The following historical information should be read in conjunction with information included elsewhere herein, including the consolidated financial statements, the notes thereto, and Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.” The results of operations presented below are not necessarily indicative of the results of operations that may be achieved in the future.
In 2003, we received $1.5 million from the favorable settlement of a lawsuit and we incurred operating expense of $7.5 million in connection with the reorganization of the Human Capital Practice.
In 2001, we incurred operating expense of $2.1 million in connection with the write-down of assets acquired from Insurance Alliances Group.
In 2004, we incurred other expense of $1.5 million associated with a prospective securitization financing that was terminated.
On February 1, 2006, James M. Benson was appointed to our Board of Directors. Mr. Benson fills a recently created Class III Board seat. Mr. Benson will be eligible for re-election as a Class III director at the Company’s 2007 Annual Meeting of Stockholders. The Board of Directors does not plan to appoint Mr. Benson to serve on any committees of the Board of Directors since Mr. Benson is not an independent director.
On January 18, 2006, Robert E. Long, Jr., was appointed to our Board of Directors. Mr. Long fills a recently created Class II Board seat. Mr. Long will be eligible for re-election as a Class II director at the Company’s 2006 Annual Meeting of Stockholders. The Board of Directors does not plan to appoint Mr. Long to serve on any committees of the Board of Directors since Mr. Long is not an independent director.
On January 27, 2006, the Securities and Exchange Commission released a proposal that would revamp the current disclosure requirements for executive compensation, related-party transactions, director independence, and other corporate governance matters. The purpose of the proposal is to provide shareholders with more comprehensive information on how a company compensates its directors and certain executive officers. It is anticipated that these requirements may become effective for the 2007 proxy season. If these proposed rules are enacted, it may lead to more engagements for the Pearl Meyer & Partners practice.
In 2005, the flattening yield curve proved challenging to our sales force for closing new insurance cases in the Banking market. In early 2006, the yield curve has become inverted which makes our existing fixed rate insurance products even less attractive.
Given the homogenous nature of such cases and historical information about chargebacks, we believe we are able to accurately estimate the revenue earned. We currently maintain a chargeback allowance, which is monitored on a quarterly basis for adequacy. The chargeback allowance is calculated based on the average percentage rate of the last two years of chargebacks multiplied by the first year revenue for the trailing twelve months.
Renewal Commission Revenue and Related Fees. Renewal revenue is recognized on the date that the renewal premium is due or paid by the client to the insurance company depending on whether a policy is considered fixed or variable. Fixed renewal policies have predictable set premium amounts. Revenue on these policies is recognized on the premium due date. Variable renewal policy premiums can be based upon such items as value of underlying investments in the policy, cash surrender value of the policy, or mutual fund values. In some cases, we are able to obtain information directly from the carriers allowing us to reasonably and reliably estimate the expected renewal premiums. Revenue is recognized based upon these estimates at a policy’s renewal date. For those policies where we are unable to obtain information to reasonably estimate the expected renewal premiums, revenue is not recognized until the confirmation has been received from the insurance carrier that the client’s premium payment has been received. We are notified in advance if a client plans to surrender, so adjustments in subsequent periods due to cancellations are infrequent and minor. Revenue associated with policies to be surrendered is not recognized.
Administrative service fee revenue consists of fees we charge our clients for the administration of their benefit programs and is earned when services are rendered. These revenues are mainly included in our renewal commissions and related fees line on our consolidated statements of income.
Supplemental Compensation Arrangements. A portion of our revenue is derived from certain supplemental compensation arrangements with insurance carriers. These arrangements generate additional revenue with respect to primarily existing and, to a lesser extent, new blocks of business. Payments under such arrangements are typically based on the cash value (or fair value) of our existing in-force business with these carriers at specified dates of measurement and, to a much lesser extent, based on the value of new business generated. We realized approximately $11.1 million, $11.3 million and $10.3 million in revenue under such arrangements for the years ended December 31, 2005, 2004, and 2003, respectively.
act as the principal in the transaction by helping clients select the right product or service;
are viewed by the client as the administrator of the program once the product is sold.
We are required to assess potential impairments of long-lived assets in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for Impairment of Long-Lived Assets, if events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable. In assessing the recoverability of goodwill in accordance with SFAS No. 142, Goodwill and Other Intangible Assets, and the net present value of future cash flows from policies inforce, we must make assumptions regarding estimated future cash flows, mortality, lapse, and other factors to determine the fair value of the respective assets. If these estimates and related assumptions change in the future, we may be required to record impairment charges.
Revenue. Total revenues for the year ended December 31, 2005 were $273.8 million, a decrease of 13.2% from revenues of $315.6 million for the year ended December 31, 2004. First year commission revenues for the year ended December 31, 2005 were $74.0 million compared to $97.5 million for the year ended December 31, 2004. First year commission revenue for the year ended December 31, 2004 included $9.3 million for a single large case. Banking Practice’s first year commission revenue for the year ended December 31, 2005, was impacted by a soft market for BOLI products and the historically low long-term interest rate environment. On September 29, 2005, the Treasury Department issued initial guidance regarding changes to nonqualified deferred compensation plans necessitated by the American Jobs Creation Act, passed in October 2004. The delay in this guidance created uncertainty in regards to amending existing plans and delayed the implementation of new plans for both the Executive Benefits Practice and Banking Practice. First year revenue in 2005 included approximately $1.2 million from commissions received in connection with the exchange of policies related to our deferred compensation plans. Total revenue for the years ended December 31, 2005 and 2004, included approximately $11.1 million and $11.3 million, respectively, related to supplemental compensation arrangements. Renewal revenue for the year ended December 31, 2005, was $142.8 compared to $157.5 million for the year ended December 31, 2004. The decrease in renewal revenue was expected and is primarily a result of changes in contract renewal commission rates that carriers pay on certain products as the policies age at both the Executive Benefits Practice and Banking Practice. Consulting fees for Pearl Meyer & Partners and Federal Policy Group as a percentage of total revenue increased to 15.6% for the year ended December 31, 2005 compared to 14.6% in the year ended December 31, 2004. For the year ended December 31, 2005, executive compensation consulting services experienced an increase in demand over the prior year due to corporate focus on corporate governance and executive compensation.
General and administrative expense. General and administrative expense for the year ended December 31, 2005 was $161.0 million, or 58.8% of total revenue, compared to $164.3 million, or 52.1% of total revenue, for the year ended December 31, 2004. The decrease in general and administrative expenses was attributable to a decrease in bonus expense associated with weaker financial results in 2005 compared to 2004.
Other income (expense). Other income for the year ended December 31, 2005 included $1.6 million of net life insurance proceeds following the death of an executive in our Healthcare Practice. This amount is not subject to taxation. The year ended December 31, 2004 results included a $1.5 million write-off of costs associated with a prospective securitization financing that was abandoned.
Income taxes. Income taxes for the year ended December 31, 2005 were $6.6 million, an effective tax rate of 38.5%, compared to $11.2 million, an effective tax rate of 38.2%, for the year ended December 31, 2004. The effective tax rate for the year ended December 31, 2005 is impacted by the $1.6 million of non-taxable life insurance proceeds received in the second quarter of 2005. There were net adjustments of approximately $380 thousand reducing income tax expense for the year ended December 31, 2004 reflecting favorable revisions to our state income tax rate as a result of implementation of several strategies aimed at reducing state income taxes.
Net income. Net income for the year ended December 31, 2005 was $10.6 million, or $0.58 per diluted common share, versus net income of $18.2 million, or $0.97 per diluted share, for the year ended December 31, 2004.
Year ended December 31, 2004 compared to year ended December 31,
Revenue. Total revenues for the year ended December 31, 2004 were $315.6 million, a decrease of 3.2% from revenues of $325.9 million for the year ended December 31, 2003. First year commission revenues for the year ended December 31, 2004 were $97.5 million compared to $113.3 million for the year ended December 31, 2003. First year revenue of the Banking Practice was $19.5 million less for the year ended December 31, 2004 when compared to the year ended December 31, 2003 due to clients’ efforts in mid 2003 to lock in interest rates prior to anticipated interest rate reductions in late 2003. Revenue for the years ended December 31, 2004 and 2003 included approximately $11.3 million and $10.3 million, respectively, related to supplemental compensation arrangements with insurance carriers. Renewal revenue for the year ended December 31, 2004, was $157.5 compared to $159.1 million for the year ended December 31, 2003. The decrease in renewal revenue is primarily the result of over funding of certain corporate plans in 2004. Consulting fees for Pearl Meyer & Partners and Federal Policy Group as a percentage of total revenue increased to 14.6% for the year ended December 31, 2004 compared to 12.0% in the year ended December 31, 2003. For the year ended December 31, 2004, consulting services experienced an increase in demand over the prior year due to corporate focus on corporate governance and executive compensation.
Commission and fee expense. Commission and fee expense for the year ended December 31, 2004 was $74.3 million, or 23.5% of total revenue, compared to $88.6 million, or 27.2% of total revenue, for the year ended December 31, 2003. The amount paid in commission expense (both in dollar terms and as a percent of revenue) declined primarily due to an increasing percentage of sales by employee consultants who have a lower commission rate than independent producers. In the second half of 2003, Banking Practice acquired two of its former independent producer organizations. Some of the commission savings from sales by employees is spent in the form of increased operating expenses. Independent producers cover their operating expenses out of their commissions. Also impacting the commission percentage to revenue is the higher amounts of supplemental compensation arrangement revenues and consulting revenues that have no related commission expense.
General and administrative expense. General and administrative expense for the year ended December 31, 2004 was $164.3 million, or 52.1% of total revenue, compared to $158.9 million, or 48.8% of total revenue, for the year ended December 31, 2003. The increase in general and administrative expenses was attributable to expenditures associated with Sarbanes-Oxley compliance ($1.6 million) and approximately $1.1 million of legal fees associated with the MacDonald litigation. The MacDonald litigation was settled with no cash being exchanged during the year ended December 31, 2004. Also contributing to the increase was approximately $6.9 million of additional bonus expense associated with the improved 2004 operating results versus 2003.
Human Capital Practice reorganization. In the fourth quarter of 2003, we reorganized our executive compensation consulting practices. As part of the reorganization, some of the operations and employees of the Human Capital Practice were transferred to the Pearl Meyer & Partners practice. In addition, several partners and staff members were terminated which resulted in exiting certain activities of the Human Capital Practice and creating unused leased office space in numerous cities. We recorded a charge of $7.5 million in the fourth quarter of 2003 relating to the reorganization, of which $3.3 million remained on the consolidated balance sheet as of December 31, 2004. During the year ended December 31, 2004, we recorded a net decrease to expense of approximately $200 thousand relating to the Human Capital Practice reorganization.
Other income (expense). Other income (expense) for the year ended December 31, 2004, includes a $1.5 million write-off of costs associated with a prospective securitization financing that was terminated in 2004.
Net income. Net income for the year ended December 31, 2004 was $18.2 million, or $0.97 per diluted common share, versus net income of $12.7 million, or $0.68 per diluted share, for the year ended December 31, 2003.
Our acquisition criteria focuses on the quality of management, future earnings, and the strategic fit with our company, as well as the growth potential of the target company. In several of our acquisitions, we also acquire the financial value embedded in a book of recurring renewal business that is expected to be realized for many years after the acquisition takes place. Historically, our future renewal revenue stream has been the source of collateral for our line of credit, which we frequently use for acquisitions. As we acquire more businesses that do not have this attribute, this may limit our future borrowing availability. We typically structure a majority of the purchase price in cash. We generally acquire little in the way of tangible assets, thus creating a substantial amount of intangible assets on our balance sheet. The companies we acquire are frequently privately owned and structured as subchapter S corporations and the acquisitions are usually effected through a purchase of assets with the income taxed directly to the stockholders of the target.
In the fourth quarter of 2003, we reorganized our executive compensation consulting practices. As part of the reorganization, some of the operations and employees of the Human Capital Practice were transferred to the Pearl Meyer & Partners Practice. In addition, four partners and six staff members were terminated which resulted in exiting certain activities of the practice and creating unused leased office space in numerous cities. We recorded a charge of $7.5 million in the fourth quarter of 2003 relating to the reorganization of which $2.7 million remains on the consolidated balance sheet as of December 31, 2005. The remaining business of the Human Capital Practice in 2004 consisted of actuarial/retirement plan and investment advisory services. Effective January 1, 2005, the Human Capital Practice was merged into the Executive Benefits Practice.
A portion of our revenue is derived from certain supplemental compensation arrangements with insurance carriers. These arrangements generate additional revenue with respect to primarily existing and, to a lesser extent, new blocks of business. Payments under such arrangements are typically based on the cash value (or fair value) of our existing in-force business with these carriers at specified dates of measurement and, to a much lesser extent, based on the value of new business generated. We realized approximately $11.1 million, $11.3 million and $10.3 million in revenue under such arrangements for the twelve months ended December 31, 2005, 2004, and 2003, respectively. Future payment amounts would be negatively impacted by potential future surrenders of the inforce business or non-renewal of the agreements and positively impacted by asset growth of these contracts.
Total revenue for the year ended December 31, 2005 was $59.1 million compared to $81.5 million for the year ended December 31, 2004, a decrease of 27.4%. First year commission revenue for the year ended December 31, 2005 was $15.8 million compared to $26.2 million for the year ended December 31, 2004. On September 29, 2005, the Treasury Department issued initial guidance regarding changes to nonqualified deferred compensation plans necessitated by the American Jobs Creation Act, passed in October 2004. The delay in receiving guidance created uncertainty in regards to amending existing plans and delayed the implementation of new plans. Consulting revenue (included in first year revenue) decreased 14.2% due to a significant decline in the number of consultants. First year 2004 revenue for the year ended December 31, 2004 included $8.6 million for one large case. Renewal revenue for the year ended December 31, 2005 was $36.1 million compared to $46.5 million for the year ended December 31, 2004. The decrease in renewal revenue is primarily the result of the timing of premium payments from certain clients, some of which were delayed pending Treasury Department guidance mentioned above, and changes in contract renewal rates that carriers pay on certain cases as the policies age. Commission expense as a percentage of total revenue decreased to 31.1% for the year ended December 31, 2005, from 35.9% for the year ended December 31, 2004, due to the decreased revenue resulting in lower tiered payouts to producers. General and administrative expense for the year ended December 31, 2005 was $38.2 million compared to $41.1 million for the year ended December 31, 2004. The decrease is primarily a result of weaker financial results than 2004 generating less bonus expense.
Total revenue decreased 15.2% to $123.1 million for the year ended December 31, 2005, from $145.2 million for the year ended December 31, 2004. First year revenues for the year ended December 31, 2005 were $28.8 million compared to $46.8 million for the year ended December 31, 2004. First year revenue was impacted by a soft market for BOLI products and the historically low long-term interest rate environment. On September 29, 2005, the Treasury Department issued initial guidance regarding changes to nonqualified deferred compensation plans necessitated by the American Jobs Creation Act, passed in October 2004. The delay in receiving guidance created uncertainty in regards to amending existing plans and delayed the implementation of new plans. Total revenue for the years ended December 31, 2005 and 2004 included approximately $6.2 million and $6.6 million, respectively, related to supplemental compensation arrangements. Renewal revenue for the years ended December 31, 2005 and 2004, was $94.3 million and $98.4 million, respectively. The decrease in renewal revenue is a result of the changes in contract renewal commission rates that carriers pay on certain products as policies age and the mix of products. Commission expense for the year ended December 31, 2005 was $28.9 million, or 23.5% of revenue, compared to $41.0 million, or 28.2% of revenue, for the year ended December 31, 2004. The commission expense as a percentage of revenue continues to decrease due to the lower first year revenue and significant reduction in independent producer commission expense. General and administrative expenses for the year ended December 31, 2005 was $45.4 million, compared to $44.9 million for the year ended December 31, 2004. These expenses increased primarily as a result of costs associated with the BancPlan acquisition in May of 2005. Amortization expense for the years ended December 31, 2005 and 2004 was $10.5 million and $12.3 million, respectively. The decrease is based on the timing of scheduled amortization of our acquired inforce revenue.
Total revenue decreased 12.4% to $145.2 million for the year ended December 31, 2004, from $165.8 million for the year ended December 31, 2003. First year revenues for the year ended December 31, 2004 were impacted by a soft market for BOLI products, historically low interest rates, and sales force turnover that occurred in the second quarter of 2004. Total revenue for the years ended December 31, 2004 and 2003 included approximately $6.6 million and $4.7 million, respectively, related to supplemental compensation arrangements. Renewal revenue for the years ended December 31, 2004 and December 31, 2003, was $98.4 million and $99.5 million, respectively. Commission expense for the year ended December 31, 2004, was $41.0 million, or 28.2% of revenue, compared to $55.0 million, or 33.2% of revenue, for the same period in 2003. The commission expense as a percentage of revenue continues to decrease as a result of a higher percentage of first year revenue produced by employee consultants versus independent producers and the mix between first year revenues and renewal revenues. In addition, we do not pay commission expense on the revenue associated with the supplemental compensation arrangements. In the second half of 2003, Banking Practice acquired two of its former independent producer organizations. General and administrative expense for the year ended December 31, 2004, was $44.9 million, or 30.9% of revenue, compared to $40.4 million, or 24.3% of revenue, for the comparable period in 2003. We terminated seventeen Banking Practice employees, representing roughly 6% of the Practice’s employees, or 2% of our employees, in September of 2004. The actions resulted in $230 thousand of severance costs. The higher percentage of general and administrative expenses to revenue reflects increased operating expenses relating to former independent producers and the lower revenue base. Amortization expense for the year ended December 31, 2004 and 2003, was $12.3 million and $15.2 million, respectively. The decrease is based on the timing of scheduled amortization of our inforce revenue and a $550 thousand adjustment to the purchase accounting for the LongMiller acquisition in the third quarter of 2003.
Healthcare Group revenues were slightly lower (1.2%) for the year ended December 31, 2004, compared to December 31, 2003. First year commission revenue for the year ended December 31, 2004, was lower by $3.3 million than December 31, 2003 due to a lower number of new implementation projects and lower add-on commissions as a result of split dollar regulations and clients electing to split consulting engagements from the company who sells the funding solution. However, consulting fee revenue (included in first year revenue) increased over December 31, 2003 by $1.7 million due to growth in several services. Renewal revenue for the year ended December 31, 2004 was approximately $10.4 million compared to $9.1 million for the year ended December 31, 2003. General and administrative expenses remained flat due to cost containment efforts.
Consulting revenue increased 3.1% to $34.1 million for the year ended December 31, 2005, compared to $33.1 million for the year ended December 31, 2004. Practice performance through the first nine months of 2005 was improved over the same timeframe as 2004. Fourth quarter 2005 performance was weaker than fourth quarter 2004 due to the factors mentioned above. Operating expenses for the year ended December 31, 2005 were $29.4 million compared to $27.7 million for the year ended December 31, 2004. The increase is due to the additional expenses from higher headcounts during the first nine months of 2005 compared to first nine months of 2004.
Total consulting revenue increased 23.2% to $33.1 million for the year ended December 31, 2004, compared to $26.9 million for the year ended December 31, 2003. The practice continued to experience more sales activity as a result of additional engagements in its areas of expertise of corporate governance and executive compensation due, in part, to increased public scrutiny of these areas. Operating expenses were $27.7 million for the year ended December 31, 2004, compared to $25.8 million for the year ended December 31, 2003 reflecting higher headcount (97 in 2004 and 83 in 2003).
(1) Includes restricted cash and current portion of debt associated with asset-backed non-recourse notes.
(3) Current debt plus long-term debt divided by current debt plus long-term debt plus stockholders' equity.
As a company with historically strong operating cash flow, we believe we have little need to maintain substantial cash balances. To the extent we have net cash from operating activities, we use it to fund capital expenditures, and service existing debt. We expect large cash outlays, such as future acquisitions, will be financed primarily through externally available funds. However, we can offer no assurance such funds will be available and, if so, on terms acceptable to us.
In addition to our tangible balance sheet assets and liabilities, we have an on-going non-securitized renewal revenue stream, estimated to be $765.8 million, on a gross basis, over the next ten years. This on-going renewal revenue stream reflects current conditions and is not necessarily indicative of the revenue that may actually be achieved in the future and we cannot assure you that commissions under these policies will be received.
The following tables represent the estimated gross renewal revenue associated with the business-owned life insurance policies owned by our clients as of December 31, 2005. The projected gross revenues are not adjusted for mortality, lapse, or other factors that may impair realization, have not been discounted to reflect their net present value, and do not reflect the commission expense we must pay to consultants when we recognize the related revenue. We cannot assure you that commissions under these policies will be received. These projected gross revenues are based on the beliefs and assumptions of management and are not necessarily indicative of the revenue that may actually be realized in the future.
Non-securitized Gross Inforce Revenues. The following table represents the estimated gross inforce revenue associated with business-owned life insurance policies owned by our clients as of December 31, 2005, not including estimated securitized inforce revenues, which are set forth in a separate table.
Pearl Meyer & Partners and Federal Policy Group generate fee-based revenues and do not produce inforce revenues.
During the year ended December 31, 2005, $20.1 million of cash was used for the acquisition of the businesses including contingent consideration payments to prior owners of businesses we acquired and $6.2 million of cash was used for the purchases of fixed assets.
A substantial portion of the purchase price used to fund acquisitions has historically been paid in cash. This is primarily due to our desire to avoid diluting our existing stockholders. We expect acquisitions to continue to be financed primarily from available credit lines and possible additional equity. However, we can offer no assurances such will be the case.
For the year ended December 31, 2005, approximately $30.9 million of cash was used for financing activities. We used approximately $19.2 million for the net repayment of borrowings, approximately $3.2 million for payment of dividends, and $13.9 million for the repurchase of our stock.
As of December 31, 2005, there was restricted cash of approximately $7.8 million, a decrease of $4.2 million from December 31, 2004, which will be used to pay down the asset-backed notes issued to finance the acquisition of LongMiller. This cash is not available for general corporate purposes, but is solely to service securitization indebtedness incurred to finance the acquisition of LongMiller.
We expect to make significant cash outlays in future years for interest, taxes, and deferred compensation arrangements. However, due to their variable nature, no amounts for these items have been included in the table above.