Management’s Discussion and Analysis of Financial Condition and Results of Operations below presents the Company’s operating results for each of the two years in the period ended December 31, 2013, and its financial condition as of December 31, 2013. Except for the historical information contained herein, this report and other written and oral statements that the Company makes from time to time contain forward-looking statements, which involve substantial known and unknown risks, uncertainties and other important factors that could cause the actual results, performance or achievements of results to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. See the section of this report entitled “Special Note Regarding Forward-Looking Statements.” Among the factors that could cause actual results to differ materially are those discussed in “Risks Factors” in Item 1A of this report. In addition, the following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in connection with the information presented in the Company’s consolidated financial statements and the related notes to its consolidated financial statements included in Part IV of this report.
We are a leading developer and administrator of affordable, web-based individual health insurance plans and ancillary products. Our highly scalable, proprietary, web-based technology platform allows for mass distribution of, and online enrollment in, our large and diverse portfolio of affordable health insurance offerings.
Our technology platform provides customers, who we refer to as members, immediate access to the products we sell through our distribution partners anytime, anyplace. The health insurance products we develop are underwritten by insurance carriers, and we assume no underwriting, insurance or reimbursement risk. Members can price and tailor product selections to meet their personal insurance and budget needs, buy policies and print policy documents and identification cards in real-time. Our technology platform uses abbreviated online applications, some with health questionnaires, to provide an immediate accept or reject decision for all products that we offer. Once an application is accepted, individuals can use our automated payment system to complete the enrollment process and obtain instant electronic access to their policy fulfillment documents, including the insurance policy, benefits schedule and identification cards. We receive credit card and ACH payments directly from members at the time of sale. Our technology platform provides significant operating leverage as we add members and reduces the costs associated with marketing, selling, underwriting and administering policies.
with several highly rated insurance carriers, including, Starr Indemnity & Liability Company, HCC Life, United States Fire, ING, Nationwide and CIGNA, among others. In addition, as of December 31, 2013, the large independent distribution network we access consists of 93 licensed agent call centers and 232 wholesalers, including Marsh and eHealth, among others, that work with over 10,000 licensed brokers. Our data-driven product design, technology platform and extensive distribution network have enabled us to grow our revenues from $41.9 million in 2012 to $56.6 million in 2013.
HII was formed for the purpose of our recently completed IPO, and is a holding company whose principal asset is its interest in HPIH. All of the equity of HPIH outstanding prior to the reorganization has been exchanged for Series B Membership Interests of HPIH and an equal number of shares of our Class B common stock, and these Membership Interests and shares are held by HPI and a related entity and are beneficially owned by Michael Kosloske, our Chairman, President and Chief Executive Officer. Our financial statements consolidate the financial results of HPIH from February 13, 2013, the date of the IPO, and reflect solely the consolidated financial results of HPIH and HPI from November 7, 2012 to February 12, 2013 and solely the financial results of HPI and its subsidiaries prior to that date.
We expect that future exchanges of Series B Membership Interests (together with an equal number of our Class B common shares) for shares of our Class A common stock, as well as the prior acquisition of Series B membership interests with net proceeds of the sale of over-allotment shares as part of the IPO, will result in increases in the tax basis in our share of the tangible and intangible assets of HPIH. We expect that these increases in tax basis, which would not have been available but for the HII holding company structure, will reduce the amount of tax that we would otherwise be required to pay in the future. We will be required to pay a portion of the cash savings we actually realize from such increase (or are deemed to realize in the case of an early termination payment by us, a change in control or a material breach by us of our obligations under the tax receivable agreement, as discussed above) to the existing and certain future holders of Series B Membership Interests, pursuant to a tax receivable agreement. Furthermore, payments under the tax receivable agreement will give rise to additional tax benefits and therefore additional payments under the tax receivable agreement itself. Our former operating entity, HPI, is taxed as an S corporation for income tax purposes. Therefore, we were not subject to entity-level federal or state income taxation while operating as that entity. HPIH is currently taxed as a partnership for federal income tax purposes; and as a result, is also not subject to entity-level federal or state income taxation while the members of HPIH pay taxes with respect to their allocable shares of its net taxable income. The earnings of HII are subject to federal income taxation.
The following table presents a reconciliation of premium equivalents to revenues for the years ended December 31, 2013 and 2012 ($ in thousands):
Non GAAP gross margin. We define non GAAP gross margin as revenue less third party commissions and credit card and ACH fees. Non GAAP gross margin does not represent, and should not be considered as, an alternative to revenues, as determined in accordance with U.S. GAAP. Non GAAP gross margin is a key measure used by our management to understand and evaluate our core operating performance and trends, to prepare and approve our annual budget and to develop short-term and long-term operational plans. In particular, non GAAP gross margin can provide a useful measure for period-to-period comparisons of our business. Non GAAP gross margin has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under U.S. GAAP.
To calculate adjusted EBITDA, we calculate EBITDA, which is then further adjusted for items that are not part of regular operating activities, including acquisition costs, contract termination costs, and other non-cash items such as non-cash stock-based compensation. Adjusted EBITDA does not represent, and should not be considered as, an alternative to net income or cash flows from operations, each as determined in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. We have presented adjusted EBITDA because we consider it an important supplemental measure of our performance and believe that it is frequently used by analysts, investors and other interested parties in the evaluation of companies. Other companies may calculate adjusted EBITDA differently than we do. Adjusted EBITDA has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of our results as reported under U.S. GAAP.
Our general and administrative expenses primarily consist of personnel costs, which represent salaries, bonuses, commissions, payroll taxes and benefits. Selling, general and administrative expenses also include marketing campaign expenditures and travel costs associated with obtaining new distributor relationships. In addition, these expenses also include technology expenses and personnel costs and expenses for outside professional services, including legal, audit and financial services. Selling, general and administrative expenses increased in 2013 in part due to equity-based compensation under our long-term incentive plan. Expense for equity-based compensation to existing employees is expected to be lower in 2014 than in 2013. However, future increases associated with our business growth initiatives, including our enhanced marketing and leads generation plans, are expected.
Depreciation and amortization expense is primarily a function of amortization of intangible assets acquired as a result of our acquisitions as well as depreciation of property and equipment used in our business.
Following the IPO, HPIH continues to operate in the United States a partnership for U.S. federal income tax purposes. The portion of HPIH earnings that are allocated to HII are subject to U.S. corporate federal, state and local income taxes that are reflected in our consolidated financial statements.
Our effective tax rate includes a rate reduction attributable to the fact that our subsidiaries operate as limited liability companies which are not subject to federal or state income tax. Accordingly, a portion of our earnings or losses attributable to the noncontrolling interest are not subject to corporate level taxes. Additionally, our effective tax rate includes a valuation allowance placed on all of our deferred tax assets, as we believe it is more likely than not that our deferred tax assets will not be realized to offset future taxable income.
We account for uncertainty in income taxes using a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained upon audit, including resolution of related appeals or litigation processes, if any. The second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. Such amounts are subjective, as a determination must be made on the probability of various possible outcomes. We reevaluate uncertain tax positions on a quarterly basis. This evaluation is based on factors including, but not limited to, changes in facts or circumstances, changes in tax law, effectively settled issues under audit, and new audit activity. Such a change in recognition and measurement could result in recognition of a tax benefit or an additional tax provision.
As of December 31, 2013 and 2012, we did not have any balance of gross unrecognized tax benefits associated with uncertain tax positions, and as such, no amount would favorably affect the effective income tax rate in any future periods. We believe that there will not be a significant increase or decrease to the uncertain tax positions within 12 months of the reporting date.
We have federal net operating loss carryforwards of approximately $338,000, and varying amounts of state net operating loss carryforwards. These carryforwards remain available for utilization through the 2033 tax year.
Third-party commissions for 2013 were $32.2 million, an increase of $4.4 million, or 15.7%, compared to 2012. The increases in third-party commissions were primarily due to an increase in the number of plans in force. The acquisition enabled the Company to eliminate $2.7 million in commission expense in 2013.
Credit card and ACH fees for 2013 were $1.2 million, an increase of $210,000, or 21.8%, compared to 2012. The increase in credit card and ACH fees was primarily due to the increase in the number of plans in force. Credit card and ACH fees represented 2.1% and 2.3% of revenues for 2013 and 2012, respectively.
The increase in selling, general and administrative expenses related to Secured is $3.1 million for 2013. All selling, general and administrative expenses associated with Secured since the acquisition date are consolidated.
Professional fees increased $1.7 million for 2013 as compared to 2012, including a $1.3 million increase in accounting, tax, and other financial consulting services and $334,000 increase in legal fees.
Other increases related to our operations, such as advertising, facilities expenses and SEC filing fees, increased by $575,000, compared to 2012.
Depreciation and amortization expenses for 2013 were $1.3 million, an increase of $301,000, compared to 2012. The increase in depreciation and amortization from was primarily driven by the addition of intangible assets from the acquisition of Secured.
For the year ended December 31, 2013 we incurred a provision for income taxes of $18,000, which results in an effective tax rate of (0.2%). There was no provision for income taxes for the year ended December 31, 2012, during which time we operated as a limited liability company.
Net loss attributable to HII for the year ended December 31, 2013 included HII’s share of HPIH’s net loss and $423,000 increase in the liability for amounts payable to Mr. Kosloske under the tax receivable agreement subject to the conditions of that agreement.
We experienced negative cash flows from operations in 2013 due in large part to the payment of $5.5 million to terminate the TSG contract rights, the full amount of which was expensed during the year ended December 31, 2013, and one-time legal, professional other costs related to the IPO. We expect that we will generate positive cash flows from operations in future years, although this may fluctuate significantly on a quarterly basis. We do not expect to incur any material future expenses associated with the transaction.
On July 17, 2013, we entered into and consummated the acquisition of Secured for a cash payment of $10.0 million, plus contingent consideration, that following a subsequent modification of terms, is payable in cash in an aggregate amount up to approximately $6.6 million and is tied to the performance of the acquired businesses.
Related to the acquisition of Secured, during the year ended December 31, 2013, we recognized $301,000 in transaction costs. Transaction costs were expensed as incurred and are included in selling, general and administrative expenses in the accompanying consolidated statements of operations.
We had no indebtedness as of December 31, 2013. On February 13, 2013, we used a portion of the net proceeds from the IPO to repay all $3.2 million outstanding under our term loan. This term loan was entered into in September 2011, with an original principal amount of $4.3 million. The purpose of this bank loan was to finance the acquisition of the remaining 50% interest in HPI. Borrowings under the loan were secured by all of our assets and by a personal guarantee by Mr. Kosloske and Lori Kosloske, our Chief Broker Compliance Officer and Mr. Kosloske’s wife, and certain real properties owned by Mr. Kosloske and Mrs. Kosloske.
Our primary investing activities in 2013 consisted of purchases of investments and the acquisition of Secured. We have invested a portion of the net proceeds of the IPO in certain cash equivalents and certificates of deposit, which are classified as held-to-maturity and have maturities greater than three months. During 2013, we invested $15.0 million in a fixed income mutual fund that we sold for $15.0 million in December 2013. This transaction settled in January 2014, and as of December 31, 2013, the receivable for the proceeds is reflected as investment proceeds receivable on the accompanying consolidated balance sheets. Our capital expenditures of $143,000 primarily consisted of purchases of computer equipment, furniture and fixtures and computer software. In the future, we expect that we will continue to incur capital expenditures to support our expanding operations.
During 2013 cash used in investing activities was $32.6 million as compared to $251,000 for 2012. This change was primarily due to the acquisitions of investments of $24.9 million, offset by maturities and proceeds of sales of investments of $2.5 million and cash consideration paid for the acquisition of Secured of $9.9 million, net of cash acquired. The investments are used to temporarily invest a portion of the net IPO proceeds prior to their deployment into other areas of our operations, including, but not limited to general corporate purposes, expanding our advanced commission structure, potential acquisitions that are complementary to our business or entering new markets or providing new products or services.
On March 14, 2013, the Company terminated its contract rights with TSG for an aggregate cash price of $5.5 million. In conjunction with the transaction, Ivan Spinner joined HII as an employee.
Revenue is earned at the time of sale. Commission rates for our products are agreed to in advance with the relevant insurance carrier and vary by carrier and policy type. Under our carrier compensation arrangements, the commission rate schedule that is in effect on the policy effective date governs the commissions over the life of the policy. In addition, we earn enrollment and administration fees on policies issued. All amounts due to insurance carriers and discount benefit vendors are reported and paid to them according to the procedures provided for in the contractual agreements between the individual carrier or vendor and us. Risk premiums are typically reported and remitted to insurance carriers on the 15th of the month following the end of the month in which they are collected.
We determine the fair value using a combination of three valuation approaches: the cost approach, the market approach and the income approach. The cost approach uses multiples from publicly available transactional data of acquired comparable target companies.
The market approach uses a guideline company methodology, which is based upon a comparison of the reporting unit to similar publicly-traded companies within our industry. We derive a market value of invested capital or business enterprise value for each comparable company by multiplying the price per share of common stock of the publicly traded companies by their total common shares outstanding and adding each company’s current level of debt. We calculate a business enterprise multiple based on revenue and earnings from each company, then apply those multiples to our revenue and earnings to calculate a business enterprise value. Assumptions regarding the selection of comparable companies are made based on, among other factors, capital structure, operating environment and industry. As the comparable companies were typically larger and more diversified than our business, multiples were adjusted prior to application to our revenues and earnings to reflect differences in margins, long-term growth prospects and market capitalization.
We establish our assumptions and arrive at the estimates used in these calculations based upon our historical experience, knowledge of our industry and by incorporating third-party data, which we believe results in a reasonably accurate approximation of fair value. Nevertheless, changes in the assumptions used could have an impact on our assessment of recoverability. We believe our projected sales are reasonable based on, among other things, available information regarding our industry. We also believe the royalty rate is appropriate. The weighted average discount rate is impacted by current financial market trends and will remain dependent on such trends in the future. Absent offsetting changes in other factors, a 1% increase in the discount rate would decrease the estimated fair value of our goodwill for HPIH and Secured by approximately $3.0 million and $2.0 million, respectively, but would not result in impairment.
Our goodwill balance arose from the acquisition of the Naylor units of HPI and from our acquisition of Secured in July 2013. See Note 2 and Note 5 of the accompanying consolidated financial statements for further information on the acquisitions and our goodwill balance as of December 31, 2013 and 2012, respectively.
Expense for stock-based compensation is recognized based upon estimated grant date fair value and is amortized over the service period of the awards using the accelerated method. For grants of SARs, we apply the Black-Scholes option-pricing model in determining the fair value of share-based payments to employees. This model incorporates various assumptions, including expected volatility and expected term. Expected stock price volatilities are estimated using implied volatilities of comparable publicly-traded companies. The expected term of awards granted is based on expectations of future employee behavior.