Our consolidated financial statements now vary in important respects from our historical consolidated financial statements due to the acquisition of USAuto. For the year ended June 30, 2004, the recorded financial results reflect twelve months of our previous operations, but only the two months of results of the insurance operations since the April 30, 2004 acquisition date. Our future operating results will be more reflective of those of a fully-integrated retailer, servicer and underwriter of non-standard personal automobile insurance.
Our results for the year ended June 30, 2004 included expenses that will be discontinued as a result of the acquisition of USAuto. These principally include compensation to employees who were terminated in connection with the acquisition. Future periods will also include the cost of the advisory services agreement with an entity controlled by Donald J. Edwards, our former Chief Executive Officer, as described in note 17 to the consolidated financial statements. These items have been incorporated into the presentation of pro forma operating results for the years ended June 30, 2004 and 2003, which assume that the acquisition of USAuto occurred on July 1, 2002. See note 22 to the consolidated financial statements.
For the year ended June 30, 2004, the consolidated financial statements include the results of our acquisition activities and the real estate operations for the full year, and the results of our insurance operations for the two months since the date of the USAuto acquisition. In addition to the actual results, we will also discuss pro forma operating results that assume that the USAuto acquisition occurred on July 1, 2002. We will also separately discuss both the results of the real estate and corporate activities and the insurance operations. Such segment information is summarized below on both an actual and pro forma basis for the periods presented.
To a lesser extent, we are also winding down operations in which our managing general agency subsidiaries (MGA subsidiaries) received commissions for selling and servicing policies sold on behalf of third-party insurance companies.
Expense Ratio - Expense ratio is the ratio (expressed as a percentage) of operating expenses to premiums earned. This is a measurement which illustrates relative management efficiency in administering our operations. We calculate this ratio on a net basis as a percentage of net premiums earned. Insurance operating expenses are
reduced by fee income from insureds and ceding commissions received from our reinsurer as compensation for the costs we incur in servicing this business on their behalf.
Combined Ratio - Combined ratio is the sum of the loss ratio and the expense ratio. If the combined ratio is at or above 100, an insurance company cannot be profitable without sufficient investment income. The following table presents the combined ratios for the insurance operations on both an actual and a pro-forma basis for the periods presented.
Net loss for the year ended June 30, 2004 was $3.8 million, as compared to a net loss of $1.9 million for the year ended June 30, 2003. The prior year’s results reflect only real estate operations and the costs associated with acquisition opportunities. The current year’s results are significantly impacted by the inclusion of two months of insurance operating results as well as the severance cost to our former employees. Total severance costs were $3.3 million. In addition, we recognized $7.9 million of expenses in the current year related to stock-based compensation, most of which related to stock options which became fully vested upon the termination of employees as a result of the USAuto acquisition. For the year ended June 30, 2004, we also recognized gains on the sale of foreclosed real estate of $4.1 million versus gains of $0.2 million in the prior year.
Loss per share on a fully diluted basis for the year ended June 30, 2004 was $0.15, as compared to a loss of $0.09 for the year ended June 30, 2003. The net loss for the year ended June 30, 2004 was net of an income tax benefit of $2.2 million, while no tax benefit was recognized in the prior year as a result of the uncertainty of its utilization.
On a pro forma basis, net income for the year ended June 30, 2004 was $11.6 million, versus $9.1 million for the year ended June 30, 2003. Pro forma income per share on a fully diluted based for the year ended June 30, 2004 was $0.24, as compared to $0.19 for the year ended June 30, 2003.
Stock-based compensation for the year ended June 30, 2004 was $7.9 million compared to $0.5 million for the same period last year. This increase was primarily the result of recognizing the expense for the immediate vesting, upon his termination, of nonqualified stock options granted to our former President and Chief Executive Officer, Donald J. Edwards, for an option to purchase 2,573,678 shares of our common stock at an exercise price of $3.00 per share. Additionally, this expense also includes the cost associated with an option to purchase 1,152,000 shares granted to Mr. Edwards as a result of the rights offering in accordance with the anti-dilution terms of his employment agreement, and options to purchase 392,000 shares granted to other former employees.
Other operating expenses increased for the year ended June 30, 2004 primarily as a result of the $3.3 million in severance cost to former employees who were terminated as a result of the USAuto acquisition.
On a pro forma basis, income before taxes for the year ended June 30, 2004 was $16.6 million versus $15.6 million for the year ended June 30, 2003. These results assume that the acquisition had occurred on July 1, 2002 and therefore these results include twelve months of insurance operations.
Net premiums earned increased 50% to $57.7 million for the year ended June 30, 2004 from $38.4 million for the same period last year. This increase is primarily related to the fact that more of our insurance business was written through our insurance company subsidiaries than for other insurance companies through our managing general agency operations. In addition, effective February 1, 2004, we increased our assumed reinsurance percentage from 15% to 50% for our Alabama business, which is written through another insurance company since we are not licensed there. Likewise, as a result of shifting the insurance underwriting to our insurance subsidiaries, commissions and fees declined over the same period and ceding commissions from our reinsurer increased.
Fiscal Year Ended June 30, 2003 Compared With Fiscal Year Ended June 30, 2002
Net loss for the year ended June 30, 2003 was $1.9 million, as compared to net income of $0.5 million for the year ended June 30, 2002.
Gains on sales of foreclosed real estate were $0.2 million for the year ended June 30, 2003 as compared to $0.1 million for the year ended June 30, 2002. The gains on sales of real estate represent proceeds received from the sale of foreclosed real estate in excess of carrying value. The gains recognized for the years ended June 30, 2003 and 2002 were from the sale of 58.6 acres and 59.4 acres, respectively, in San Antonio, Texas.
There was a loss on the write-down of foreclosed real estate of $0.1 million for the year ended June 30, 2003. We recorded a write-down on the book values of certain parcels of land in San Antonio, Texas to adjust for decreased market values on the properties due to a softening of the local real estate market as well as the continued general economic downturn. No losses on write-downs of real estate were recognized in the same period in 2002.
Since the completion of the USAuto acquisition, our liquidity and capital resources have become more reflective of those of a fully-integrated retailer, servicer, and underwriter of non-standard personal automobile insurance. Primary sources of funds are from premiums received, commission and fee income and investment
Net cash used by investing activities for the year ended June 30, 2004 was $67.5 million compared to $0.5 million provided in the same period last year. During the year ended June 30, 2004, $72.4 million was used in the acquisition of USAuto (net of cash received) and $4.6 million was provided from the proceeds of sales of foreclosed real estate versus only $0.7 million provided in the same period last year.
As a result of the USAuto acquisition, we are now part of an insurance holding company system with substantially all of our operations being conducted by our insurance company subsidiaries. Accordingly, the holding company will only receive cash from operating activities as a result of investment income and the ultimate liquidation of our foreclosed real estate held for sale. Cash could be made available through loans from financial institutions, the sale of common stock, and dividends from insurance company subsidiaries. In addition, as a result of our tax net operating loss carryforwards, taxable income generated by the insurance company subsidiaries will provide cash to the holding company through an intercompany tax allocation agreement through which the insurance company subsidiaries will reimburse the holding company for current tax benefits utilized through recognition of the net operating loss carryforwards.
There was a loss for the write-down of foreclosed real estate of $142,000 for the year ended June 30, 2003 as a result of a write-down on the book values of certain parcels of land in San Antonio, Texas to adjust for
We believe that existing cash and investment balances, when combined with anticipated cash flows generated from operations, will be adequate to meet our expected liquidity needs in both the short term and the reasonably foreseeable future.
Based on business activity prior to the USAuto acquisition, management believed it was more likely than not that we would not realize the benefits of the loss carryforwards. Therefore, a full valuation allowance had been established. Based upon our estimates of our future taxable income after the USAuto acquisition, we have reduced our deferred tax valuation allowance by $41.3 million. At June 30, 2004, our total gross deferred tax asset is $85.8 million, and we had net operating loss carryforwards for federal income tax purposes of approximately $222 million. On a net basis, the deferred tax asset is $45.4 million after an allowance of $40.4 million. Realization of this deferred tax asset is dependent upon our generation of sufficient taxable income in the future. If future taxable income is not sufficient to recover the deferred tax assets, the maximum charge to the provision for income taxes will be $45.4 million. If we generate sufficient future taxable income to fully utilize the deferred tax assets as of June 30, 2004, the maximum benefit for income taxes will be $40.4 million.
Goodwill and identifiable intangible assets. The USAuto acquisition resulted in goodwill of $97.3 million, subject to increase in the event additional shares are issued pursuant to the terms of the acquisition. Goodwill represents the excess of the purchase price over the fair value of the net assets of USAuto. The acquisition also resulted in other identifiable intangible assets of $6.0 million. As required by SFAS No. 142, we will perform an annual impairment test of goodwill and identifiable intangible assets. If impairment indicators exist between the annual testing periods, management will perform an interim impairment test. Should either an annual or interim impairment test determine that the fair value of USAuto is below the carrying value, a write-down of these assets for USAuto will be required. In evaluating whether impairment exists, management also considers the fair value in excess of the carrying value for certain assets.
Consolidated Statements of Stockholders’ Equity for the Years Ended June 30, 2004, 2003 and 2002
Fixed maturities, available for sale, are bonds with fixed principal payment schedules, held for indefinite periods of time, and may be used as a part of the Company’s asset/liability strategy or sold in response to changes in interest rates, anticipated prepayments, risk/reward characteristics, liquidity needs or other economic factors. These securities are carried at market value with the corresponding unrealized appreciation or depreciation, net of deferred income taxes, reported in other comprehensive income or loss. Market values are obtained from a recognized pricing service.
Investment securities are exposed to various risks such as interest rate, market and credit risk. Market values of securities fluctuate based on the magnitude of changing market conditions; significant changes in market conditions could materially affect portfolio value in the near term. When a security has a decline in market value which is other than temporary, the Company reduces the carrying value of such security to its current market value.
Property and equipment are recorded at cost. Depreciation is provided over the estimated useful lives of the assets (ranging from three to seven years) using the straight-line method.
The Company offers policyholders the option, for a fixed monthly fee, to pay for their insurance premium in equal monthly installments. Such installment billing fees are recognized as revenue when each installment is billed. Motor club fees written by an affiliate are earned on a pro-rata basis over the respective terms of the contracts. Fees are paid monthly by motor club members and are generally collected in advance of providing coverage, minimizing the Company’s exposure to credit risk.
Foreclosed real estate held for sale is recorded at the lower of cost or fair value less estimated costs to sell. Cost is the carrying amount of the mortgage note at the time of foreclosure net of any allowances. The Company periodically reviews its portfolio of foreclosed real estate held for sale using current information including (i) independent appraisals, (ii) general economic factors affecting the area where the property is located, (iii) recent sales activity and asking prices for comparable properties and (iv) costs to sell and/or develop that would serve to lower the expected proceeds from the disposal of the real estate. Gains (losses) realized on liquidation are recorded directly to operations.
In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard, (“SFAS”) No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure,” which is effective for fiscal years beginning after December 31, 2002. SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to the fair value method of accounting for stock-based compensation. In addition, SFAS No. 148 amends the disclosure provisions of Statement 123 to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and income (loss) per share in annual and interim financial statements. Effective July 1, 2003, the Company adopted the prospective method provisions of SFAS No. 148.
EITF 00-21, “Revenue Arrangements with Multiple Deliverables,” addresses certain aspects of accounting for arrangements in which a vendor performs multiple revenue-generating activities. EITF 00-21 specifies certain criteria to determine whether multiple revenue-generating activities represent one or more units of accounting and how the arrangement consideration should be allocated to the separate units of accounting. EITF 00-21 is applicable to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. Management has determined that the adoption of the provisions of EITF 00-21 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.
Cash and cash equivalents consist of bank demand deposits and highly-liquid investments. For purposes of the consolidated statement of cash flows, the Company considers all investments with original maturities of three months or less to be cash.
Basic net (loss) income per share is computed by dividing net (loss) income available to common shareholders by the weighted average number of common shares, while diluted net income per share is computed by dividing net income available to common shareholders by the weighted average number of such common shares and dilutive share equivalents.
Certain amounts in the consolidated financial statements for prior years have been reclassified to conform with the current year’s presentation.
There was no stock-based employee compensation during the fiscal year ended June 30, 2002.
The aggregate purchase price was $160,080 consisting of $76,000 in cash, 13,250 shares of the Company’s common stock valued at $82,362 and $1,718 in acquisition expenses. In addition, the Company paid $2,905 in USAuto debt at closing. The value of the shares issued was determined based on the average market price of the Company’s common stock over the three-day period before and after the terms of the acquisition were agreed to and announced. Up to an additional 750 shares may also be issued at a later date if certain financial targets through December 31, 2004 are reached. Such consideration will be recorded as additional goodwill related to the acquisition at such time that the financial targets may be reached.
At June 30, 2004, the Insurance Companies had fixed maturities and cash with an amortized cost of $3,982 on deposit with various insurance departments as a requirement of doing business in those states.
Net realized losses on investments for the year ended June 30, 2004 were all derived from fixed maturities available for sale and consisted of losses of $47 net of gains of $41.
The composition of maturities of the portfolio at June 30, 2004 was as follows:
The percentage of premiums assumed to net premiums written for the year ended June 30, 2004 was 22%.
The federal income tax expense (benefit) for the years ended June 30, 2004, 2003 and 2002 differs from the amounts computed by applying the U.S. Federal corporate tax rate of 35% (34% in 2003 and 2002) to (loss) income before income taxes as follows:
The net change in the valuation allowance for the years ended June 30, 2004, 2003 and 2002 was a (decrease) increase of ($39,171), $632 and ($168), respectively. Prior to the acquisition of USAuto, a full valuation allowance had been established, as management believed that it was more likely than not that the Company would not realize the benefits of the loss carryforwards. However, as result of the acquisition, management has reduced the valuation allowance based upon internally-prepared projected operating results.
The Employment Agreement further granted Mr. Edwards, as an inducement to his employment with the Company, the right to purchase up to 333 shares of common stock of the Company (the “Purchased Shares”) at a
price of $3.00 per share. Mr. Edwards purchased 166 and 167 shares contemplated by the Employment Agreement on July 9, 2002 and June 30, 2003, respectively. The aggregate market value of the Purchased Shares at the grant date was $1,200. The difference between the aggregate market value and purchase price of the Purchased Shares of $200 was recorded as stock-based compensation expense in the consolidated statement of operations for the year ended June 30, 2003.
During the year ended June 30, 2004, in accordance with the terms of the Plan, the Company’s Board of Directors granted to employees, options to purchase 142 shares of common stock of the Company at an exercise price of $3.00 per share. Of these shares, 122 shares were issued upon the termination of an employee. The options expire between June 30, 2013 and April 29, 2014. The aggregate market value of the securities underlying the employees’ options at the grant dates was approximately $928. Stock-based compensation for the year ended June 30, 2004 was $7,850 which included the acceleration of amortizable amounts as a result of the immediate vesting of terminated employees’ options.
As a closing condition to the USAuto acquisition, the Company issued to each of two USAuto executives, options to purchase 100 shares of the Company’s common stock at an exercise price of $6.64 per share which was equal to the fair market value at the time of grant. The options are subject to vesting, which is subject to acceleration upon certain events such as a change of control (as defined therein), termination of employment by such executive for good reason (as defined in their respective employment agreement), by us without cause (as defined in their respective employment agreement) or due to death or disability. The options terminate upon the first to occur: (i) the tenth anniversary of the date of grant, (ii) 12 months following the date of an executive’s termination of employment by us for cause or (iii) 24 months following the date of an executive’s termination of services for any reason other than cause.
The Insurance Companies are required to file statutory-basis financial statements each December 31 with state insurance departments in all states where they are licensed. These statements are prepared in accordance with accounting practices prescribed or permitted by the Department of Insurance in each company’s respective state of domicile. Effective January 1, 2001, each state of domicile required that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the NAIC (“National Association of Insurance Commissioners”) Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile. In addition, the Insurance Companies are required to report their risk based capital or “RBC” each December 31. Failure to maintain an adequate RBC could subject the Insurance Companies to regulatory action and maintaining an adequate RBC could restrict the payment of dividends. As of December 31, 2004, the Insurance Companies’ “RBC” levels did not subject them to any regulatory action.
Information regarding the reserve for unpaid losses and loss adjustment expenses for the year ended June 30, 2004 is as follows. Management believes that, for the two months ended June 30, 2004, there was no change in the estimate of unpaid loss and loss adjustment expense for losses and loss adjustment expenses incurred prior to the April 30,2004 acquisition date of USAuto.
The costs of acquiring new and renewal business, which vary with and are directly related to the production of such business, have been deferred (net of ceding commission income from reinsurer) to the extent that such costs
are deemed recoverable from future unearned premiums and anticipated investment income. Amortization charged to income for the year ended June 30, 2004 was $18.
Note payable to financial institution at June 30, 2004 consisted of a term loan with an unpaid principal balance of $4,000, at LIBOR plus 366 basis points (4.77%) due in scheduled quarterly installments through June 30, 2007, secured by the common stock and certain assets of the USAuto’s direct wholly-owned subsidiaries.
The maturities of the note payable as of June 30, 2004 were as follows:
The components of property and equipment as of June 30, 2004 is as follows:
At June 30, 2004, the Company had certain concentrations of credit risk with several financial institutions in the form of cash, which amounted to $38,352. For purposes of evaluating credit risk, the stability of financial institutions conducting business with the Company is periodically reviewed. If the financial institutions failed to completely perform under the terms of the financial instruments, the exposure for credit loss would be the amount of the financial instruments less amounts covered by regulatory insurance.
Direct policyholders make payments directly to USAuto. Balances due from policyholders are generally secured by the related unearned premium. USAuto requires a down payment at the time the policy is originated and subsequent scheduled payments are monitored in order to prevent USAuto from providing coverage beyond the date for which payment has been received. If subsequent payments are not made timely, the policy is generally cancelled at no loss to USAuto.
Reinsurance is subject to credit risk relating to USAuto’s ability to collect the payments from reinsured losses due from reinsurers. Since December 1, 2000, the Company’s primary reinsurer has been Transatlantic Reinsurance Company. The current treaty took effect September 1, 2003 and is continuous, subject to annual cancellation by either party with 90 days prior written notice. (See note 21.B.) The limit, per state, on the reinsurer’s liability for its share of losses paid in excess of policy limits and for its share of extra contractual obligations is $500 each risk, each loss, subject to a total annual per state limit of liability of $2,000 for all such losses. The reinsurer’s liability arising from any act(s) of terrorism is subject to an annual per state limit of $1,500.
USAuto sponsors a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. This plan covers substantially all employees who meet specified service requirements. Under this plan, USAuto may, at its discretion, match 50% of each employee’s contribution up to 6% of the employee’s salary. USAuto’s contributions to the plan for the year ended June 30, 2004 were $38.
The Company has entered into employment agreements with certain executives which grant the executives the right to receive certain benefits, including base salary, should such executives be terminated other than for cause.
USAuto is named as a defendant in various lawsuits, arising in the ordinary course of business, generally relating to its insurance operations. All legal actions relating to claims made under insurance policies are considered by USAuto in establishing its loss and loss adjustment expense reserves. Management believes that the ultimate resolution of these matters will not materially affect the consolidated financial statements.
Prior to the April 30, 2004 acquisition of USAuto, the Company’s business activities were limited to pursuing opportunities to acquire an operating company and to dispose of foreclosed real estate held for sale. As a
result of the acquisition, the Company’s primary focus is now the selling, servicing and underwriting of non-standard personal automobile insurance. Segment information is therefore only presented as of and for the year ended June 30, 2004.
The Company’s wholly-owned subsidiary, LNC Holdings, Inc., owned approximately 41 acres of land located in Arlington, Texas until July 6, 2004. This property was encumbered by property tax liens totaling $1,700, including penalties and interest. The property has no carrying value due to the encumbrances. On July 6, 2004, the City of Arlington took possession of and title to the property in order to satisfy outstanding tax liens. LNC Holdings, Inc. has accrued property taxes and related penalties and interest for calendar years 1996 through 2004 totaling $433. The remainder of the tax lien relates to the property prior to LNC Holdings, Inc.’s ownership of the property, and is against the property in rem only. Since the sole asset has been taken by the City of Arlington, it is management’s belief that the Company has no obligation for any outstanding tax liens for this property for the period of 1996 though 2004, or until the date of possession by the City in 2004. As a result of the City’s action, the Company will reverse the $433 accrual during the three months ended September 30, 2004.
As a result of its acquisition by the Company and the resulting available liquidity to increase the statutory capital and surplus of the Insurance Companies, effective September 1, 2004, the Insurance Companies have elected to not renew their 50% quota-share reinsurance treaty. As part of such non-renewal, an election was also made to “cut-off” the reinsurance as of the non-renewal date. Therefore, on such date, the reinsurer will return the ceded unearned premium, net of ceding commissions, to the Insurance Companies, and the reinsurer will not be liable for any losses incurred after the non-renewal date.
To eliminate investment income that would not have been earned if the acquisition had been completed on July 1, 2002.
To eliminate compensation expense of Company employees terminated pursuant to the terms of the acquisition agreement effective upon closing of acquisition and to include the expense of a new advisory agreement (see note 17).
Interim results are not necessarily indicative of fiscal year performance because of the impact of seasonal and short-term variations. Selected quarterly financial data are summarized as follows. Note that there was no income tax expense (benefit) recorded for the years ended June 30, 2003 and 2002 as a result of the uncertainty of the utilization of any tax benefit.