodwill.
Interest expense - net. Net interest expense excluding the interest expense for the settlement of an interest rate swap associated with the pay off of our outstanding bank debt with the proceeds from our secondary offering was $5.2 million in 2001 compared to $4.7 million in the prior year. We borrowed $20.0 million during the year to fund our acquisitions.
YEAR ENDED DECEMBER 31, -------------------------- 2002 2001 ---------- ----------- Pro Forma Revenue....................... $329,435 $302,715 Net income.................... 17,534 21,095 Diluted earnings per share.... 1.00 1.43
The former Andersen partners received full recourse and interest bearing loans in the amount of $8.4 million. Of these loans, $1.2 million have a term of two years and the remaining $7.2 million have a term of six and one-half years. As long as the partner is employed on the hiring anniversary date for the two year loans and each December 31st for the six and one-half year loans, a pro rata portion of the loans will be forgiven at each date. These loans are classified as other assets on the December 31, 2002 balance sheet and are being amortized into the Human Capital Practice financial results as general and administrative expense. In October 2002, we agreed with one of the partners to terminate our relationship. In December 2002, we recorded a charge of approximately $575,000 related to the forgiveness of part of the partner's loan. The remaining loan amount of approximately $834,000 will be received over the next six years. Assuming all remaining partners continue to be employed by us throughout the terms of the loans, the amounts amortized into operating expense for the following fiscal years would be:
2003 $1,480 2004 1,134 2005 887 2006 887 2007 887 2008 and thereafter 887
In addition, support staff received a total of $602,000 in sign-on bonuses at the time of their employment. The support staff will retain the bonus payments if they remain employed through May 16, 2003. If they voluntarily leave before this date, they must repay a pro-rata portion of their bonus. The sign-on bonuses are amortized into the Human Capital Practice results over the first twelve months of employment. As of December 31, 2002, approximately $201,000 is included in other assets.
In connection with the formation of the Human Capital Practice, the asset purchase agreement for Rewards and Performance Group (formerly Rich, Florin/Solutions, Inc.) was amended. One-half of the original contingent consideration (approximately $3.8 million) will be paid in March 2003 through March 2005 regardless of performance of the practice and the other half is contingent upon the results of the Human Capital Practice. Accordingly, $3.8 million has been accrued with a corresponding increase in goodwill.
agreement. Under the terms of this agreement, we expect to continue to receive approximately $2.5 million annually from the carrier for a period of 30 years, depending upon certain conditions. Of this annual amount $2.0 million is included in the cash flows securitizing the asset-backed notes issued to finance the acquisition of LongMiller, and we will not have access to this cash for general corporate purposes until the securitized notes are fully paid. This revenue, net of amounts provided for chargebacks, will be recognized on a monthly basis beginning in October 2002. The amounts received are subject to chargeback (reimbursement of a portion of amounts received) if any policies under this agreement are surrendered or exchanged. Any chargeback amounts would be deducted from the next scheduled payment.
In recent years, the Internal Revenue Service ("IRS") has undertaken a major enforcement initiative to disallow the interest deductions on certain leveraged business-owned life insurance programs sold during or prior to 1995. The IRS has prevailed on the cases it has litigated to-date related to this initiative and has recently made a temporary public settlement offer to address ongoing cases. While we stopped selling leveraged business-owned life insurance programs after 1995 and we do not expect any material adverse impact on our revenue from this enforcement initiative, it is impossible to determine the impact of this initiative on a client's decision to continue or surrender an existing leveraged business-owned life insurance program.
On July 30, 2002, President Bush signed the Sarbanes-Oxley Act of 2002 into law. This law generally prohibits any personal loans from certain SEC regulated companies to current directors or executive officers of such companies. While it is not entirely clear, there is a possibility that company premium payments made on or after July 30, 2002 on collateral-assignment split dollar policies, on current directors or executive officers of those SEC-regulated companies, could be covered by the loan prohibition. Without favorable clarification of this law, revenue from collateral assignment split dollar arrangements could be reduced as a result of this law.
We have certain split dollar policies with four of our officers. These policies are expected to be terminated in 2003.
Wamberg Financial Corporation, one of our wholly-owned subsidiaries, leases hangar space for the corporate aircraft from WTW Investment, an entity controlled by Mr. Wamberg for an annual rent of approximately $45,000.
Mr. Wamberg's two step-sons, Jason French and Chuck French, are employed by us. Jason is a Director of Corporate Marketing and Chuck is a consultant with the Executive Benefits Practice. Neither of them report directly to Mr. Wamberg.
William Archer, a member of our Board of Directors since February 2001, is a senior policy advisor at PricewaterhouseCoopers LLP. We previously engaged PricewaterhouseCoopers LLP to perform various consulting related to the installation of our wide area network and a knowledge management system at one of our compensation consulting practices. In addition, PricewaterhouseCoopers was retained by one of our practices to perform certain legislative work. During 2002 and 2001, we paid approximately $380,000 and $726,000, respectively, to PricewaterhouseCoopers LLP for these services.
Robert Long became a member of our Board of Directors in January 2003 as a result of the LongMiller acquisition. He received a substantial amount of the proceeds including notes from our November 2002 purchase of LongMiller.
Fox-Pitt Kelton, co-manager of our November 2001 secondary offering, owns Conning Capital Partners. Steve Piaker, a member of our Board of Directors, is a partner with Conning Capital Partners.
of changes in the timing of the services being provided, revenue under these agreements should have been recognized on the straight-line during 2002. Historically, these fees were recognized 75% in the renewal month and 25% ratably over the remainder of the annual service agreement. In addition, we are also restating to reflect a timing difference whereby CBFS was under-recognizing revenue in the period earned. This restatement for CBFS had no impact on prior years reported or on 2002 results for the full year.
Our revenue is difficult to forecast, and we believe that comparing our consecutive quarterly results of operations is not necessarily meaningful, nor does it indicate what results we will achieve for any subsequent period. Our quarterly results can vary due to the timing of acquisitions and/or the closing of large cases, which may not repeat in subsequent quarters. As a result, past operating results are not reliable indicators of future performance.
The following analysis depicts the results of each of our operating segments on a stand-alone basis. No allocation of corporate overhead or interest has been made.
The acquisitions of Comiskey Kaufman, Inc. (acquired April 2002), Lyons Compensation and Benefits, LLC (acquired August 2001) and Coates Kenney (acquired December 2001) contributed approximately $7.5 million to the year ended December 31, 2002 revenue and $1.7 million of operating income. Renewal revenue increased due to higher than anticipated premium payments on in-force business and additional renewals from 2001 new business. General and administrative expense increased for the year ended December 31, 2002 over 2001 due to the acquisitions mentioned above and additional hirings. Amortization expense decreased in 2002 when compared to 2001 primarily due to the elimination of goodwill amortization as of January 1, 2002. Goodwill amortization for EBP in 2001 was approximately $759,000.
Total revenue increased 37.7% for the year ended December 31, 2002. Revenue continues to be favorably impacted by the acquisition of Management Science Associates ("MSA") as it was included for the full year 2002 compared to six months for 2001 and continued focus on marketing efforts of the managing directors. Consulting fees included in the first year revenue line for the Healthcare Group also increased considerably during the period. Revenue from increased fees for providing recordkeeping services (included in renewal commission and related fees) contributed $632,000 to revenue for the year ended December 31, 2002. Reimbursable expenses revenue increased from the year ended December 31, 2001 as MSA is included for the entire year of 2002 compared to six months for 2001. Commission expense as a percent of revenue decreased to 10.7% of revenue for the year ended December 31, 2002 as compared to 10.9% of revenue in the year ended December 31, 2001, reflecting the increase in administration and recordkeeping fees, in which no commissions are paid to consultants. General and administrative expenses increased 15.1% over 2001 primarily due to a full year of expenses in 2002 for MSA. Severance expense of approximately $550,000 was incurred during the year associated with the downsizing of existing staff levels of the Healthcare Group. Operating income for the year ended December 31, 2002 was $4.8 million, the highest in any period since acquiring the Healthcare Group, which is a result of the factors discussed above.
In May 2002, the Human Capital Practice was formed by combining our existing Rewards and Performance Group with the addition of 10 partners and 74 employees from Andersen's Human Capital Practice. The year ended December 31, 2002 includes $13.3 million of operating expenses related to the costs of additional personnel, space and administrative costs and approximately $825,000 of severance costs associated with not pursuing the International Employment Solutions practice. The Human Capital Practice results reflect difficulties related to the start-up of a new consulting practice in the current challenging economic climate.
Total consulting revenue increased 3.8% to $13.1 million for the year ended December 31, 2002 compared to $12.6 million for the year ended December 30, 2001. General and administrative expense increased to $9.6 million for the year ended December 31, 2002 from $8.7 million for the year ended December 31, 2001 due to additional depreciation for new information systems, increased compensation costs, and a higher headcount than in 2001. Amortization expense for the year ended December 31, 2002 decreased compared to the year ended December 31, 2001 due to the elimination of goodwill amortization as of January 1, 2002. Operating income of $1.9 million for the year ended December 31, 2002 decreased compared to the adjusted $2.3 million (before amortization) for the year ended December 31, 2001 due to the slow economy and the difficult consulting environment. However, the practice is beginning to experience more sales activity as a result of engagements in its areas of expertise of corporate governance and executive compensation.
Although other segments offer compensation consulting in connection with their benefit plan activities, the June 2000 acquisition of Pearl Meyer & Partners represented our major initiative into this vital and logical extension of our business. The performance of compensation consulting was negatively impacted by the events of September 11, 2001; however, quarterly revenue continued to increase throughout 2002.
In the acquisition of LongMiller, we incurred approximately $392.5 million in additional debt. Of this amount, $305 million represents non-recourse debt ("asset-backed notes") incurred by a wholly-owned, special purpose subsidiary and secured by certain renewal commissions and related payments associated with in-force policies previously sold by LongMiller. The remaining $87.5 million was drawn under our revolving credit facility.
As a service organization with historically strong operating cash flow and a revolving credit facility, we believe we have little need to maintain substantial cash balances. We use net cash from operating activities primarily to fund capital expenditures, small acquisitions and service existing debt. We expect large cash outlays and future acquisitions will be financed primarily through externally available funds. However, we can offer no assurance such funds will be available and, if so, on terms acceptable to us.
Our cash flow from operating activities for the twelve months ended December 31, 2002, 2001, and 2000 were as follows:
Cash provided by operating activities for the twelve months of 2002 reflects $8.4 million paid for sign-on loans to the former Andersen partners who joined us from the Human Capital Practice and also reflects the $13.3 million of related general and administrative expense from May 16, 2002, offset by $3.8 million of revenues as a result of the continued development of the practice. The non-cash expenses mentioned above include depreciation of equipment and leasehold improvements, amortization of intangibles, impairment charge for adoption of SFAS No. 142, and charge for performance-based stock options issued to non-employee producers.
The following table represents the estimated gross renewal revenue associated with our securitized in-force bank-owned life insurance policies as of December 31, 2002. These revenue streams are restricted for the specific purpose of paying off our asset-backed notes which were issued in connection with the acquisition of LongMiller in November 2002.
During the year ended December 31, 2002, acquisitions accounted for $363.2 million used in investing activities and $7.7 million was used for the purchase of equipment.
A substantial portion of the purchase price used to fund the acquisitions has historically been paid in cash. This is primarily due to our desire to avoid diluting our existing shareholders. We expect acquisitions to continue and be financed primarily from available credit lines and possible additional equity. However, we can offer no assurances such will be the case.
In May 2002, we amended our December 28, 1999 Credit Agreement to increase the amount available under the credit facility to $125.0 million. We converted $50 million of the year-end amount under the revolving credit facility to term debt at December 31, 2002. The term debt will be paid quarterly over five years under the term facility agreement. We had $18.0 million available under our credit lines at December 31, 2002.
We believe that our cash flow from operating activities will continue to provide sufficient funds to service our debt obligations. However, as our business grows, our working capital and capital expenditure requirements will also continue to increase. There can be no assurance that the net cash flow from operations will be sufficient to meet our anticipated cash flow requirements or that we will not require additional debt or equity financing in the future. We may continue to issue stock to finance future acquisitions.
Below is a summary of our contractual cash obligations and other commitments and contingencies:
Inflation has not had a material effect on our results of operations. Certain of our expenses, such as compensation, benefits and capital equipment costs, are subject to normal inflationary pressures. However, the majority of our service and administrative agreements with clients, which generate fee income, have a cost of living adjustment tied to the consumer price index.
We adopted SFAS No. 142 in the first quarter of 2002. We tested goodwill for impairment using the two-step process prescribed in SFAS No. 142. The first step is a determination of potential impairment, while the second step measures the amount of the impairment, if any. We performed the required impairment tests of goodwill as of January 1, 2002 in the first quarter of 2002. An after-tax impairment charge of $523,000 ($892,000 before tax) resulting from these impairment tests is reflected as the cumulative
On January 1, 2002, we adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of and the accounting and reporting requirements of Accounting Principles Board ("APB") Opinion No. 30, Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions for the disposal of a segment of a business. SFAS No. 144 removes goodwill from its scope and it establishes a primary asset approach to determine the cash flow estimation period for determining potential impairment of a group of assets. The adoption of this statement did not have a material impact on our consolidated financial statements.
Emerging Issues Task Force Issue No. 01-14, Income Statement Characterization of Reimbursements Received for "Out-of-Pocket" Expenses Incurred
Our financial statements begin on page 47 of this Form 10-K.