The Company’s corporate headquarters is located at 787 Seventh Avenue, 11th Floor, New York, NY 10019, where the Company leases approximately 35,200 square feet of space. The Company’s subsidiaries NFPSI and NFPISI lease approximately 63,177 square feet of space in Austin, Texas. Additionally, the Company’s firms lease properties for use as offices throughout the United States. The Company believes that its existing properties are adequate for the current operating requirements of NFP’s business and that additional space will be available as needed.
You should read the selected consolidated financial data set forth below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the consolidated financial statements and the related notes included elsewhere in this report. The Company derived the following selected financial information as of December 31, 2006 and 2005 and for each of the three years in the period ended December 31, 2006 from the Company’s audited consolidated financial statements and the related notes included elsewhere in this report. The Company derived the selected financial information as of December 31, 2004, 2003 and 2002 and for each of the two years in the period ended December 31, 2003 from the Company’s audited consolidated financial statements and the related notes not included elsewhere in this report.
As a result of adopting SFAS 123R the Company recorded, for firm employees, principals and firm activities, a charge to cost of services of $3.2 million for 2006. The Company recorded $6.0 million of such expense for 2006, in corporate and other expenses-general and administrative. Previously all stock-based compensation was included in general and administrative expense as a component of corporate and other expenses. Total stock-based compensation for 2006 was $9.2 million. Total stock-based compensation of $4.5 million in 2005, $1.4 million in 2004, $0.2 million in 2003, and $9.9 million in 2002 is included in corporate and other expenses-general and administrative to conform to the current period presentation.
combined firm continues to be included in the calculation after the merger. With respect to the sub-acquisitions described above, to the extent the sub-acquired firm does not separately report financial statements to NFP, the acquiring firm is excluded from the calculation from the time of the sub-acquisition until the first fiscal quarter beginning one year following the sub-acquisition. Sub-acquisitions that represent less than 25% of the base earnings of the acquiring firms are considered to be internal growth. For further information about sub-acquisitions, see “Business-Operations-Sub-Acquisitions.” With respect to dispositions, the Company includes these firms up to the time of disposition and excludes these firms for all periods after the disposition. The calculation is adjusted for intercompany transactions for all periods after December 31, 2005. Management believes that the intercompany adjustments made to the internal revenue growth rate for periods after December 31, 2005 does not significantly impact its comparability with prior year periods.
(d) The growth of revenue less commissions and fees as a component of cost of services of firms included in the internal revenue growth calculation, as defined above.
Operating expenses. The Company’s firms incur operating expenses related to maintaining individual offices, including compensating producing and non-producing staff. Firm operating expenses also include the expenses of NFPSI and NFPISI, two subsidiaries that serve the Company’s acquired firms and through which the Company’s acquired firms and its third-party distributors who are members of its marketing organizations access insurance and financial services products and manufacturers. With the adoption of SFAS 123R the Company now records share-based payments related to firm employees and firm activities to operating expenses as a component of cost of services. Previously all share-based expense components for year end periods prior to December 31, 2006 were recorded under Corporate and other expenses - general and administrative expense.
Management fees. The Company pays management fees to the principals of its firms and/or certain entities they own based on the financial performance of the firms they manage. The Company typically pays a portion of the management fees monthly in advance. Once the Company receives cumulative preferred earnings (base earnings) from a firm, the principals and/or an entity the principals own will earn management fees equal to earnings above base earnings up to target earnings. An additional management fee is paid in respect of earnings in excess of target earnings based on the ratio of base earnings to target earnings. For example, if base earnings equal 40% of target earnings, the Company receives 40% of earnings in excess of target earnings and the principal and/or the entity receives 60%. A majority of the Company’s acquisitions have been completed with a ratio of base earnings to target earnings of 50%. Management fees also include an accrual for certain performance-based incentive amounts payable under the Company’s ongoing incentive plan. Incentive amounts are paid in a combination of cash and the Company’s common stock. For firms that began their incentive period prior to January 1, 2005, the principal could elect from 0% to 100% to be paid in the Company’s common stock.
(1) Excludes amortization and depreciation, which are shown separately as part of Corporate and other expenses.
General and administrative. At the corporate level, the Company incurs general and administrative expense related to the acquisition and administration of its firms. General and administrative expense includes both cash and stock-based compensation, occupancy, professional fees, travel and entertainment, technology, telecommunication, advertising and marketing, internal audit and certain corporate compliance costs. Prior to the adoption of SFAS 123R on January 1, 2006, all stock-based compensation was included in general and administrative expense. Effective January 1, 2006, all stock-based compensation related to firm employees, principals or firm activities has been included in cost of services. Stock-based compensation related to firm employees and firm activities issued prior to the adoption of SFAS 123R totaled approximately $3.2 million, $1.1 million, and $0.2 million for the full year 2006, 2005 and 2004 respectively. Total stock-based compensation for 2006 was $9.2 million. Total stock-based compensation of $4.5 million in 2005 and $1.4 million in 2004 is included in corporate and other expenses-general and administrative.
Depreciation. The Company incurs depreciation expense related to capital assets, such as investments in technology, office furniture and equipment as well as amortization for its leasehold improvements. Depreciation expense related to the Company’s firms as well as the Company’s corporate office is recorded within this line item.
Impairment of goodwill and intangible assets. The firms the Company acquires may not continue to positively perform after the acquisition for various reasons, including legislative or regulatory changes that affect the products in which a firm specializes, the loss of key clients after the acquisition closed, general economic factors that impact a firm in a direct way, the cultural incompatibility of an acquired firms management team with the Company and the death or disability of significant principals. In such situations, the Company may take impairment charges in accordance with SFAS No. 142 and SFAS No. 144 and reduce the carrying cost of acquired identifiable intangible assets (including book of business, management contracts, institutional customer relationships and tradename) and goodwill to their respective fair values. Management reviews and evaluates the financial and operating results of the Company’s acquired firms on a firm-by-firm basis throughout the year to assess the recoverability of goodwill and other intangible assets associated with these firms. In assessing the recoverability of goodwill and other intangible assets, management uses historical trends and makes projections regarding the estimated future cash flows and other factors to determine the recoverably of the respective assets. If a firm’s goodwill and other intangible assets do not meet the recoverability test, the firm’s carrying value will be compared to its estimated fair value. The fair value is based upon the amount at which the acquired firm could be bought or sold in a current transaction between the Company and the principals and/or the present value of the assets’ future cash flows. The intangible assets associated with a particular firm may be impaired when the firm has experienced a significant deterioration in its business indicated by an inability to produce at the level of base earnings for a period of four consecutive quarters and when the firm does not appear likely to improve its operating results or cash flows in the foreseeable future. Management believes that this is an appropriate time period to evaluate firm performance given the seasonal nature of many firms’ activities.
Loss (gain) on sale of businesses. From time to time, the Company has disposed of acquired firms or certain assets of acquired firms. In these dispositions, the Company may realize a gain or loss on the sale of acquired firms or certain assets of acquired firms.
internal growth. For further information about sub-acquisitions, see “Business-Operations-Sub-Acquisitions.” With respect to dispositions, the Company includes these firms up to the time of disposition and excludes these firms for all periods after the disposition. The calculation is adjusted for intercompany transactions for all periods after December 31, 2005. Management believes that the intercompany adjustments made to the internal revenue growth rate for periods after December 31, 2005 does not significantly impact its comparability with prior year periods.
Commissions and fees. Commissions and fees expense increased $100.3 million, or 40.5%, to $348.1 million in 2006 from $247.8 million in 2005. Commissions and fees expense from existing firms increased $71.0 million, to $318.8 million in 2006 from $247.8 million in 2005. Commissions and fees expense from new firms in 2006 totaled $29.2 million. As a percentage of revenue, commissions and fees expense increased to 32.3% in 2006 from 27.8% in 2005. The increase in commissions and fees expense was primarily due to increased production with third party producers and other non-affiliated firms and higher payouts in wholesale entities. In addition, there was an increase in the mix of revenue generated through wholesale operations which have higher payouts.
Management fees. Management fees increased $9.3 million, or 4.5%, to $217.9 million in 2006 compared with $208.6 million in 2005. The increase in management fee expenses is due to increased earnings at acquired firms. Management fees as a percentage of revenue decreased to 20.2% in 2006 from 23.4% in 2005. Management fees were 52.2% of gross margin before management fees in 2006 compared with 54.4% in 2005. The decrease in management fees, as a percentage of both revenues and gross margin before management fees, results from higher earnings at NFPISI and NFPSI for which no management fee expense is incurred and additional management fees of $6.1 million incurred in 2005 due to the transition to a single methodology for both calculating and paying management fees partially offset by increased accruals for ongoing incentive plans in 2006. The accrual for ongoing incentive plans was $17.0 million in 2006 as compared to $13.6 million in 2005.
Income tax expense. The effective tax rate was 43.2% in 2006 compared with 42.1% in 2005. The effective tax rate differs from the provision calculated at the federal statutory rate primarily because of certain expenses that are not deductible for tax purposes, as well as the effects of state and local taxes. The effective tax rate rose in 2006 resulting largely from higher nondeductible expenses related to impairments and the absence of non-taxable key person life insurance proceeds received in 2005.
Net income. Net income increased $16.1 million, or 40.1%, to $56.2 million in 2005 compared with $40.1 million in 2004. The increase in 2005 was primarily a result of the continued growth of existing firms, the acquisition of new firms (both terms as previously defined) and a decrease in the estimated effective tax rate to 42.1% in 2005 from 44.4% in 2004.
Operating expenses. Operating expenses increased $69.7 million, or 36.6%, to $259.9 million in 2005 compared with $190.2 million in 2004. As a percentage of revenue, operating expenses declined to 29.2% in 2005 from 29.7% in 2004 as the rate of expense growth was below the rate of revenue growth. Operating expenses from new acquisitions were approximately $49.1 million in 2005. Operating expenses from existing firms were approximately $210.8 million in 2005, an increase of $36.0 million, or 20.6%, from $174.8 million in 2004.
Gross margin. Gross margin increased $34.7 million, or 24.7%, to $175.1 million in 2005 compared with $140.4 million in 2004. As a percentage of revenue gross margin declined to 19.6% in 2005 compared with 22.0% in 2004 as a result of the higher commissions and fees and management fees paid partially offset by a lower rate of growth of firm operating expenses. Excluded from gross margin are stock-based compensation and depreciation expense related to firm operations which have historically been shown as separate line items in Corporate and other expenses. Total stock-based compensation and depreciation expense related to firm operations totaled $1.1 million and $5.3 million in 2005 and $0.2 million and $5.1 million in 2004, respectively.
General and administrative. General and administrative expenses increased $8.9 million, or 24.2%, to $45.7 million in 2005 compared with $36.8 million in 2004. The increase resulted primarily from $4.0 million of expenses related to the Company’s internal review of its insurance operations coupled with an increase in compensation and related costs, including compensation of $5.8 million principally due to planned increases in the corporate infrastructure to support acquisitions and internal growth, partially offset by lower cost related to the implementation of Sarbanes-Oxley. The increase in compensation of $5.8 million includes a $3.1 million increase in stock-based compensation which was principally due to new awards granted during the fourth quarters of 2004 and 2005. As a percentage of revenue, general and administrative expense declined to 5.1% in 2005 compared with 5.7% in 2004, as the Company continues to benefit from the absorption of corporate expenses over an expanding revenue base.
Amortization. Amortization increased $4.2 million, or 21.5%, to $23.7 million in 2005 compared with $19.5 million in 2004. Amortization expense increased as a result of a 20.7% increase in amortizing intangible assets resulting primarily from new acquisitions. As a percentage of revenue, amortization was 2.7% in 2005 compared with 3.0% in 2004.
Interest and other expense. Interest and other expense increased $2.7 million, or 96.4%, to $5.5 million in 2005 compared with $2.8 million in 2004. The increase was principally comprised of higher interest expense resulting from increased average borrowings for acquisitions (see “-Liquidity and Capital Resources”).
The 2004 effective tax rate included $2.9 million of adjustments to deferred tax assets and liabilities, of which $1.1 million related to purchase accounting adjustments and partnership earnings from the period 1999 through 2001.
reflected in cash flows from operating activities. Investing activities also include capital expenditures, largely to support the corporate technology infrastructure and those acquired firms engaged in providing third party administration services or platforms. Financing activities reflect the use of available credit facilities, capital transactions and dividends returned to shareholders. The Company’s cash requirements are principally impacted by the timing of the Company’s acquisitions and the Company uses its bank credit facility to provide for the excess cash needs, which typically occurs earlier in the fiscal year. As acquisitions slow in the latter part of the fiscal year, the Company’s cash flow from operations are used to reduce outstanding borrowings. The Company expects this pattern of cash usage to continue in 2007.
Cash and cash equivalents at December 31, 2006 declined by $7.6 million from the prior year end principally due to a decrease in cash flows provided by financing activities as fewer stock-based awards were exercised and dividends to shareholders increased. Cash flows provided by operations and used in investing activities were comparable to the prior year. Cash and cash equivalents at December 31, 2005 had increased $22.7 million from December 31, 2004 as the increased cash flows used in investing activities, principally acquisitions, were supported by increased cash flows from financing activities, including borrowings under the Company’s bank credit facility and proceeds received from the exercise of stock-based awards. At December 31, 2004 cash and cash equivalents increased $11.9 million from the prior year end.
result of net borrowings under the Company’s line of credit of $43.0 million and cash proceeds received from the exercise of stock options, including tax benefit of $10.4 million, offset by approximately $22.6 million in dividend payments. During 2005, cash provided by financing activities was primarily the result of net borrowings under the Company’s line of credit of $40.0 million and cash proceeds received from the exercise of stock options, including tax benefit, of $25.4 million offset by approximately $17.0 million in dividend payments. In 2004, cash used in financing activities was largely the result of $13.3 million of common stock dividends paid offset by $8.0 million of cash proceeds from the exercise of stock options, including tax benefit.
Some of the Company’s firms maintain premium trust accounts, which represent payments collected from insureds on behalf of carriers. Funds held in these accounts are invested in cash, cash equivalents and securities purchased under resale agreements (overnight). At December 31, 2006, the Company had cash, cash equivalents and securities purchased under resale agreements in premium trust accounts of $57.4 million, an increase of $5.0 million from the balance of $52.4 million at December 31, 2005. At December 31, 2005, the Company had cash, cash equivalents and securities purchased under resale agreements in premium trust accounts of $52.4 million, a decrease of $1.3 million from the balance of $53.7 million at December 31, 2004. Changes in these accounts are the result of timing of payments collected from insureds on behalf of insurance carriers.
On August 22, 2006, the Company entered into a $212.5 million credit facility with Bank of America, N.A., as administrative agent. This credit facility replaced the Company’s previous $175 million credit facility and is used to finance acquisitions and fund general corporate purposes.
Borrowings under the credit facility bear interest, at the Company’s election, at a rate per annum equal to (i) at any time when the Company’s Consolidated Leverage Ratio, as defined in the credit facility, is greater than or equal to 2.0 to 1.0, the ABR plus 0.25% per annum or the Eurodollar Rate plus 1.25%, (ii) at any time when the Company’s Consolidated Leverage Ratio is less than 2.0 to 1.0 but greater than or equal to 1.0 to 1.0, the ABR or the Eurodollar Rate plus 1.00% and (iii) at any time when the Company’s Consolidated Leverage Ratio is less than 1.0 to 1.0, the ABR or the Eurodollar Rate plus 0.75%. As used in the credit facility, “ABR” means, for any day, the greater of (i) the federal funds rate in effect on such day plus 0.5% and (ii) the rate of interest in effect as publicly announced by Bank of America as its prime rate.
The credit facility is structured as a revolving credit facility and matures on August 22, 2011. The Company’s obligations under the credit facility are secured by all of its and its subsidiaries’ assets. Up to $35 million of the credit facility is available for the issuance of letters of credit and there is a $10 million sublimit for swingline loans. The credit facility contains various customary restrictive covenants that prohibit the Company and its subsidiaries from, subject to various exceptions and among other things, (i) incurring additional indebtedness or guarantees, (ii) creating liens or other encumbrances on property or granting negative pledges, (iii) entering into a merger or similar transaction, (iv) selling or transferring certain property, (v) declaring dividends or making other restricted payments and (vi) making investments. In addition, the credit facility contains financial covenants requiring the Company to maintain a minimum interest coverage ratio and a maximum consolidated leverage ratio.
The Company had a balance of $83 million under its credit facility as of December 31, 2006 and a balance of $40 million under its previous credit facility at December 31, 2005. At December 31, 2006 management believes that the Company was in compliance with all covenants under the facility.
On June 9, 2006 the Company filed a shelf registration statement on Form S-3 with the SEC. The shelf registration statement allows NFP to borrow using various types of debt instruments, such as fixed or floating rate notes, convertible or other indexed notes, as well as to issue preferred and/or common stock. In addition, NFP’s restricted stockholders are permitted to use the shelf to sell shares into the secondary market. As of December 31, 2006 there were no issuances under the shelf registration statement. Subsequent to year end, NFP issued $230 million of convertible senior notes and certain of the Company’s stockholders offered 1,850,105 shares of NFP common stock through a secondary offering under this shelf. See also Item 8 - Financial Statements and Supplementary Data-Note 19-Subsequent Events.
The Company has from time to time disposed of firms. The Company has also agreed, in certain cases, to reduce the levels of base earnings and target earnings in exchange for a payment from the principals of a firm. In these situations, the Company typically takes back a note for a portion of the cost of the disposition or the restructuring to the principal.
In the ordinary course of business, the Company is involved in lawsuits and other claims. Management considers these lawsuits and claims to be without merit and the Company intends to defend them vigorously. In addition, the sellers of firms that the Company acquires typically indemnify it for loss or liability resulting from acts or omissions occurring prior to the acquisition, whether or not the sellers were aware of these acts or omissions. Several of the existing lawsuits and claims have triggered these indemnity obligations.
During 2004, several of the Company’s firms received subpoenas and other informational requests from governmental authorities, including the New York Attorney General’s Office, seeking information regarding compensation arrangements, any evidence of bid rigging and related matters. The Company has cooperated and will continue to cooperate fully with all governmental agencies.
In March 2006, the Company received a subpoena from the New York Attorney General’s Office seeking information regarding life settlement transactions. One of the Company’s subsidiaries received a subpoena seeking the same information. The Company is cooperating fully with the Attorney General’s investigation. The investigation, however, is ongoing and the Company is unable to predict the investigation’s outcome.
The Company cannot predict at this time the effect that any current or future regulatory activity, investigations or litigation will have on its business. Given the current regulatory environment and the number of the Company’s subsidiaries operating in local markets throughout the country, it is possible that the Company will become subject to further governmental inquiries and subpoenas and have lawsuits filed against it. The Company’s ultimate liability, if any, in connection with these matters and any possible future such matters is uncertain and subject to contingencies that are not yet known.
The Company’s $212.5 million credit facility provides for the issuance of letters of credit of up to $35 million on NFP’s behalf, provided that, after giving effect to the letters of credit, the Company’s available borrowing amount is greater than zero. As of December 31, 2006 the Company was contingently obligated for letters of credit in the amount of $1.6 million.
The minimum contingent payments which could be payable as purchase consideration and employee compensation in each year is zero. The maximum contingent payment which could be payable as purchase consideration and employee compensation based on commitments outstanding as of December 31, 2006 consists of the following:
The maximum contingent consideration is generally payable upon a firm achieving a 35% rate of growth, or higher, in earnings during the first three years following acquisition. The payments of purchase consideration are generally made in cash and the Company’s common stock (based on the average closing price of NFP common stock for the twenty trading days up to and including the end of the period), in proportions that vary among acquisitions. Contingent firm employee payments are generally payable in cash and recorded as an expense in the year earned.
The table below shows the Company’s contractual obligations as of December 31, 2006:
In accordance with SFAS No. 142, the Company recognized an impairment loss on goodwill and identifiable intangible assets not subject to amortization of $5.2 million, $3.1 million, and $2.4 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company’s firms earn commissions related to the sale of securities and certain investment-related insurance products. NFP firms also earn fees for offering financial advice and related services. These fees are based on a percentage of assets under management and are generally paid quarterly. In certain cases, incentive fees are earned based on the performance of the assets under management. Some of the Company’s firms charge flat fees for the development of a financial plan or a flat fee annually for advising clients on asset allocation. Any investment advisory or related fees collected in advance are deferred and recognized as income on a straight-line basis over the period earned. Transaction-based fees, including performance fees, are recognized when all contractual obligations have been satisfied. Securities and mutual fund commission income and related expenses are recorded on a trade date basis.
The Company is authorized under its Amended and Restated 1998, 2000 and 2002 Stock Incentive Plans, and the Company’s Amended and Restated 2000 and 2002 Stock Incentive Plans for Principals and Managers, to grant stock options, stock appreciation rights, restricted stock units, and performance units to officers, employees, principals of its acquired firms and/or certain entities principals own, independent contractors, consultants, non-employee directors and certain advisory board members. Awards granted under the 1998, 2000 and 2002 Stock Incentive Plans are generally subject to a vesting period from 0 to 10 years from the date of grant. Awards granted under the 2000 and 2002 Stock Incentive Plans for Principals and Managers generally vest immediately upon grant.
Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123R which is a revision of SFAS 123, which superseded APB 25 and amended SFAS No. 95, “Statement of Cash Flows.” The Company adopted the modified prospective transition method provided for under SFAS 123R and, accordingly, has not restated prior year amounts. Under the transition method, compensation expense for 2006 includes compensation expense for all share-based payment awards granted prior to, but not yet vested as of, January 1, 2003, the date of the Company’s adoption of SFAS 123, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Stock-based compensation expense includes an estimate for forfeitures which is recognized over the expected term of the award on a straight-line basis. The Company evaluated the need to record a cumulative effect adjustment relating to estimated forfeitures for unvested previously issued awards and the impact was not deemed to be material.