CMI leases 56,000 square feet of office space in Oakland, California for its Octagon headquarters. The initial lease term is for five and one-half years and is scheduled to expire in August 2009. The lease provides for a renewal option for an additional five years.
CMI has 26 other leases for office space of between 1,000 and 14,000 square feet that serve as regional offices and service centers. These leases have initial terms between two and six years and expire between 2005 and 2010.
The Company believes its leased properties are adequate for its current needs.
The following table sets forth certain selected consolidated financial data for the Company. The selected consolidated financial data should be read in conjunction with the consolidated financial statements and the notes thereto included in Item 8. “Financial Statements and Supplementary Data” and
This filing contains “forward-looking” statements within the meaning of the “safe harbor” provisions of the Private Litigation Reform Act of 1995. Such statements are based on management’s current expectations and are subject to a number of factors and uncertainties which could cause actual results to differ materially from those described in the forward-looking statements. Such factors and uncertainties include, but are not limited to: future legislative changes which could impact the laws governing workers’ compensation and medical malpractice insurance in the various states in which the Company’s employer cost containment and health services segment operates, the Company’s ability to enhance its existing services and successfully introduce and market new services, new service developments by the Company’s competitors, market acceptance of new services of both the Company and its competitors, competitive pressures on prices, the ability to attract and retain qualified personnel, interest rates, the Company’s ability to attract qualified franchisees or access to financing for these franchisees, the effects on the Company if a lender to one of the Company’s subsidiaries utilizes remedies available to it upon an event of default on loans at one of the Company’s subsidiaries, the Company’s ability to file the 2004 Form 10-K and the First Quarter Form 10-Q, the Company’s ability to regain compliance with the AMEX’s continued listing standards and decisions relative to and the outcome of any such decisions regarding strategic alternatives with respect to maximizing stockholder value and enhancing stockholder liquidity.
In January 2004, we announced that our Board of Directors had formed a Special Committee to explore strategic alternatives. In particular, the Special Committee was charged with considering various ways of maximizing stockholder value and providing an opportunity for liquidity to our public stockholders.
We recognized that, with the costs of being a public company increasing, and only 19% of our shares in public hands, it might not make sense for us to continue as a publicly traded company. Accordingly, Mr. Fitzgerald and Capital Partners submitted an offer to the Special Committee in July 2004 for the public shares they did not control (the “Capital Partners Offer”). The Special Committee subsequently received other offers for the entire Company, including an offer in September 2004 from a group that included certain current and former members of the management of CMI, the main operating subsidiary of WC (the “CMI Management Offer”). Both the Capital Partners Offer and the CMI Management Offer were subsequently increased.
Unfortunately, the Special Committee’s ability to move forward with the process of exploring strategic
alternatives and providing a liquidity event for public stockholders was hampered by a number of unforeseen events. Most notably, the Company’s management, beginning in July 2004, had to perform various supplemental procedures (“Supplemental Procedures”), and the Audit Committee of the Company’s Board of Directors, beginning in November 2004, performed and an internal independent investigation (“Investigation”) into certain related-party transactions and conflicts of interest involving certain members of CMI’s management team. The Investigation, which concluded in March 2005, caused a delay in the filing of our quarterly report on Form 10-Q for the quarter ended September 30, 2004 until March 11, 2005, and set back our work on the Company’s financial statements for the year ended December 31, 2004, our annual audit and the filing of this Form 10-K. In addition, in response to an SEC letter issued to the American Institute of Certified Public Accountants in February 2005, the Company’s management conducted an internal review of our accounting practices with respect to leases and leasehold improvements, concluding that various adjustments were required, and that previously issued financial statements should be restated.
At Primrose, we have continued to expand the number of franchisees and to achieve improved operating results. During 2004, Primrose opened seven new schools, bring the total number of Primrose schools to 125. In addition, at December 31, 2004, we had awarded 58 additional franchise units that were in various stages of development and construction.
With respect to financial matters, we have successfully refinanced the $30,000 Note that we had issued at the corporate level in January 2004 in connection with our exploration of strategic alternatives and paid down our overall debt by almost $10,000 to $24,929 at December 31, 2004 from $34,889 at December 31, 2003. In March 2005, we entered into a $40,500 Credit Agreement and used the proceeds to acquire Caronia ($16,000 purchase price) and refinance existing debt. As a result, consolidated debt at March 31, 2005 increased to $40,500.
Recognizing that we were now a stronger and much more valuable company, and that the market for control of companies such as ours had recovered considerably over the last year and one-half, in May 2005 our Board of Directors, upon the recommendation of the Special Committee, determined to switch to a formal sale process to seek the highest price reasonably attainable for the Company. On June 6, 2005, the Board retained UBS Securities LLC to assist it in that process.
While there can be no assurance that the formal sale process will result in the sale of the Company at an acceptable price, the management and Board of Directors, including the Special Committee, believe that a formal sale process represents the best possibility at this time to maximize stockholder value. The formal sale process will take several months and will involve considerable management time, energy and costs. Management and our Board of Directors are, however, committed to the process as the best and most efficient way to provide liquidity for our stockholders. For their part, Mr. Fitzgerald and Capital Partners also fully support the formal sale process, have stated to the Board that they would not participate as a bidder in the process and have committed to sell the shares
In the coming months, we will continue to actively manage WC and Primrose, to keep them on a solid operational footing and to grow them internally and through acquisitions as opportunities arise. Both businesses now have strong management and solid financial positions and are poised to produce improved operating results while the formal sale process continues.
In July 2004, the Company discovered that CMI and CompManagement Health Systems, Inc. (“CHS”, and collectively with CMI, the “CMI Companies”), wholly owned subsidiaries of WC, may have engaged in potential related-party transactions with an entity that was controlled by certain officers of the CMI Companies (“CMI Management”). Management of the Company (“SCC Management”) immediately notified the Company’s Audit Committee of these potential related-party transactions and resulting conflicts of interest and launched a review of the matter by making additional inquiries and performing supplemental procedures (the “Supplemental Procedures”). The Supplemental Procedures, which were conducted through October 2004, revealed that certain members of CMI Management owned, operated and controlled two entities that had certain unauthorized and undisclosed transactional, operational and financial relationships with the CMI Companies. The Supplemental Procedures also revealed that the unauthorized and undisclosed transactional, operational and financial relationships with the CMI Companies resulted in conflicts of interest, but no fraud or financial impropriety that would indicate the Company’s historical financial statements were misstated. CMI Management had either previously divested its controlling interest or, as a result of the Supplemental Procedures, divested its controlling interest, in each of these entities.
Additionally, in November 2004, the Company’s Audit Committee initiated an internal independent investigation (the “Investigation”) into the above-described related-party transactions and conflicts of interest designed to investigate those matters previously discovered by SCC Management, to search for other instances of potential related-party transactions or conflicts of interest and to determine the impact, if any, of such matters on the Company’s previously issued financial statements. To assist in the Investigation, the Audit Committee retained independent legal counsel and forensic accounting experts.
that our previously issued financial statements for the years ended December 31, 2003, 2002 and 2001, and each of the first three quarters of 2004 and four quarters of 2003 should no longer be relied upon and should therefore be restated.
The incorrect application of SFAS 13 related to the way we accounted for periods of “free-rent”, or rent holidays, contractual increases in the minimum rental payments and lease incentives. The effect of the restatement was to decrease each of consolidated income from continuing operations, net income and income available to common stockholders by $94 and $65 for the years ended December 31, 2003 and 2002, respectively, and earnings per diluted share by $0.01 and $0.00, respectively (see Note 2 to the Consolidated Financial Statements for the effects of the restatement on our consolidated balance sheet at December 31, 2003 and on our consolidated statements of income for the years ended December 31, 2003 and 2002).
On June 7, 2005, we announced that the Special Committee had recommended, and the full Board of Directors had approved, a formal sale process of the Company and the retention of UBS Securities LLC (“UBS”) to conduct the process. For the past year and one-half, the Special Committee has evaluated various strategic alternatives to maximize stockholder value and provide liquidity to our public stockholders, including the offers described below, and now supports the switch to a formal sale process. Management fully supports the recommendation of the Special Committee and the actions of the full Board and believes that a formal sale process represents the best possibility of achieving the highest price reasonably obtainable for the stockholders of the Company.
the purchase price of an acquisition to the fair value of tangible and intangible assets acquired and liabilities assumed.
Receivables are composed primarily of amounts due for contract services provided by WC and royalty payments due to Primrose from franchisees. We establish an allowance for doubtful accounts based on customer credit evaluations, collection history and other pertinent information. Receivables are generally not collateralized.
Acquisitions are accounted for under the “purchase method” whereby acquired tangible and intangible assets and assumed liabilities are recorded at fair value. Identified intangible assets are amortized over their estimated useful lives.
Goodwill is not amortized; however, it is subject to annual impairment testing.
To test goodwill for impairment, the carrying amount of the net assets of each “reporting unit” is compared to the fair value of the reporting unit. If the fair value of the reporting unit is greater than the carrying amount, no additional testing is required. However, if the fair value of the reporting unit is less than its carrying amount, then the fair value of the reporting unit is allocated to the assets and liabilities of the reporting unit, including an amount for any “implied” goodwill. If implied goodwill exceeds the net carrying amount of goodwill, no impairment loss is recorded. Otherwise, an impairment loss is recognized for the difference.
Revenues from the Educational Services segment for the year ended December 31, 2003 increased $1,591, or 19% to $9,834 compared to $8,243 for 2002. This increase was primarily attributable to an increase in royalty revenue of $1,166, or 17% compared to the prior year, due to same school revenue increases and the revenue contributions made by the 13 new schools opened since December 31, 2002.
SG&A expenses in the Employer Cost Containment and Health Services segment increased $32,297, or 45% to $104,006 for the year ended December 31, 2004 compared to $71,709 for 2003. SG&A increased $30,405 as Octagon was included for twelve months in 2004 compared to only the last three months in 2003 following its acquisition. Also, for the year ended December 31, 2004, SG&A expense included $900 for the Supplemental Procedures and the Investigation and higher audit fees of $892.
SG&A expenses in the Educational Services segment increased $1,241, or 31% to $5,267 for the year ended December 31, 2003 compared to $4,026 for 2002. The increase was primarily due to the closing of a Company-owned school in early 2002 and the opening of a new Company-owned school in January 2003. Expenses of the Company-owned school closed in 2002 were $320 through the date it was closed (May 2002), whereas total expenses in 2003 associated with the start-up and operation of the new Company-owned school were $806. Expenses also increased in 2003 due to increased headcount necessary to service the number of franchised schools.
D&A for the Employer Cost Containment and Health Services segment increased $194, or 11% for the year ended December 31, 2003 from $1,699 in 2002. This was primarily due to depreciation and amortization of fixed and intangible assets acquired in the Octagon acquisition, partially offset by a decrease in depreciation and amortization expense as certain office furniture and equipment were fully depreciated by the end of 2002.
WC seeks to mitigate its exposure to changes in variable rates through the use of interest rate swaps, which effectively convert variable rate debt to fixed rate debt. WC has an interest rate swap agreement with a notional value of $8,500, under which it pays a fixed rate of 5.85% and receives a variable rate based one-month LIBOR, and an interest rate swap with a notional value of $10,000 under which it pays a fixed rate of 3.44% and receives a variable rate based on one-month LIBOR. During 2004, WC borrowed under its then-existing senior term debt (“WC Term Debt”). The borrowings bore interest at one-month LIBOR plus 1.75%. The interest rate swaps effectively fix the borrowing rate on $18,500 of WC Term Debt to the weighted average fixed rate paid under the swaps of 4.5% plus 1.75%. Interest expense by segment was as follows:
Interest expense at the Employer Cost Containment and Health Services segment increased $524, or 41% to $1,789 for the year ended December 31, 2004 from $1,265 for 2003 due to the additional debt related to the Octagon acquisition. Interest expense at the Employer Cost Containment and Health Services segment decreased $802, or 39% to
$1,265 for the year ended December 31, 2003 from $2,067 for 2002 due to lower debt levels for the first nine months of the year preceding the Octagon acquisition and as a result of scheduled term debt repayments and lower borrowing rates.
Interest expense at corporate was $2,423 for the year ended December 31, 2004 compared to no interest expense in 2003 due to the issuance of the Note. The Note was issued to provide us with immediately available funds while we reviewed various alternative strategic uses for the proceeds. The proceeds were held in a collateral account and were to be released once a use of the proceeds was approved by the lender. The interest rate was initially 10% per annum, but was scheduled to increase to 16% on September 30, 2004. The proceeds were not used and, because of the significant increase in the cost of the debt at September 30, 2004, and the availability of less expensive financing alternatives, we prepaid the Note without penalty prior to September 30, 2004.
The increase in interest income in the year ended December 31, 2004 compared to 2003 was due to interest earned on the proceeds from the Note held in escrow from January 2004 through September 2004. The unrealized gain (loss) from derivatives resulted from changes in the fair value of our $8,500 notional value interest rate swap. This swap has not been designated as a hedge for accounting purposes and, as a result, changes in the fair value of this swap are recorded as other income or expense. The loss on marketable securities of $251 in 2003 was from the sale of securities acquired in the Octagon acquisition, and warrant income in 2002 of $1,334 was from the gain on the Primrose redemption of bank warrants.
The effective tax rate in 2004 benefited from state tax credits of approximately $330 earned by WC. The impact of these credits had the effect of reducing our overall effective tax rate by 3.0%. Additional state tax credits may be earned in the future; however, the application process to receive certain state tax credits is cumbersome and on a first-come, first-serve basis. Accordingly, we cannot determine or estimate at this time the amount, if any, of state tax credits that will be received in the future.
While we believe that our tax return positions are fully supportable, we expect that certain positions could be challenged and that we may not be able to successfully defend our positions. Accordingly, we establish certain reserves, including interest, for these items. In the second quarter of 2005, the reserves established for certain positions taken on our 2001 tax return will be reversed as management believes these reserves are no longer necessary. Accordingly, our tax provision for 2005 will be reduced by approximately $1,600 due to the reversal of these reserves. The reversal of these reserves will not have an impact on 2005 cash flows.
Discontinued operations include the results of Pumpkin and Possible Dreams as follows:
On October 25, 2004, we consummated the sale of substantially all of the assets of Pumpkin to Rauch Industries, Inc. (“Rauch”) for $7,000, which was subject to a working capital adjustment. The working capital adjustment has been finalized, resulting in the Company’s receiving an additional payment from Rauch of $1,741. The net loss from Pumpkin is composed of net income from operations of $1,182 and a net loss on the sale of $3,928.
On November 5, 2004, we entered into an agreement with the bankruptcy trustee for Possible Dreams to resolve all outstanding claims against the Company for $442. As a result, an after-tax gain of $1,516 was recognized as we had established reserves for potential losses and the settlement amount was substantially less than our reserves.
Due to the late filing of this Form 10-K, we do not anticipate filing our Quarterly Report on Form 10-Q for the quarter ended March 31, 2005 until July 29, 2005. However, preliminary results for the first quarter of 2005 indicate that revenues will be up approximately $4,000, or 13% over the first quarter of 2004. Revenues from the Employer Cost Containment and Health Services segment will be approximately $3,400, or 12% higher than the first quarter of 2004 and revenues from the Educational Services segment will be approximately $600, or 22% higher. The growth in revenues in the Employer Cost Containment and Health Services segment is mainly due to growth at Octagon and to a lesser extent, the impact of 2004 acquisitions. The growth in the Educational Services segment is due to higher royalties, franchise fees and real estate services fees. Royalty fees increased approximately $200, or 10% in the first quarter of 2005 compared to the first quarter of 2004, primarily due to royalties from schools opened during 2004. Franchise fees and real estate services fees in total increased approximately $350, as seven franchises were awarded in the first quarter of 2005 compared to none in the first quarter of 2004.
Net income for the quarter ended March 31, 2005 is estimated to be approximately $1,515 compared to income from continuing operations of $1,194 for the quarter ended March 31, 2004. We compare 2005 net income to 2004 income from continuing operations because net income in 2004 included the results of our then-discontinued operations. Due to the sale of Pumpkin and the settlement of the Possible Dreams bankruptcy in 2004, for 2005, we will no longer report discontinued operations. Net income reported in the first quarter of 2004 was $622 and included a loss from discontinued operations of $572. The estimated results for the quarter ended March 31, 2005 include approximately $2,100 of expenses incurred in connection with the Investigation, which concluded in March 2005.
The first quarter 2005 amounts above are preliminary and subject to change based on a more detailed review and analysis by management and the results of our first quarter review to be conducted by our independent registered public accounting firm.
Net cash of $15,671 was used in financing activities during 2004, primarily for the net repayment of debt of $9,960 and the redemption of all issued and outstanding shares of Preferred Stock for $5,000. Net cash of $11,932 was provided by financing activities during 2003, primarily due to the debt proceeds to fund the Octagon acquisition partially offset by repayments of existing debt. Finally, net cash of $11,851 was used in financing activities during 2002, primarily for the repayment of debt.
On March 31, 2005, pursuant to the terms of a stock purchase agreement, dated March 17, 2005, between Octagon and Continental Casualty Company, our majority owned subsidiary, Octagon, acquired 100% of the outstanding capital stock of Caronia , for $16,000 in cash, subject to a working capital adjustment. Such working capital adjustment has not been finalized.
under the Amended WC Revolver bear interest at LIBOR plus 2% or Prime minus 0.5%, at the Company’s option. Principal payments of $675 are due monthly beginning May 1, 2005, and additional principal payments are due each year, beginning on March 31, 2006, based on cash flow, as defined in the Credit Agreement, for the preceding fiscal year. The proceeds of the Term Loan were used to fund the Caronia acquisition and repay the WC Term Debt.
At December 31, 2004, WC maintained an $8,000 revolving line of credit (the “WC Revolver”), and Primrose maintained a $1,000 revolving line of credit (the “Primrose Revolver”). The WC Revolver was replaced with the Amended WC Revolver on March 31, 2005. There were no borrowings under the WC Revolver or the Primrose Revolver at December 31, 2004. Management believes that cash flow from operations along with the available borrowing capacity under the Revolvers will be sufficient to fund our operations and service our debt for the next 12 to 24 months.
As a result of the transactional, financial and operational relationships between the CMI Companies and certain members of CMI Management, as previously described above, and the failure to obtain the lender’s prior written consent for certain acquisitions and other actions taken during 2004, WC was in default of certain covenants under the WC Revolver and the WC Term Debt. WC had obtained a waiver from the lender for these events of default prior to the filing of its Form 10-Q for the quarter ended September 30, 2004.
Prior to the announcement of the formal sale process, Brian D. Fitzgerald, our Chairman of the Board, President and Chief Executive Officer and, through Capital Partners, the controlling person of our majority stockholder, CPI, had submitted an offer to acquire the stock that they do not control, at a price of $10.60 per share. However, Mr. Fitzgerald and Capital Partners, who control approximately 81% of the stock, have declared their support for the formal sale process and have committed to sell the shares they control if appropriate value is achieved in the transaction. As a declared seller in the formal sale process, Mr. Fitzgerald and Capital Partners have stated that they would not participate as a bidder in such process. In addition to the Capital Partners Offer, two other offers to acquire the entire company for $11.00 per share and $13.00 per share that have been submitted to the Special Committee. The Special Committee has informed the bidders that their offers were being referred to UBS for consideration in the formal sales process.
The table below shows our payments due under contractual obligations at December 31, 2004 for the periods indicated.
As previously mentioned, on March 31, 2005, WC entered into the Credit Agreement and used a portion of the proceeds to fund the Caronia acquisition and the remainder of the proceeds to refinance existing debt. Under the Credit Agreement, principal payments of $675 are due each month beginning May 1, 2005. Also, additional principal payments are due each year, beginning on March 31, 2006, based on cash flow of WC, as defined in the Credit Agreement, for the preceding fiscal year. Accordingly, principal payments required under the Credit Agreement presented in the table below do not include any additional principal payments that may be due based on the cash flows of WC as as we cannot, at this time, estimate the amount, if any, that may be required.
The following is a summary of operating results by quarter. The information presented below for the first three quarters of 2004 and the four quarters of 2003 has been restated to reflect the impact of the restatement for lease accounting.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Security Capital Corporation and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
Security Capital Corporation (“Security Capital”, “Company”, “we”, “us” and “our”) operates as a holding company that actively participates in the management of its subsidiaries. At December 31, 2004, we operated two subsidiaries, WC Holdings, Inc. (“WC”) and Primrose Holdings, Inc. (“Primrose”). WC is an 80%-owned subsidiary that provides cost containment services relative to direct and indirect costs of corporations and their employees primarily relating to industrial health and safety, industrial medical care and workers’ compensation insurance. WC’s activities are primarily centered in California, Ohio, Virginia, Maryland, Texas, Michigan, Florida, Washington and Minnesota. Primrose is a 98.5%-owned subsidiary involved in the franchising of educational childcare centers, with related activities in real estate consulting and site selection services. At December 31, 2004, Primrose schools are located in the Southeast, Southwest and Midwest.
Pumpkin Masters Holdings, Inc. (“Pumpkin”) was a wholly owned subsidiary engaged in the business of designing and distributing Halloween-oriented pumpkin carving kits and related accessories throughout the United States and in Canada. During the fourth quarter of 2003, we committed to a plan to sell the operations of Pumpkin and, accordingly, for all periods presented, the net assets and results of operations of Pumpkin were reported as a discontinued operation. As discussed in Note 7, we sold the assets of Pumpkin in October 2004.
The incorrect application of SFAS 13 related to the way we accounted for periods of “free-rent”, or rent holidays, contractual increases in the minimum rental payments and lease incentives. The effect of the restatement was to decrease each of consolidated income from continuing operations, net income and income available to common stockholders by $94 and $65 for the years ended December 31, 2003 and 2002, respectively, and earnings per diluted share available to common stockholders by $0.01 and $0.00, respectively. The impact of the restatement also affected our 2001 earnings and has been reflected as a $95 increase to accumulated deficit as of December 31, 2001 in the accompanying consolidated statements of stockholders’ equity. The restatement had no impact on net revenue or cash flows
The following is a summary of the effects of the restatement on our consolidated statements of income for the years ended December 31, 2003 and 2002 and on our consolidated balance sheet at December 31, 2003.
In November 2004, the Company’s Audit Committee initiated an internal independent investigation (the “Investigation”) into the above-described related-party transactions and conflicts of interest designed to investigate those matters previously discovered by SCC Management, to search for other instances of potential related-party transactions or conflicts of interest and to determine the impact, if any, of such matters on the Company’s previously issued financial statements. To assist in the Investigation, the Audit Committee retained independent legal counsel and forensic accounting experts.
As a result of the findings of the Investigation, and upon the recommendation of the Company’s Audit Committee, the CEO and CFO/General Counsel of the CMI Companies were terminated for cause. The Company has implemented enhanced controls and procedures related to the identification and reporting of related-party transactions and conflicts of interest.
The accompanying consolidated financial statements include the accounts of Security Capital and its subsidiaries and have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). All intercompany balances have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates. Significant estimates include an allowance for doubtful accounts, allowance for uncollectible assignment development costs, bankruptcy accruals, reserves for contingencies, the utilization of carry forward tax benefits, the determination of fair value and economic lives of intangible assets, the estimates and
Revenues from the Educational Services segment are composed of royalties, franchising fees, assignment fees, transfer fees, real estate services fees, forfeiture fees and tuition fees. Royalties are received from franchisees based on a percentage of the school’s monthly revenue and includes fees for corporate services provided to franchisees. Royalty revenue is recorded in the month earned and typically collected in the subsequent month. Franchising fees are received when a franchise agreement is signed with a franchisee and recognized as revenue when the school receives its certificate of occupancy, which is generally concurrent with the commencement of operations. Assignment fees are received for pre-development services, such as site identification and the preparation for the construction of the school, including applying for and obtaining all required building and zoning permits. Assignment fees are recognized upon the sale of the property to the franchisee. Real estate services fees are received for consulting services related to architectural and engineering design services provided to the franchisee during the construction of the school. These fees are received when the franchise agreement is signed with a franchisee and recognized when the school receives its certificate of occupancy. Transfer fees are received and earned upon the sale of an existing franchise to another franchisee. Forfeiture fees include fees applicable to the termination of franchise agreements or for the expiration of option agreements. Tuition fees are earned at the Company-owned school and are generally billed weekly for services to be provided in the following week. All fees received in advance of the services being provided are initially deferred.
Primrose will occasionally provide existing franchisees an option to purchase a franchise in a designated geographical area for a stated period of time (typically six to twelve months) for which Primrose receives a fee. This fee is initially deferred when received. When the option is exercised, the option fee is credited against the amount of the franchise fee and recognized as revenue when the school receives its certificate of occupancy. If the option expires, the fee is recognized as a forfeiture fee.
A summary of the changes in the allowance for doubtful accounts for the years ended December 31, 2004, 2003 and 2002 is as follows:
Assignment development costs are recoverable costs incurred on behalf of future franchisees that have executed assignment agreements with Primrose for pre-development services, such as site identification and the preparation for the construction of the school, including applying for and obtaining all required building and zoning permits. These costs are reimbursed by the franchisee upon the purchase of the property by the franchisee. A reserve is established for potentially uncollectible assignment development costs based on franchisee credit evaluations, historical experience and other pertinent information.
A summary of the changes in the allowance for uncollectible assignment development costs for the years ended December 31, 2004, 2003 and 2002 is as follows:
Property and equipment are stated at cost, less accumulated depreciation and are depreciated using the straight-line method over their estimated useful lives. Computer equipment and software are generally depreciated over three to five years, machinery and equipment are generally depreciated over three to seven years and furniture and fixtures are generally depreciated over three to seven years. Leasehold improvements are depreciated over the shorter of the estimated life of the improvement or the lease term, which ranges from five to 15 years. Property and equipment, net of accumulated depreciation, at December 31, 2004 and 2003 was as follows:
To test goodwill for impairment, the carrying amount of the net assets of each “reporting unit” is compared to the fair value of the reporting unit. If the fair value of the reporting unit is greater than the carrying amount, no additional testing is required. However, if the fair value of the reporting unit is less than its carrying amount, then the fair value of the
Our use of derivative financial instruments is currently limited to interest rate swap agreements utilitized to mitigate exposure to changes in interest rates on variable rate debt. We do not use derivatives for trading or speculative purposes. All derivative instruments are recorded at fair value, which is obtained from a major financial institution based on current market prices of similar instruments. For those instruments designated as hedges, to the extent the derivative financial instrument provides an effective hedge, changes in the fair market value are recorded in the consolidated balance sheets as other comprehensive income or loss, a component of stockholders’ equity. Any ineffectiveness is recorded in the consolidated statements of income as other income or expense. Changes in fair market value of those instruments not designated as hedges are recorded in the consolidated statements of income as other income or expense. The fair value of derivatives at December 31, 2004 and December 31, 2003 is $137 and $662, respectively, and is recorded as other long-term obligations in the consolidated balance sheets.
The Company measures compensation cost for stock options issued to employees using the intrinsic value method of accounting for stock-based compensation under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). Under APB 25, when the exercise price of the Company’s stock options equals the market
value of the underlying stock on the date of the grant, no compensation expense is recognized. The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transitions and Disclosure, an amendment to FASB Statement No. 123 (“SFAS 148”).
The fair value of options was estimated at the date of grant using a Black-Scholes option pricing model with the following weighted average assumptions:
Basic earnings per common share (“EPS”) are derived by dividing income available to common stockholders by the weighted average shares outstanding. Diluted EPS assumes the potential dilution from the exercise of employee stock options in Company stock and in stock of subsidiary companies. The assumed exercise of stock options of subsidiary companies has the effect of reducing our earnings (“diluted earnings”) as our overall ownership interest in the subsidiary companies, and thus our share of the net income of the subsidiaries, would be reduced. Diluted EPS are derived by dividing the applicable diluted earnings by the weighted average shares outstanding plus the dilutive effect, if any, of outstanding stock options and the Preferred Stock. Weighted average shares outstanding include the weighted average number of Common and Class A Common shares outstanding because the two classes are identical except for certain transfer restrictions.
In October 2003, WC, through its subsidiary, CMI, acquired all of the outstanding shares of Octagon Risk Services, Inc. (“Octagon”) for $30,000. Octagon, based in Oakland, California, provides workers’ compensation and professional liability claims administration and consulting services primarily in the western United States, including California. The Octagon acquisition was intended to expand the Company’s geographical presence in the United States.
The following unaudited pro forma financial information presents the combined results from continuing operations of the Company and Octagon as if the Octagon acquisition had taken place on January 1, 2002. The pro forma amounts give effect to certain adjustments, including the amortization of intangibles, increased interest expense and income tax effects. This pro forma information does not necessarily reflect the results of operations as they would have been if the business had been managed by the Company during these periods and is not indicative of results that may be obtained in the future.
The results of operations for all acquisitions are included in our consolidated financial statements from the acquisition date.
Additions to goodwill in 2004 include $406 from the acquisition of KRAMMCO, Inc., $997 from the acquisition of ICS and a purchase price adjustment of $364 relating to the 2002 acquisition of Barron Risk Management Services. Deductions represent net purchase price adjustments related to the 2003 acquisition of Octagon.
and trademarks are amortized on a straight-line basis over 15 years. The following table displays the details of identified intangible assets:
Estimated amortization expense for each of the years 2005 - 2009 is $1,960, $1,924, $1,759, $1,482 and $1,111, respectively.
In July 2003, we sold a 25% interest in Possible Dreams for nominal consideration to the newly-named CEO of Possible Dreams. A net charge of $2,420 was recognized to writeoff a deferred tax asset which could no longer be utilized as a result of the sale of the 25% interest. In addition, because the Company’s investment in this subsidiary was negative, the sale of a minority interest generated a gain which was deferred at the time of sale because the minority interest shareholder had no legal obligation to fund his share of Possible Dreams’ net deficit.
On November 5, 2004, we entered into an agreement with the bankruptcy trustee to liquidate all outstanding claims against the Company for $442. As a result, an after-tax gain of $1,516, which included the deferred gain from the sale of a minority interest described above, was recognized during 2004.
Revenues from discontinued operations were $10,500, $21,600 and $29,700 for the years ended December 31, 2004, 2003 and 2002, respectively, and the assets and liabilities of discontinued operations at December 31, 2003 consisted of the following:
The WC Holdings Note Payable was due in annual installments of principal and interest through May 31, 2004 with interest imputed at 8%. This note was repaid in full in 2004.
At December 31, 2004, WC maintained an $8,000 revolving line of credit (the “WC Revolver”), and Primrose maintained a $1,000 revolving line of credit (the “Primrose Revolver”). There were no borrowings under the WC Revolver or the Primrose Revolver at December 31, 2004. Borrowings under the WC Revolver bore interest at LIBOR plus 1.75% and the WC Revolver was scheduled to expire in December 2006. Borrowings under the Primrose Revolver bear interest at LIBOR plus 2.0% or Prime, at our option, and the Primrose Revolver expires in December 2005.
The WC Term Debt, WC Revolver, and Primrose Revolver each contain restrictive covenants that prohibit or limit certain actions, including specified levels of capital expenditures, investments and incurrence of additional debt, and require the maintenance of a minimum fixed charge ratio. Most borrowings are secured by a pledge of substantially all assets at the subsidiary level, as well as a pledge of the Company’s ownership in the subsidiary. As a result of the transactional, financial and operational relationships between the CMI Companies and certain members of CMI Management, as previously described above, and the failure to obtain the lender’s prior written consent for certain acquisitions and other actions taken during 2004, WC was in default of certain covenants under the WC Revolver and the WC Term Debt. WC had obtained a waiver from the lender for these events of default prior to the filing of its Form 10-Q
The changes in the fair value of the interest rate swaps were as follows:
The Company had issued 500,000 shares of zero coupon, redeemable convertible preferred stock (“Preferred Stock”) that had a stated redemption value of $10 per share. The Preferred Stock was convertible into Class A common stock on a 1:1 basis. The Preferred Stock was redeemable at the option of the stockholder at the greater of liquidation value in the event of a liquidation or upon the earlier of (1) the date Primrose’s EBITDA exceeded $8,500 on a latest twelve month basis on or after April 2002, (2) on April 6, 2004 at a ratio of actual EBITDA for the most recently completed fiscal year over $8,500 multiplied by $5,000 or (3) on April 6, 2006. The Preferred Stock had a liquidation preference of $10 per share paid before the common stockholders in the event of a liquidation or change of control. The difference between the carrying value of the Preferred Stock and the redemption value was accreted using the interest method over the remaining estimated period to redemption by charges to additional paid-in capital. On November 10, 2004, we redeemed all shares of Preferred Stock at a redemption price of $10 per share. For 2004, the consolidated statements of operations reflect Preferred Stock accretion of $1,275 to accrete the carrying value of the Preferred Stock to its redemption value.
The authorized common stock of the Company consists of Common Stock and Class A Common Stock. The Class A Common Stock shares are identical in rights to the Common Stock shares, except that transfer of shares of the Class A Common stock is prohibited to a person who is, or would thereby become, a holder of 4.75% or more of the fair market value of the Common Stock and the Class A Common Stock.
The Company has not paid any dividends to common stockholders during the last five years. In January 2004, our Board of Directors formed a Special Committee to evaluate various strategic alternatives, one of which included the payment of an extraordinary cash dividend to stockholders. No such extraordinary dividend was paid during 2004, or is contemplated at this time. Certain financing arrangements limit the ability of our subsidiaries’ to pay dividends to Security Capital, thus limiting our ability to pay dividends to our stockholders.
The Company’s subsidiaries each sponsor a defined contribution 401(k) plan in which qualifying employees greater than 21 years of age who meet minimum service requirements may participate. Eligible employees may elect to make pre-tax contributions of up to 15% of their eligible earnings. The subsidiary companies also make matching contributions. At WC, the contribution is equal to 50% of each participant’s contribution up to 6% of eligible compensation and, at Primrose, the contribution is equal to 50% of each participant’s contribution up to 1.5% of eligible compensation. Effective January 1, 2005, Primrose’s matching contribution was increased to equal 50% of each participant’s contribution up to 3% of eligible compensation. The aggregate matching contributions were $1,162, $750 and $565 for the years ended December 31, 2004, 2003 and 2002, respectively.
We maintain a stockholder-approved stock incentive plan (the “Incentive Plan”), whereby certain employees and non-employee directors are eligible to receive stock options, stock appreciation rights, limited stock appreciation rights in tandem with stock options, restricted stock, deferred stock and stock granted as a bonus or in lieu of other awards (collectively, “Awards”). The Board of Directors administers the Incentive Plan and has full authority, among other things, to select participants to whom Awards will be granted, determine the type and number of Awards to be granted, the exercise price of the Award and all other relevant provisions, including, but not limited to forfeiture, vesting, restrictions on exercises, and transferability of the Award. Awards are typically granted at the fair market value of our Class A Common Stock on the date of the grant and expire 10 years from the date of grant. Non-employee directors receive options to purchase 24,000 shares upon election to the Board of Directors. At December 31, 2004, the Company had reserved 123,346 shares of Class A Common Stock for future Awards.
We have issued stock options to employees of Primrose to acquire 1,675.56 common shares of Primrose at an exercise price of $500.00 per share and options to acquire 585 shares at an exercise price of $701.51. These options were granted at the fair market value of a share of stock in Primrose on the date of grant, as determined by the Company, and approved by the Board. The options vest between three and five years and expire on the tenth anniversary of the grant date. At December 31, 2004, options to acquire 2,026.56 shares of stock in Primrose were exercisable at a weighted average exercise price of $534.90 per share, and there were 339.44 shares available for future issuance. The options may be settled in either Security Capital stock or cash, at the option of the Company. If all outstanding options had been vested and exercised for Primrose stock at December 31, 2004, our ownership share of Primrose would have been 90.6%.
In 2004, we established a deferred compensation plan (the “Octagon Plan”) for key employees of Octagon. An Administrative Committee has been appointed to administer the Octagon Plan and the Committee has the authority, among other things, to determine those employees who will participate in the Octagon Plan, approve the performance goals that each participant will be measured against, determine whether those goals were achieved, and the amount to be awarded to each participant. The amount each participant can be awarded is based on a percentage of their eligible compensation (as defined), but the total amount awarded to all participants cannot exceed 10% of Octagon EBITDA. The amounts awarded to participants vest 50% after five years and 100% after 10 years. The Octagon Plan is not required to be funded. For the year ended December 31, 2004, we recognized expense of $322 related to the Octagon Plan.
The items comprising the Company’s net deferred tax assets are as follows:
A reconciliation of the tax provision at the Federal statutory rate of 34% to the reported tax provision is as follows:
At December 31, 2004, the Company had NOL carryforwards for federal income tax purposes of approximately $12,118. The use of the NOL carryforwards is subject to certain limitations under Internal Revenue Code Section 382. The NOL carryforwards are set to expire between 2018 and 2022.
While we believe that our tax return positions are fully supportable, we expect that certain positions could be challenged and that we may not be able to successfully defend our positions. Accordingly, we establish certain reserves, including interest, for these items. We have tax reserves of $6,910 at December 31, 2004. While it is difficult to determine the final outcome if certain positions were to be challenged, we believe that the tax reserve at December 31, 2004 reflects the maximum exposure. None of the Company’s consolidated tax returns is currently under examination.
The following shows the calculation of basic and diluted EPS from continuing and discontinued operations for the years ended December 31, 2004 and 2003 and basic and diluted EPS from continuing operations, discontinued operations and the cumulative effect of a change in accounting principle for the year ended December 31, 2002:
* Basic and diluted EPS are based on unrounded amounts and therefore may not equal the sum of EPS from continuing operations and discontinued operations.
For the year ended December 31, 2004 and 2003, 500,000 shares of Preferred Stock, which were convertible into 500,000 shares of Class A Common Stock, and stock options to acquire 318,000, 324,000 and 309,000 shares of Class A Common Stock in 2004, 2003 and 2002, respectively, were excluded from the computation of diluted EPS because the effect of their assumed conversion was antidilutive.
We are party to several legal actions arising in the ordinary course of business. It is management’s opinion that we have adequate legal defenses to these actions and that the resolution of such matters will not have a material adverse effect on our financial condition, results of operations or cash flows.
Prior to the announcement of the formal sale process, Mr. Fitzgerald, our Chairman of the Board, President and Chief Executive Officer and, through Capital Partners, the controlling person of CPI, had submitted an offer to acquire the stock that he and Capital Partners did not control at a price of $10.60 per share. However, Mr. Fitzgerald and Capital Partners, who control approximately 81% of the stock, have declared their support for the formal sale process and has committed to sell the shares they control if appropriate value is achieved in the transaction. As a declared seller in the formal sale process, Mr. Fitzgerald and Capital Partners have stated that they would not participate as a bidder in such process. Two other offers to acquire the entire Company for $11.00 per share and $13.00 per share were submitted to the Special Committee. The Special Committee has informed the bidders that their offers were being referred to UBS for consideration in the formal sales process.
Caronia provides third-party professional medical liability claims administration and risk management services to hospitals and healthcare systems, physician and paraprofessional groups, nursing homes, rehabilitation centers and clinics. Its business is based in Melville, New York, and it services clients through 40 locations nationwide. After the consummation of the transaction, Managed Care Holdings and Caronia Corp. became part of the employer cost containment and health services operating segment.
On October 25, 2004, we consummated the sale of substantially all of the assets of Pumpkin to Rauch for $7,000, subject to a working capital adjustment. The working capital adjustment has been finalized, resulting in the Company receiving an additional payment from Rauch of $1,741. An after-tax loss of $3,928 was incurred on the sale.
On November 5, 2004, we entered into an agreement with the bankruptcy trustee to resolve all outstanding claims against the Company in connection with the Possible Dreams bankruptcy for $442. As a result, an after-tax gain of $1,516 was recognized during 2004.
On January 14, 2004, we issued a $30,000 Senior Subordinated Promissory Note (the “Note”), due September 30, 2008, to a mezzanine lender to provide us with immediately available funds while we reviewed and analyzed various alternative uses for the proceeds. The proceeds were held in a collateral account and would be released once a use of the proceeds was approved by the lender. The interest rate was initially 10% per annum, with interest payable quarterly beginning March 31, 2004, and would increase to 16% on September 30, 2004. Due to the then-outstanding offers to acquire the Company, management determined that any use of the proceeds would not occur prior to September 30, 2004. Accordingly, because of the significant increase in the cost of the debt at September 30, 2004, and the availability of less expensive financing alternatives, we prepaid the Note without penalty prior to September 30, 2004.